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The Winds of November

There’s no mistaking autumn. The air is crisp and clear, the foliage awash in color, our lawn blanketed by a tapestry of leaves, and football season is in full swing. Yet “seasonality” applies to more than just foliage and professional sports. For those of us in the claims resolution field, autumn is the time of year when the concept of structuring attorney fees once again takes center stage.

Why autumn you ask? It’s only natural: by this time of year, law firms and attorneys have a pretty good handle on how much income they’re going to have to report for the year. And if it’s been a good year and they have already been pushed into the higher tax brackets, then it makes no sense to receive additional income in this tax cycle. It will only be taxed at that same high rate. Opting to defer further compensation into another tax year might work out better.

How is this accomplished? According to noted tax attorney Rob Wood, the legal picture on this strategy has clarified much over the past ten years.1 Protocols now exist to make this a fairly routine transaction. Provided an attorney has a contingent fee arrangement in place with their client, they may craft/amend that agreement to permit the payment of fees over time rather than having the full amount due at time of settlement. Under this alternative arrangement, payments are made directly from the defendant to the attorney as opposed to being paid first to the client and then to the attorney.

Mechanically, structured attorney fee arrangements are established just like ordinary structured settlements: via purchase of an annuity owned by an assignment company paid directly by the defense carrier or self-insured. Funds that would formerly have been included in the cash portion of the settlement are instead included in the amount allocated to structure.

When set up this way, the lawyer pays tax only in the year that he or she actually receives the money. For example, instead of receiving a $500,000 lump sum at time of settlement, the lawyer might receive $70,000 a year for ten years (the extra $200,000 in this example is attributable to the tax-deferred interest earned on the money). Rather than paying taxes on $ 500,000 this year the attorney pays taxes on the $ 70,000 per year as it is received. Remember, attorney fee structures are only tax-deferred, not tax-free as the future payments will generally be to the claimant. 2

The key tax ruling governing tax treatment of periodic payments for legal fees was secured in a 1994 case known as Childs v. Commissioner 3. In this case, the IRS argued that it did not matter when the attorney received payment, his fee was earned the year settlement was achieved. But, the tax court ruled otherwise, holding that the attorney did not necessarily constructively receive income merely because an annuity contract had been purchased to meet future payments owed for legal. The fair market value of the right to receive payments was not includible as income at the time of the annuity purchase and the attorney was not liable for taxes until they actually received payments from the annuity.

[Please note that although the author of this newsletter may be a highly skilled professional and expert on all things regarding structured settlements, he is not, however, a tax attorney. Any transaction involving tax strategies should be entered into only after consultation with a qualified tax attorney.]

Like ordinary structures, structured attorney fees must be established as a part of the settlement and the future payments reflected in the settlement agreement and release and qualified assignment documents. A structured legal fee should follow the tried and true format of using a single premium immediate annuity as the funding vehicle; attempts to use other funding vehicles in structuring legal fees have been problematic at best. There is a time and a place to be creative but this is not one of them. A traditional annuity issued by a state-regulated life insurance company offers maximum planning flexibility while still ensuring that the arrangement is respected for tax purposes.

Although I have framed today’s discussion around the theme of seasonality and year-end tax planning, structured legal fees provide other benefits as well. Many trial attorneys employ them to level out the peaks and valleys of an inherently unpredictable business. Some of the lawyers I work with will structure a portion of every contingent fee as a method of retirement planning. The income arrives on the dates and in the amounts they contracted for, guaranteed and without any false limitations on contribution levels as are the case with 401(k) plans.

More importantly, to the extent they defer income until after they have retired from active practice, their income tax rate may be lower, thus allowing them to keep a greater percentage of the income after taxes.

This particular kind of tax planning is not available to other high wage earners, only attorneys working on contingent fee have the chance to plan their income in this way. It is a big advantage in many cases and now is the time to get going on it.

It is generally a good idea to raise this idea on any large settlement between now and the end of the year. And if you would like help explaining how it all works, call Frank C. Kilcoyne, CSSC at 800-544-5533. I am here to help.

1 "Ten Things CPAs Need to Know about Structured Legal Fees", the Tax Adviser (July 2008), p.435.

2 Provided the compensation is for personal physical injury as per IRC Section 104

3 Childs v. Commissioner, 103 T.C. 634 (1994)