A litigation practice, where most income is derived from contingency fees, is notfor the faint of heart, particularly for solo and small law firms. While the eventual payoutcan be substantial, a firm can experience long periods where little or no income isgenerated. This can doom a small firm or solo practice without adequate reserves. Onestrategy to help stabilize a firm’s cash flow and better plan for future costs is throughstructuring attorney fees. The concept is much like creating structured settlements forinjured clients (but with tax differences).
Attorneys suggest structured settlements for their clients when the settlementfunds must last a long period (even a lifetime) to help pay for medical bills and livingexpenses, or to pay for big-ticket items such as housing, a new vehicle or even collegecosts. Structured settlements offer guaranteed, scheduled, tax-free payments to theinjured client without worry about market fluctuations, bad investment decisions ordownturns in the economy.
While no means on par with the concerns of a client facing lifelong medicalissues, a contingency fee-based sole practitioner or small firm can experience constantfinancial pressure as practice income ebbs and flows.
Structuring Fee BasicsThe 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 decisionthat allows attorneys to structure their fees and to pay taxes on the fees only when theyare received. Payments are reported on IRS Form 1099.
- The timing for structuring attorney fees is similar to the timing for structuring asettlement.
- 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 planthrough strict document filings. The IRS has challenged structured attorney fees in thepast 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’spayment stream is completely separate from that of the attorney or law firm. A client canreceive all of his or her settlement in a lump sum cash payment, while the client’sattorney can elect to receive tax-deferred fee income over time.
How Fees Are StructuredStructuring attorney fees begins by including the proper verbiage in the client’ssettlement 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 feearrangement). Claimant consents to the above-mentioned portion of thesettlement obligation assigned to the assignment company, (insert name of anassignment company once a life insurance company is chosen). The assignmentcompany 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 anannuity 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 conservativeinvestment vehicles, typically U.S. Treasury securities.
The attorney or firm does not own the annuity. The annuity is transferred from theinsurance 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 insurancecompanies to abide by strict solvency standards to protect their assets. The CaliforniaDepartment of Insurance must first approve companies offering structured settlementsin California. Those insurers are subject to mandatory annual audits and other financialcompliance requirements.
By regulation, all annuity reserves within insurance companies must have assetsthat are equal to or exceed the corresponding payment obligations. In addition, theassets supporting these reserves may not be removed from the insurance company.
Reserve sufficiency is mandatory and is frequently monitored by state legislators andauditors. State insurance commissioners have developed these regulations to preservethe solvency of general accounts in which assets are held so that contractualobligations 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 tobe involved in a physical injury claim for fees to be structured. Other insurance companies offer producstry type of settlement includingdiscrimination, sexual harassment, wrongful termination, badfaith, breach of contract and construction defect claims–as long as the fees are determinedbased on a negotiated settlement. The attorney fee payment can go to an individuallawyer 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 inworkers’ comp cases. While most of your cases involve small dollar amounts, yourcurrent case appears it will settle for a significant amount resulting in sizable attorneyfees.
As a sole practitioner or small law firm, you are responsible for paying firmexpenses incurred litigating the soon-to-be-completed case. These expenses could beconsiderable 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 theattorney fees, there are compelling reasons to structure the fees into an annuity so theyare paid in guaranteed periodic payments. One is the tax deferral advantage. If you arein your 40s now and plan to retire in your 60s, you can arrange to begin receivingannuity payments upon retirement so the income would be taxed presumably at a lowertax rate. The money would compound over those 20 years generating more incomethan 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 collegeeducation, with the money placed in a structured annuity with payouts beginning whenthe children reach age 18. Another added benefit: annuity payments can be transferredto designated beneficiaries.
For a law firm, payments can be arranged so they are received monthly orannually so the firm is assured a consistent income flow. This predictable incomestream can better help manage firm finances.
Having reliable income gives law firms the financial freedom of taking on largercases. The decision to accept a large contingency case may be easier to make whenthe firm has guaranteed monthly or annual income. The peace of mind of knowing thefirm can weather larger than normal expenditures can be part of the decision-makingprocess of accepting a case.
Structured ScenariosHere are samples of structured fees. Because the underlying assets grow tax-deferred and are compounded, the total payout can be considerably higher than theoriginal 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. Aspart 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 annuitycommencing at age 55. The annuity is guaranteed to pay him $1,443.35 per month for20 years. While the cost for the annuity was $150,000 (the amount of the fee), theactual guaranteed yield is $346,404. When factoring in life expectancy, an additional 10years 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 $250,000from successfully representing her client. She decides to structure the fee with a non-qualified, tax-deferred, monthly annuity payments starting immediately. The guaranteedyield 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 aswell, but in this example, a firm wants to use its $350,000 settlement fee to helppay off a five-year loan. The firm’s tax-deferred annuity will pay $71,000 per year forfive years beginning in 2016. Because the length of the structure is only five years, theguaranteed yield is $355,000, $5,000 more than the original fee.
Other Options and IssuesSometimes, unexpected circumstances arise and the cash that was placed in theannuity is needed before scheduled payments. Attorneys should be aware that once thestructured annuity is created, payments cannot be accelerated or decreased. Theannuity payments cannot be sold. To compensate for increasing financial demands overthe long-term, structured payments can include an inflation component so paymentsincrease 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 thepayout period or structuring only a portion of the fee. However, even with current low rates, byfactoring 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 toconsult with your tax advisor first before making any decision. Structuring fees, however,should be part of every discussion in sizable contingency fee case settlements.