A litigation practice, where most income is derived from contingency fees, is not for the faint of heart, particularly for solo and small law firms. While the eventual payout can be substantial, a firm can experience long periods where little or no income is generated. This can doom a small firm or solo practice without adequate reserves. One strategy to help stabilize a firm’s cash flow and better plan for future costs is through structuring attorney fees. The concept is much like creating structured settlements for injured clients (but with tax differences).
Attorneys suggest structured settlements for their clients when the settlement funds must last a long period (even a lifetime) to help pay for medical bills and living expenses, or to pay for big-ticket items such as housing, a new vehicle or even college costs. Structured settlements offer guaranteed, scheduled, tax-free payments to the injured client without worry about market fluctuations, bad investment decisions or downturns in the economy.
While no means on par with the concerns of a client facing lifelong medical issues, a contingency fee-based sole practitioner or small firm can experience constant financial pressure as practice income ebbs and flows.
Structuring Fee Basics
The ability to structure legal fees came about as the result of Richard A. Childs, et al. v Commissioner of Internal Revenue 103 T.C. 36, aff’d 89 F.3d 856 (11th Cir. 1996). The U. S. Court of Appeals for the 11th Circuit affirmed a lower court’s decision that allows attorneys to structure their fees and to pay taxes on the fees only when they are received. Payments are reported on IRS Form 1099.
- The timing for structuring attorney fees is similar to the timing for structuring a settlement.
- It must be done prior to actually receiving the fees.
- Structuring fees is limited to contingency fees.
- Structuring hourly fees is not allowed. Since contingency fees come out of the client’s damages, the decision to create a structured fee must be completed prior to the conclusion of the final settlement for the injured client.
- Waiting until a settlement is funded is too late. The fee, at that point, is considered earned income and the entire amount is fully taxable.
An important part of the process is notifying the IRS of the structured fee plan through strict document filings. The IRS has challenged structured attorney fees in the past under Internal Revenue Code sections 1.83-3(3), 476(a)(2) and 451 so taxreporting procedures must be followed very carefully.
Structuring fees is not predicated on a client structuring a settlement. The client’s payment stream is completely separate from that of the attorney or law firm. A client can receive all of his or her settlement in a lump sum cash payment, while the client’s attorney can elect to receive tax-deferred fee income over time.
How Fees Are Structured
Structuring attorney fees begins by including the proper verbiage in the client’s settlement agreement. Here is a sample:
“The claimant solely for his/her convenience directs the above payment stream(s) to be paid to (name of attorney or firm with whom claimant has a contingent fee arrangement). Claimant consents to the above-mentioned portion of the settlement obligation assigned to the assignment company, (insert name of an assignment company once a life insurance company is chosen). The assignment company will purchase an annuity from (insert name of life insurance company) to fund this obligation in an assignment intended to meet Section 130 of the IRC.”
The defendant, the defendant’s insurance company or a trust then purchases an annuity from a highly-rated life insurance company (as rated by A. M. Best, Standard & Poor’s or Moody’s). The insurance company invests the annuity funds in conservative investment vehicles, typically U.S. Treasury securities.
The attorney or firm does not own the annuity. The annuity is transferred from the insurance carrier to an assignment company that is responsible for making payments. Payments are guaranteed by the life insurance company. The question becomes: What if the insurance company goes out of business? What happens to the annuity payments? State and federal regulations require insurance companies to abide by strict solvency standards to protect their assets. The California Department of Insurance must first approve companies offering structured settlements in California. Those insurers are subject to mandatory annual audits and other financial compliance requirements.
By regulation, all annuity reserves within insurance companies must have assets that are equal to or exceed the corresponding payment obligations. In addition, the assets supporting these reserves may not be removed from the insurance company.
Reserve sufficiency is mandatory and is frequently monitored by state legislators and auditors. State insurance commissioners have developed these regulations to preserve the solvency of general accounts in which assets are held so that contractual obligations to policyholders are met.
Most insurance companies only structure fees received for workers’ comp, personal injury and physical sickness settlements. However, the client does not have to be involved in a physical injury claim for fees to be structured. Other insurance companies offer producstry type of settlement including discrimination, sexual harassment, wrongful termination, bad faith, breach of contract and construction defect claims–as long as the fees are determined based on a negotiated settlement. The attorney fee payment can go to an individual lawyer or to his or her law firm.
Is Structuring Fees Right for Your Firm?
