Today’s guest blogger is Jason D. Lazarus, Esq. of Synergy Settlement Services. I invited Jason to explain a few techniques that I’ve seen many successful contingent-fee lawyers use to help manage their income stream, tax burden and even plan for retirement. I hope this is helpful to you. – Mike Swanson.
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Harnessing the Power of Tax Deferral for Contingent Legal Fees
By Jason D. Lazarus, J.D., LL.M.
Lawyers who earn contingent legal fees have a unique ability to control the timing of their income with either attorney fee structures or deferred compensation arrangements. While many lawyers fail to consider these vehicles due to lack of information, it is easy to see once one understands the options how powerful this can be for contingent legal fees. Through these mechanisms, a lawyer can forego taxation of fees earned in one tax year and spread out the income over a number of subsequent tax years. It allows a contingent fee to be paid out over time and taxed in the years each payment is received instead of in year one. This method was born out of the landmark tax decision in Childs v. Commissioner[1]. In the Childs case, the IRS challenged just such an arrangement. The IRS ultimately lost in the 11th Circuit. Since it was decided in 1996, Childs has not been challenged by the Service and has even been cited by the IRS as a precedent in a recent Private Letter Ruling[2]. According to Robert Wood, the preeminent expert on taxation of damages, “the IRS has begun uniformly citing Childs favorably, and is apparently quite comfortable with this.”[3]
The benefits of using an attorney fee tax deferral program regularly are significant. First, it allows a trial lawyer to even out what usually can be uneven cash flows. Controlling timing of income is a huge advantage over other professions where it can’t be controlled. Since a lawyer can defer only part of their fee if they so choose, there is complete control over the income a lawyer takes in any given year. In addition, there is no requirement that the client structure their monies or participate in any way with their attorney. Second, fees are invested pre-tax allowing one hundred percent of the money to earn interest and no tax is due until distributions begin. Third, it can help lower the overall tax burden by spreading taxation out over a longer period of years when hopefully the lawyer is in a lower tax bracket. It can also possibly avoid application of the Alternative Minimum Tax (AMT). Fourth, the future periodic payments from the fee structure or the nonqualified deferred compensation arrangement can be planned out to match future needs such as college tuition for children, large expenditures or retirement. The periodic payments can also be paid in the short term to assist with immediate cash flow. . Lastly, there are no limits on the amounts to be deferred or restrictions on distributions like qualified retirement plans.
There are two different mechanisms that can be used to defer taxation of fees. The first is an attorney fee structured settlement and the second is a nonqualified deferred compensation plan using a CaR trust. For an attorney fee structure, the fee is deferred through either a qualified or non-qualified assignment. A qualified assignment utilizes a fixed annuity and pays out over a specific time period or life depending on the plan selected by the lawyer. A non-qualified assignment may use a fixed annuity, high yield fixed payment rights or securities. With any type of fee structure, the fees must go directly from the defendant to the assignment corporation like a traditional structured settlement. Special language must be included in the release and an assignment document must be executed. The terms of the lawyer’s future periodic payments from the fee structure must be contained in the release.
With a nonqualified deferred compensation plan using a CaR trust, the fee is deferred by having the defendant pay the fee to the plan administrator. The investments inside the trust may be selected by the attorney and can include securities based investments as well as high yield fixed payment rights. The deferral program goes for 20 quarters with the first payment deferred 5 quarters. Each quarterly bucket is credited with investment earnings. When it is due to be paid, it can either be paid out in full, partially or deferred. If it is deferred, it goes to the end of the line of the 20 quarters worth of buckets. This allows a lawyer to elect not to receive payments at any given time if their current income necessitates more deferral. For example, a lawyer has a great year and can then decide he does not want any buckets in that particular year. With a nonqualified deferred compensation plan there is no need for an assignment or special language in the release. The details of the arrangement do not have to be disclosed in the settlement documents. The defendant would still have to make out a check to the deferred compensation plan. A nonqualified deferred compensation program can be used to retain key lawyers in a firm and potentially can be used for borrowing purposes.
The beauty of both fee structures and nonqualified deferred compensation plans is that there are no limits on the amount you can defer or participation requirements like with qualified plans. An attorney can also develop a strategy using a portion of each fee earned to create a significant amount of pre-tax and tax deferred investments. For example, a firm I work with takes a small portion of each fee ($25 to $50k) and sets up deferred fee structures. Over a 10 year period they accumulated over $1 million in deferred attorney fee structures. However, because both the fee structure and nonqualified deferred compensation plans are complex planning tools, you should employ an experienced planner to walk you through the options and develop a strategy. Both options have pros and cons. They both have technical requirements which require the help of experts. Learn more about how to maximize the fees you earn and harness the power of pre-tax and tax deferred investment options for contingent fees.
To learn more about tax deferral of contingent attorney fees, visit www.structuredfees.com
To learn more about Synergy Settlement Services, visit www.synergysettlements.com
[1] 103 T.C. 634 (1994), aff’d without opinion 89 F.3d 856 (11th Cir. 1996).
[2] PLR 150850 (2008)
[3] Legal Fee Structures Can Hedge the Insecurities Many Lawyers Face, Los Angeles Daily Journal (Friday August, 28, 2009) at P. 6.
