Your client just received a large jury award or settlement. Your client is satisfied with the outcome and you will be compensated for often years of hard work and out-of-pocket expenses. You can collect your fee as a lump sum, but there is another option: structuring the fee so payments are delayed or spread out over time.
Tax Code Governing Structured Fees
Legal fee structuring is possible because of Richard A. Childs, et al. v Commissioner of Internal Revenue 103 T.C. 36, aff’d 89 F.3d 856 (11th Cir. 1996). In Childs, the U. S. Court of Appeals, 11th Circuit affirmed a lower court’s decision allowing attorneys to structure their fees and to pay taxes on the fees only when they are received (included on IRS Form 1099). Only contingency fees can be structured. Hourly or retainer fees cannot.
Structuring Fee Mechanics
Legal fee structures are similar to non-qualified personal injury structured settlements in a number of ways.
As with client settlement structures, timing is important. The fee structure must be set up prior to the law firm actually taking possession of the funds. Once the funds are deposited into an attorney or law firm’s bank account, fee structuring is off the table. The IRS labels it as earned income and it becomes immediately taxable.
Since attorney fees are deducted from the client’s settlement amount, fee structure verbiage must be included in the client’s settlement agreement with the defendant. Clients do not need to structure their settlement in order for their attorney to structure fees.
As with non-qualified personal injury structured settlements, proceeds compound tax-free in the annuity and only become taxable upon receipt.
Attorneys are required to notify the IRS of their fee structure plans. Once the fee structure instructions are included in the client’s signed settlement documents, the defendant, its insurance company or trust then purchases an annuity for the amount of the legal fees through a life insurance company. The insurance company invests the annuity funds in conservative investments such as U.S. Treasury securities.
The sole practitioner or law firm does not own the annuity. The life insurance company purchases and guarantees the annuity and then transfers the annuity to an assignment company that is responsible for making the payments according to the instructions laid out in the structure documents.
Safety of Annuity’s Underlying Assets
When it comes to structures, the big question is, are the funds safe? Life insurance companies must receive approval from the California Department of Insurance before they can offer structure settlements. State regulations dictate that these insurance carriers maintain assets equal to or exceed their annuity payment obligations. Carriers are audited annually to make sure they comply.
The majority of insurance companies offering to structure fees will only do so in cases involving personal injury or workers’ comp settlements. A smaller number will structure fees for any number of case types including discrimination, sexual harassment, wrongful termination, bad faith and construction defect claims—cases where fees are determined as part of a negotiated settlement.
Managing The Firm’s Financials
For many solo practitioners and small law firms with mostly contingency-fee clients, it is often feast or famine. Attorneys can be under financial pressure to cover law firm expenses during lean months.
Fee structuring can relieve some of the stress. The firm receives steady, guaranteed income over a specified period. This enables attorneys to use the funds as a financial planning tool. Cash flow stabilizes and becomes predictable. The fee payouts are taxable, but by being spread over time (often years), the distributions may be taxed at a lower rate meaning the overall tax burden could be lower. Your tax advisor can offer guidance on whether deferring payment can save on taxes.
Determining Whether Structuring Fees Make Sense
Structuring attorney fees is not always the right decision. Your firm may want to use the fee income to pay off a large high-interest debt or a multitude of small expenses, purchase a building to house the law office, hire new staff or buy out a retiring partner. Relieving costly debt or updating/improving the law firm practice may take precedent over a consistent income stream.
Paying Off Debt
A popular option is to receive a portion of your fees at settlement to cover immediate expenses and structure the rest.
In one instance, a law firm was awarded $850,000 in attorney fees. Of that, the partners decided to receive $250,000 upfront to pay off the mortgage on their office building. The remainder would be paid out annually in the amount of $92,034 per year, guaranteed for seven years and factoring in compounding interest.
Saving For Retirement
By spreading fee income over a number of years or until after retirement, an attorney may be in a lower tax bracket with a lower tax obligation.
A sole practitioner decided to postpone received $500,000 in attorney fees until he turned 70 and retired in 2029. He created a structure with instructions that annual payments of $71,701 would begin in November 2029 with the last guaranteed payment in November 2038. The $500,000 will remain in the structured annuity, growing tax-free by more than $200,000, until withdrawn. If the attorney should pass away before all payments are distributed, payments can be transferred to designated beneficiaries.
An attorney can also decide to receive all or part of a fee to pay for tuition costs when a son or daughter reaches college age.
For example, a $100,000 in attorney fees could be structured to pay for the college education of a five-year-old son or daughter beginning at age 18. In this case, payments would be for $28,779, guaranteed for five years when factoring in compounded interest.
The attorney would still be the payee of the yearly payments over the five-year period. Note that if the money is not needed (i.e., the child earns a full scholarship), the payouts would still take place as scheduled.
Your Decision Is Final
Once a structured annuity is created, payments cannot be altered, nor can the annuity be cashed in and a lump sum distributed to the sole practitioner or firm. To protect yourself from rising costs, a cost-of-living component can be factored into the distribution schedule to offset inflation.
Another issue to consider is today’s current low interest rates on government securities. Funds within the annuity can only be invested in safe, government-backed investment vehicles. In today’s low interest rate environment, it may be hard to justify locking in annuity payments at those low rates.
Every Firm Has its Own Set of Financial Needs
Firm partners should discuss options with the firm’s tax advisor—receive a lump sum payment upfront, pay the taxes and invest the rest (and be taxed on the income) or go with the structured annuity with compounded tax-deferred benefits. Regardless of the ultimate decision, structuring fees earned from a sizable contingency fee case settlement should be a part of every payment discussion.