Let’s say you are a sole practitioner or small firm that represents plaintiffs in workers’ comp cases. While most of your cases involve small dollar amounts, your current case appears it will settle for a significant amount resulting in sizable attorney fees.
As a sole practitioner or small law firm, you are responsible for paying firm expenses incurred litigating the soon-to-be-completed case. These expenses could be considerable and may preclude the practicality of structuring fees for later access.
Here are questions to ask before deciding whether structuring fees makes sense:
- Are there big ticket items or services that you have been putting off acquiring that would enhance your work environment or attract new clients?
- Does the firm want to pay off debt?
- Buy out a retiring partner?
- Purchase a home or vehicle? Is a wedding in the near future, kids’ college tuition?
If the answer is yes to any of these, it may be appropriate to receive all or a portion of your fees upfront (all fees received immediately would be taxed at the attorney’s or law firm’s current tax rate). If your firm (or you personally), however, does not need all or a portion of the attorney fees, there are compelling reasons to structure the fees into an annuity so they are paid in guaranteed periodic payments. One is the tax deferral advantage. If you are in your 40s now and plan to retire in your 60s, you can arrange to begin receiving annuity payments upon retirement so the income would be taxed presumably at a lower tax rate. The money would compound over those 20 years generating more income than if you were to have taken a taxable lump sum immediately after settlement.
Attorneys with school-aged children could use the settlement for their children’s college education, with the money placed in a structured annuity with payouts beginning when the children reach age 18. Another added benefit: annuity payments can be transferred to designated beneficiaries.
For a law firm, payments can be arranged so they are received monthly or annually so the firm is assured a consistent income flow. This predictable income stream can better help manage firm finances.
Having reliable income gives law firms the financial freedom of taking on larger cases. The decision to accept a large contingency case may be easier to make when the firm has guaranteed monthly or annual income. The peace of mind of knowing the firm can weather larger than normal expenditures can be part of the decision-making process of accepting a case.
Here are samples of structured fees. Because the underlying assets grow tax-deferred and are compounded, the total payout can be considerably higher than the original fee amount, and the income tax due at the time of settlement is avoided.
Case #1 A 43-year-old male attorney settles a car accident case for his injured client. As part of his retirement savings plan, he decides to structure the $150,000 earned in fees. The attorney structures his fees with a non-qualified, tax-deferred, monthly annuity commencing at age 55. The annuity is guaranteed to pay him $1,443.35 per month for 20 years. While the cost for the annuity was $150,000 (the amount of the fee), the actual guaranteed yield is $346,404. When factoring in life expectancy, an additional 10 years of payments could be received, bringing the expected yield to $519,606.
Case #2 A 60-year-old female attorney, who is close to retirement, will earn $250,000 from successfully representing her client. She decides to structure the fee with a non- qualified, tax-deferred, monthly annuity payments starting immediately. The guaranteed yield is $298,824. She will receive $1,245.10 per month guaranteed for 20 years. Again, factoring in life expectancy, that amount could reach an expected yield of $418,354.
Case#3 Structuring fees for law firms can be used as part of retirement planning as well, but in this example, a firm wants to use its $350,000 settlement fee to help pay off a five-year loan. The firm’s tax-deferred annuity will pay $71,000 per year for five years beginning in 2016. Because the length of the structure is only five years, the guaranteed yield is $355,000, $5,000 more than the original fee.
Other Options and Issues
Sometimes, unexpected circumstances arise and the cash that was placed in the annuity is needed before scheduled payments. Attorneys should be aware that once the structured annuity is created, payments cannot be accelerated or decreased. The annuity payments cannot be sold. To compensate for increasing financial demands over the long-term, structured payments can include an inflation component so payments increase automatically based on inflation rates.
NOTE: Structuring all fees in the current low interest rate environment may mean not being able to take advantage of rising interest rates. This can be mitigated by shortening the payout period or structuring only a portion of the fee. However, even with current low rates, by factoring in the annuity payments’ compounded, tax-deferred benefit, taxable yield rates would need to increase two or more percentage points to gain the advantage.
There is no “one size fits all” decision when it comes to structuring attorney fees. Each attorney and each firm has its own unique set of financial needs. It is prudent to consult with your tax advisor first before making any decision. Structuring fees, however, should be part of every discussion in sizable contingency fee case settlements.
Patrick Farber is a structured settlements broker in California with Atlas Settlement Group. 800-734-3910
This article first appeared in: Big News For Solo and Small Firms, The Magazine of the State Bar of California’s Solo and Small Firm Section, Summer 2015