Attorney Fee Structured Deferrals: Things to consider
With Tax Filing Season at an end, we hope that nobody was hit too hard. We’d also like to give an applause to any clients of ours & all attorneys out there that realized the actual benefits of deferring their fees this Tax Filing Season. In this article, we’d like to flush out exactly why attorneys are even allowed to defer their fees & discuss some of the important items to consider when moving forward with an Attorney Fee Structured Deferral.
Attorneys that are paid on a contingent-fee-basis are the only attorneys that are allowed to structure their legal fees. This is a great benefit from a tax perspective and should not be taken lightly. When an attorney enters into a contingent fee agreement with a client/plaintiff, the attorney can decide to take his/her fee in a lump sum or in periodic payments over time. In either scenario, the attorney is paid after settlement and from the defendant; however, when taken as payments over time – a structured fee arrangement is established, where funding is provided by an annuity (in some cases) purchased by an assignment company from moneys delivered by the defendant in the case.
Having one’s contingent legal fees paid out over time results in many benefits (see article # 1). Most importantly is the ability to defer taxes over time, which allows an attorney to (1) reduce income taxes in a given year & (2) partake in tax-deferred investment returns that would not have been available if fees were taken as a lump sum. For the attorney, they would only pay taxes in the year that they receive a periodic payment.
The use of Attorney Fee Structured Deferrals was first approved in Childs v. Commissioner, 103 T.C. 634 (1994), aff'd per curiam, 89 F.3d 856 (11th Cir. 1996). In this case, the court held that the attorney did not receive constructive receipt of his attorney fee as income in the year that the annuity was purchased. Thus, the court ended up ruling that the attorney could not be liable for taxes until he received his periodic payments that would be coming from the annuity.
While Childs provides us the legal and tax rulings as to why a contingent fee-based attorney is entitled to a benefit that nobody else receives, it also helps to understand the nature of these professionals’ practices. Because a plaintiff attorney’s income fluctuates so much, it makes sense that they are given the opportunity to level out their income by having the option to defer their contingent fees.
Things to consider:
One important piece to think about when moving forward with structuring fees is to make sure that the attorney elects to defer his/her fees before settlement. By doing this, the attorney will avoid any constructive receipt issues – and in doing so, will have a peace of mind regarding any tax concerns. As the attorney, if you are thinking about structuring your fees on a case – you should stay ahead of settlement and make sure you bring this up. A great way to be proactive in this regard is to simply have, within your fee agreement, something of the nature saying that the attorney may receive his/her fee in cash or as periodic payments.
While it is not always necessary, it may be advantageous to set up a Qualified Settlement Fund (QSF) when considering to structure legal fees. Essentially, what a QSF does is provide plaintiffs and their lawyers more time to figure out how they would like to receive their settlement money. Whether the plaintiff, attorney, or both need more time to consider – the funds would be put into the QSF and the defendant would no longer be involved. Where a QSF makes sense and could be helpful, is if the attorney is hoping to structure their attorney fees in a way that matches up with their financial planning goals (as a business, for their family/children, retirement, etc.). While structuring one’s fees allows for flexibility in deciding when your periodic payments kick-in (and how much each time), the payment “plan” is set and cannot be changed once locked-in. By having the QSF, the attorney can bide some time if needed and maximize their tax & financial planning strategy.
Another consideration that should be addressed is how the attorney’s firm is arranged. It is usually the case that structuring the attorney fees for solo practitioners is relatively simple. However, depending on if the attorney is a partner or not, if the firm is an S-Corp, LLP, etc. – there are further legal & tax matters to address.
Finally, it is important to consider the choice that an attorney has in the vehicle that they decide to go with when structuring their attorney fees. Traditionally, an Attorney Fee StructuredDeferral would be placed via a fixed annuity product through a Life Insurance Company. However, with different products and providers out there – there is a market for alternative options, where trust & investment companies take the place of assignment/life insurance companies (discussed above). Because of this, attorneys now have the option of an Attorney Fee Structured Deferral that can either involve traditional life insurance products or a portfolio investment model that is tied to the market. Depending on one’s risk tolerance & goals, one option may be better than the other for a particular attorney. (See article # 2 for a case analysis).
Utilizing Attorney Fee Structured Deferrals should be a no-brainer, tax-planning strategy for attorneys that are paid on a contingent-fee-basis. Such attorneys (personal injury plaintiff attorneys, for example) have a unique advantage to smooth out their income, while generating tax benefits; not many professionals & attorneys can do this. However, as mentioned above – there are many things to consider. Please do not hesitate to reach out if you have any questions – our team would be more than happy to help you navigate through this space.
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