By Patrick Farber and Mark Simurda
As published in The Bottom Line, Volume 31, No.3 June 2010
Structuring attorneys’ fees is playing a larger role in law firm and sole practitioner financial planning.
Receiving a fee over the course of years instead of in a single lump sum payout can help manage firm cash flow and have positive tax ramifications. Not every fee is eligible, however, and certain initial steps must be taken so the fees qualify for preferred tax status. Structured settlements for injured parties have been around since Congress authorized their federal income tax incentives through The Periodic Payment Settlement Act of 1982 (Public Law 97-473). Most attorneys are now familiar with how they work: instead of receiving a settlement in one payout, personal injury plaintiffs can choose to receive periodic payments or a combination of cash and structured payments arranged through a structured settlement insurance annuity.
These annuities are guaranteed to provide a steady stream of secure, tax-free income for the injured party over time. Not surprisingly, structured settlements have become a popular option.
Although structured attorney fees do not have all the tax advantages of structured settlements for plaintiffs, there are still elements that make them attractive. Attorneys began using structured payments for legal fees in physical injury or sickness cases after the decision in Childs vs. Commissioner, 103 T.C. 634 (1994), affirmed 898 F3d 856 (1996). The Tax Court held that attorney fees from these types of cases could be received in periodic payments.
Like a plaintiff ’s structured settlement, the attorney fee structure is funded by the defense through an annuity purchased from a high-rated insurance company. This insurance carrier or “assignee” then takes over the liability from the defendant and begins making periodic, predictable payments to the plaintiff’s attorney. A structured fee plan is separate from the injured party’s structured settlement plan. Attorneys can arrange a structured fee regardless of whether their client selects a lump sum settlement option or a structured settlement. Cases that are billed and paid hourly do not qualify. Once a structured fee payment plan is set, the payments cannot be altered.
Unlike structured settlements, the income generated from fee settlement annuities is not tax-free, however, the money is tax deferred. Income is taxed as it is received and reported annually on IRS Form 1099. Instead of paying a higher marginal tax rate on a lump sum payout, the income can be received in later years when an attorney’s tax bracket may be lower, or can be spread over a set number of years to assure that the firm or individual attorney receive a steady stream of income.
For sole practitioners, the annuity offers flexibility by allowing coverage of future expenses (i.e., children’s college education) with lump sum payouts in designated years. Attorneys can make changes to the annuity beneficiary designation at anytime. However, if the attorney or firm is not the main beneficiary, care must be taken not to create an unintended gift tax.
Since attorneys’ fee comes out of the client’s damages, the decision to create a structured fee must be done prior to the completion of a settlement (structured or not) for the injured client. Waiting until a settlement is made is too late. The fee, at that point, is considered earned and fully taxable.
In Childs v. Commissioner, the plaintiff’s attorney received an annuity as payment of his contingent fee. The annuity was created with various features intended to assure that the annuity was not funded nor secured prior to the time the plaintiff’s settlement was reached. As a result, the court ruled the attorney’s annuity would not be considered income under Internal Revenue Code Section 83 until fee payments were actually received.
The IRS must be notified of the structured fee plan through strict document filings. The IRS has challenged structured attorneys fees in the past under Internal Revenue Code sections 83 (and Treas. Reg. 1.83-3(3)), 476(a)(2) and 451. That’s why structuring and tax reporting procedures must be followed very carefully.
Fee Structure Considerations
One concern that is often mentioned about delaying payments through a fee structure is that income tax rates may increase, thus negating the structure’s tax advantages. This concern may have some validity, but it must be weighed against the fee structuring benefits, including stabilizing firm revenues and creating tax deferred reserves for case opportunities.
The financial ability to respond to future case opportunities may be the most appealing feature of the fee structure annuity. The decision to accept and manage a large case may be easier to make when the firm has guaranteed reserves coming in each year. The peace of mind of knowing the firm can weather a downturn because of this reliable revenue stream can mean the difference between taking on a new case and not.
Another issue of concern is interest rate fluctuation. Being tied to a structured payment plan could mean being unable to take advantage of a rising interest rate environment. Exposure to interest rates fluctuations can be reduced by shortening the payout period.
The decision to create a structured fee plan versus accepting a lump sum payment needs to be discussed on a case-by-case basis. Whether a new firm with young lawyers, an established firm, or a solo practice, these structured annuities can provide stable cash flow, manage long-term growth and better plan for retirement—all essential ingredients to a firm’s business and financial plan.
Mark Simurda is a CPA and tax partner with Lesley, Thomas,
Schwarz & Postma, Inc., in Newport Beach. Mark may be
reached at firstname.lastname@example.org, www.ltsp-cpa.com.
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