Structuring attorney fees is increasingly becoming part of a law firm or sole practitioner’s financial planning strategy. Not every fee is eligible and certain initial steps must be taken so the fee qualifies for its preferred tax status. Patrick Farber, a structured settlements broker at Ringler Associates in California, talked with Mark Simurda, a CPA and tax partner with Lesley, Thomas, Schwarz & Postma, Inc., in Newport Beach about structuring settlement fees.
Pat: What types of cases are best suited for fee structuring?
Mark: Fee structures can be done with injury and sickness cases that have unknown value at the inception and are paid upon settlement. Cases that are billed and paid hourly do not qualify.
Pat: Why do the deferred fees not count against an attorney’s taxes in the year a case is settled?
Mark: If an attorney is a cash basis taxpayer, structuring the fee results in an annuity payable over a period of time. If properly executed and documented, the income is not taxable until received. This treatment is best reflected in the Childs v. Commissioner case. In Childs the Plaintiff’s attorney received an annuity as payment for his contingent fee. The annuity was created with various features so that it was considered neither funded nor secured. As such, the annuity was not includable in income under Internal Revenue Code Section 83 until payment was actually received.
Pat: Does the attorney structuring a fee, have the same beneficiary designation options on the annuity as the injured client?
Mark: The attorney who receives the annuity can always change the beneficiary designation at anytime subject to the agreement with the insurance company. However, if the attorney or firm are changed from the main beneficiary, care should be taken as unintended taxes (gift) may be incurred.
Pat: Can attorneys arrange a structured fee themselves with an insurance agent after settlement?
Mark: No, the decision to structure a fee must be done early in the process. Once an attorney receives an agreeable settlement, the fee is considered earned. At that point, it is too late to arrange for an annuity instead of a cash payout.
Pat: Are attorneys ever better off taking the fee in cash and paying the taxes upfront?
Mark: The concern about delaying payment through a fee structure is that income tax rates will increase and reduce the amount received over time. While this concern is well founded, looking at ways to mitigate the tax while giving the firm various future advantages should be explored. These advantages include the ability to fund various pension plans, stabilize firm revenues and create tax-deferred reserves for case opportunities.
The ability to respond to future case opportunities is probably the best feature of the annuity. The decision to accept and manage a large case (or group of cases) may be easier to make knowing the firm has guaranteed, substantial reserves coming in each year. The peace of mind of knowing the firm can weather a downturn in the economy because of these reliable revenues is invaluable. Additionally, if at the end of the year the money has not been spent, other mechanisms, such as bonuses or pension contributions can be used to eliminate any remaining income.
Pat: Today’s interest rates are low by historical standards. Would it be best to wait until they rise before considering structured fees?
Mark: While interest rates are a concern, the flexibility to respond to opportunities may be of greater value. Exposure to interest rates fluctuations can be reduced by shortening the payout period.
Pat: What are some of the planning opportunities that annuities bring?
Mark: Annuities for fees offer benefits forattorneys and law firms in all stages: new, mid-career or nearing retirement. For new firms and young lawyers, the annuity brings stability to cash flow and opens opportunities for growth as they will be in a better financial position to take on new cases that offer little or no compensation until the case is completed. For mid-career firms, structured fees enable firms to respond to case opportunities quickly, stabilize cash flow, and manage long-term growth. For soon-to-be retiring sole proprietors, the annuity would allow them to defer income into their retirement years. Sole shareholders in a law practice could continue to pay wages and fund pension plans. A firm with a retiring partner could use the annuity to fund retirement benefits, making the firm’s succession planning easier.
Pat: What are some of the concerns to discuss with a broker and tax professional before deciding on a structured fee?
Mark: This is a very good question. It is important to discuss all the ramifications of a structured fee with both professionals.
Questions attorneys should ask include:
- What are my cash needs and sources of cash?
- What are the firm’s needs and sources of cash?
- What are the legal and tax requirements of the deferral to discuss in settlement negotiations?
- How will an annuity give my firm more financial flexibility?
- How can an annuity help with my retirement/succession planning?
The growth opportunities given by these arrangements could substantially increase a firm’s financial and caseload flexibility and should be considered in the firm’s overall business plan. However, the deferral of income and tax using an annuity for fee arrangements is very narrow and care must be taken to comply with the requirements. Each proposed transaction should be reviewed by a professional prior to conclusion.