Attorney Fee Structures

Do You Have a Private Retirement Plan?

Attorney fees may be deferred either as part of a “qualified assignment” of the future payments due to the client, as a convenience to the client and to satisfy the attorney fee debt, or in a non-qualified assignment. The use of the non-qualified option gives the attorney flexibility to structure fees due from other than personal physical injury or physical sickness cases. For an attorney who does not practice in physical injury tort law or workers’ compensation, the non-qualified assignment option opens up the opportunity to structure fees due from many other types of cases. An attorney fee structure can be a personal discriminatory retirement plan.

Advantages of converting an attorney fee receivable into a deferred compensation plan are:

There is no limit on the amount an attorney can defer in any year.

There is no requirement to contribute to the plan in future years.

It can supplement qualified retirement plans, again with no deferment amount limits, unaffected by the amount contributed to the qualified plan.

It can be done in addition to a SEP or an IRA, with allowed deferments unaffected by the amount contributed to the SEP or IRA.

Each time you defer a fee constitutes a separate plan, and you can have as many deferred compensation plans as you wish.

You can layer income from different plans over the same payment period and, if the funding assets are issued by different companies, you achieve portfolio diversity.

There are no annual plan evaluations required, as there are in qualified plans.

There is no requirement to include law partners, and non-attorney employees
cannot participate except through separate deferred compensation agreements with the attorney.

There is no necessity to wait until age 59½ for distribution from the plan.

You can set up lump sum payments to cover known future needs such as college education for children or to build a retirement home.

The money inside the plan, whether invested in an annuity or funded with a reinsurance assumption agreement, is guaranteed to grow at a rate specified at the time the plan is established—unaffected by the future performance of the investment marketplace. The guarantee is made by a venerable financial institution—a highly rated life insurance company by the independent analysts, i.e. Moody’s, S&P, Fitch, A.M. Best—which holds the asset.

You can avoid the highest tax bracket in an extraordinary year by spreading out income.

The plan can survive bankruptcy or divorce.

It is easy to see why a client whose damage recovery for a physical injury or physical sickness is excluded from gross income would want to receive periodic payments. The benefit is obvious. All growth of the funding asset is tax-free to the payee as long as the payee never had actual or constructive receipt of the funds used to purchase the asset, and has no ownership rights to the asset. Not only does the client receive the amount paid by the defense free of income taxes, the client can also receive future growth of that money tax-free.

In contrast, attorney fees are always taxable to the attorney as income in the years in which the fees are paid, constructively received or if the attorney is deemed to have economic benefit of an amount set aside to make future payments. The benefit of structuring taxable payments may not be so obvious, but they are significant. The taxes that would be otherwise paid by the attorney on the income earned at the time the case is settled are deferred. That money grows along with the money that ordinarily would be left after taxes. When distributions are made, the entire amount distributed during a year is taxable for that year.

Because the deferred taxes have grown for the benefit of the payee, there will be more left over after taxes than there would have been if the taxes had been withheld on the original amount earned and taxes paid each year on the entire growth—assuming tax rates do not increase. This is the principle behind qualified and nonqualified defined contribution retirement plans.

Nonqualified deferred compensation plans are very common in the corporate world and are well settled in tax law. Traditionally, deferred compensation plans involve an agreement between the company and its higher compensated executives. However, the concept of deferred compensation plans between employer and employee extends to the relationship between client and attorney. If a fee is due to the attorney from a client—whether fee-based or from a contingent fee agreement—that fee can be deferred. The obligation of the client to make the future payments can be assigned by novation—an agreed substitution of parties—to a third-party obligor holding a funding asset issued by a venerable financial institution highly rated by the independent analysts.

The IRS once challenged the attorney fee structure concept in Childs v. Commissioner, arguing that the attorneys should have recognized income that they chose to defer at a time when their fees remained contingent on the future execution of settlement agreements and the entry of a final court order approving them. However, the U.S. Tax Court rejected the IRS argument, confirming that traditional deferred compensation plans extended to lawyers and their clients. U.S. Tax Court is a federal court that hears appeals by taxpayers from adverse IRS decisions about tax deficiencies. On appeal by the IRS, the Eleventh Circuit affirmed the Tax Court’s ruling, and that case remains the nationwide precedent for tax treatment of attorney fee structures. See Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without opinion, 89 F.3d 856 (11th Cir. 1996).

Surviving Bankruptcy and Divorce

Whether a structured settlement, including an attorney fee structure, survives bankruptcy or divorce depends on specific facts and how they are applied to the governing law. Bankruptcy debtors were allowed to keep their structure payments in a 1998 ruling by the U.S. Bankruptcy court for the Northern District of Texas, Lubbock Division. They had lost their two children and were receiving periodic payments through a qualified assignment of the future payment liability. In re: David Lynn Alexander and Lyndia Kay Alexander, 227 B.B. 658. In a case involving both divorce and bankruptcy, the structured settlement payments were held to be exempt from bankruptcy creditors, including an ex-spouse, under Louisiana law. Shortly after marrying, the husband suffered closed-head injuries in an automobile accident leaving him permanently brain damaged. The couple sued for damages and settled for periodic payments to the husband, the obligation being assigned to a third party under Code section 130. They later divorced, and the husband agreed to a property settlement under which the wife would receive monthly payments for a specified period. The husband defaulted; the wife received a judgment for arrearages; the husband filed a bankruptcy petition. The annuity payments were listed as assets of the estate but were claimed to be exempt under state law, which in relevant part shields payments under annuity contracts from seizure.

The bankruptcy court denied the wife’s objection and the district court affirmed. A divided three-judge panel of the Fifth Circuit reversed. The panel majority’s judgment was then vacated and the case was reheard en banc, holding for the husband. In the Matter of: Paul William Orso, No. 98-31008, 5th Cir. (2002).

In some states, for example, marital property at the time of divorce is the property acquired by the parties during the marriage by the industry of the husband and wife. Structured settlement payments could be considered separate property, if the settlement occurred before the marriage. If the settlement had been for a cash lump sum, even if before marriage, it runs the risk of transmutation if the court finds that the property changed character because the parties acted in a manner that indicates their intent to change the character of the property. A structured settlement decreases the probability of a transmutation finding, because the payee has no power to change the character of the payments. The states are not uniform in how they treat marital property.

Constructive Receipt and Economic Benefit

For income deferment to work, the attorney may not take receipt of the funds—either actual or constructive receipt—and may not have economic benefit of the amount set aside to make the future payments. Section 451(a) of the Tax Code (26 U.S.C.) provides that the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.

Constructive receipt is defined at section 1.451-2(a) of the Income Tax Regulations (26 C.F.R.), which provides that income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

Constructive receipt generally occurs when a taxpayer receives “an unqualified vested right to receive immediate payment,” Childs, supra, quoting Martin v. Commissioner, 96 T.C. 814 (1991). Constructive receipt also occurs when a taxpayer makes a “voluntary choice not to receive payment” at a time when the taxpayer “was able to collect,” Sainte Claire Corp. v. Commissioner, T.C. Memo 1997-171 (1997).

“Disclosure by defendant of the existence, cost, or present value of the annuity will not cause … constructive receipt of the present value of the amount invested in the annuity,” Priv. Rul 83-33035.

“Knowledge of the existence, cost, and present value of the annuity contract used to fund the settlement offer … will not cause … constructive receipt of the amount payable under the annuity contract or the amount invested in the annuity contract,” Priv. Rul 90-17011.

Under the principle generally known as economic benefit, the creation by an obligor of a fund in which the taxpayer has vested rights will result in immediate inclusion by the taxpayer of the amount funded. A “fund” is created when an amount is irrevocably placed with a third party, and a taxpayer’s interest in such fund is “vested” if it is nonforfeitable. This is a common law doctrine, attributable to the landmark case Sproull v. Commissioner, 16 T.C. 244 (1950), aff’d 194 F.2d 541 (6th Cir. 1952). The 1988 amendment to section 130(c) of the Code allowing a security position in qualified assignments ahead of general creditors “was intended to allow assignments of periodic payment obligations without regard to whether the recipient has the current economic benefit of the sum required to produce payments.” Priv. Rul. 97-03038 (1997).

It should be noted that, because different annuity issuers have varying guidelines on attorney fees structures, the broker must consider this in the selection of the company to be presented for consideration.

By Richard B. Risk, Jr., Esq., and reprinted with expressed permission.