Part I of this series focused on tax reduction and deferral strategies for trial attorneys with contingent fee income using private placement variable deferred annuities in lieu of fixed annuities for structured settlement payments.
Part 2 of this series focused on the use of closely held insurance companies (aka captive insurance arrangements) to provide tax reduction and deferral of contingency fee income. In Part 2, the captive insurer can function as a multi-line insurer (property and casualty as well as life insurance) and issue the structured settlement annuities for contingency fee deferrals referenced in Part I of this series.
In Part 3, the trial attorney was able to gain a charitable tax deduction equal to the amount of the contingency fee and invest that money on a tax-deferred basis using PPLI contracts. Part 3 combined several sophisticated planning techniques such a Charitable Lead Annuity Trust with back loaded payments to a charity; a preferred partnership to transfer growth in excess of a preferred return to a family trust; tax-free treatment on investments using private placement life insurance, and lastly, a family investment management LLC owned by the trial attorney in order to generate some income from tax deferred assets that will ultimately pass outside of the taxable estate.
In Part 4, we will investigate how a trust established under IRC Sec 468B- a Qualified Settlement Fund- is really an unlimited pension plan for trial attorneys. I have noted several times already that qualified plans are pretty useless to a high income trial attorney.
A qualified retirement plan such as a defined contribution plan has a contribution limit of $50,000 in 2012 and a salary cap of $250,000. Defined benefit plans have a maximum annual benefit of $200,000 per year. However, defined benefit plans are very expensive because of the contribution and participation requirements of qualified plans.
Additionally, most trial attorneys have not utilized structured settlement annuities which are conservative fixed deferred annuity products issued by large life insurers.
Again - Why Now?
The tax environment for high income tax payers is set to undergo a substantial change. The top federal marginal tax rate is scheduled to increase to 39.6 percent in January 2013. High income tax payers will incur an additional 3.8 percent tax on unearned income for taxpayers with AGI in excess of $250,000. High income tax payers are also subject to a phase out of personal exemptions and itemized deductions which have the effect of increasing the marginal tax rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate. What this means is that many trial attorneys will have a combined marginal tax rate in excess of 50 percent.
The top marginal estate tax bracket is also set to increase to 55 percent. At the same time the exemption equivalent for federal estate and gift taxes is decreasing from $5.12 million to $1 million per taxpayer. The bottom line is that “earned income” as the trial attorney’s largest asset, is more highly taxed much than any other asset class. The combination of income and estate taxes on this windfall income can be as high as 75-80 percent.
II What is a Qualified Settlement Fund (QSF)?
QSFs are trusts that are designed to resolve litigation and satisfy claims of the litigation or even if they are not the subject of litigation. The QSF is authorized and governed by the provisions of IRC Sec 468B. Depending upon the complexity of a case, number of plaintiffs or defendants, and the level of uncertainty regarding distributions, the QSF can last for a few weeks or a few years. The key point here is that no statutory time limit exists within IRC Sec 468B or the treasury regulations in regard how long a QSF may be kept in place.
The QSF has benefits for both plaintiffs and defendants. From a defendant’s perspective, the ability to transfer assets to a QSF can resolve the claim and release the defendant from further liability while achieving an immediate tax deduction regardless of when claimants actually receive distributions. This is a significant tax point for the defendant.
The plaintiff is able to achieve numerous benefits. Claimants can use the QSF to time the receipt of their income. Plaintiffs are not taxed until they actually receive distributions from the QSF. The QSF provides the plaintiff and their attorney with the ability to work out the details of their distribution.
II What are the Requirements to Establish a QSF?
QSFs generally have three requirements. First, the QSF must be established by court order and administered under the jurisdiction of that court. The court need not be in the same jurisdiction as the legal action. In fact, a probate court in the trial attorney’s home jurisdiction can have jurisdiction over the QSF trust. Second, the QSF must be established “to resolve or satisfy one or more contested or uncontested claims that have resulted or may arise from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability”. Third, the QSF must be a trust under state law.
Once established, a QSF is a taxpayer is a taxpayer in its own right. The QSF is not taxed on contributions to the QSF trust. Any inclusion will not occur until the date of distribution. The trust is taxed on its investment income at the top federal marginal tax bracket along with any state taxation that might apply.
A QSF needs an administrator and a trustee. The two roles can be accomplished by the same organization. The trustee can be an individual or a trust company. The administrator has the responsibility of accounting and administering the QSF. These tasks include obtaining the employer identification number, preparation and filing of QSF tax returns. The trustee has all of the traditional fiduciary obligations of a trustee under state trust law.
III What Types of Cases Can Use QSFs?
Most disputes can use a QSF. Generally any claims under CERCLA can use a QSF as well as any claim arising out of a tort, breach of contract or violation of law. However, the treasury regulations (Treas Reg. 1.468B-1(g)) exclude worker’s compensation claims or bankruptcy or general creditor claims from using the QSF.
IV Single Claimant Controversy
Some practioners wonder whether a QSF can be used for a single claimant. Assuming the Government means what it says, the answer should be yes. The plain statutory language of IRC Sec 468B and Treas. Reg. 1.468B-1(c)(2) plain states the answer to this question in the affirmative.
The statutory language provides that a QSF may be “established to resolve or satisfy one or more contested or uncontested claimants that have resulted or may result from an event that has occurred or that has given rise to at least one claim asserting liability”. The concern deals with the tax doctrine of constructive receipt and economic benefit. My view on the matter is straight-forward. If the Government wanted to limit the ability to use QSFs for a single claimant, it would have written the statute differently.
V Taxation of the QSF
A QSF is taxed on its modified gross income at the maximum income for estate and trusts. The top marginal tax bracket for trusts in 2013 will be 39.6 percent not including state taxation which can easily add another 4-10 percent to the tax rate. If that weren’t enough, the new Medicare tax will also apply to trust income adding an additional 3.8 percent of taxation on trust income.
Taxable amounts transferred to the QSF do not include amounts transferred to resolve the claim for which the QSF was established. Additionally, the investment income from public utilities and federal and municipal securities under IRC Sec 115 is also excluded. A QSF may take deductions for its administrative costs, and investment losses. Distributions of cash or property are excluded from the QSF’s gross income.
When a QSF makes a distribution to a claimant, the QSF will obtain a release from that claimant. The QSF must file an annual tax return on or before March 15 of the year following the close of its taxable year.
VI QSFs and Structured Settlements and PPVAs
QSFs can be used to facilitate structured settlement distributions. In this article we are focused on structured settlement arrangements for attorneys rather than the plaintiff. Funds transferred to a QSF will include attorney fees. The plaintiff’s attorney can also be thought of as a beneficiary of the QSF. The QSF’s gross income will exclude the amount that the defendant contributes to the QSF to resolve or satisfy liabilities. This exclusion applies regardless of whether the amounts transferred to the QSF include attorney’s fees.
The QSF can be used as a repository to make structured payments to attorneys The attorney may receive structured payments even if the claimants do not receive structured payments. The QSF may serve as a repository for both qualified and non-qualified assignments. Non-qualified assignments are used to facilitate periodic payments involving tort claims that do not involve personal physical injuries such as racial discrimination, wrongful termination, or violations of ADA or ERISA.
Private Placement Variable Annuities (PPVA) are an ideal asset to be owned by the trust or an assignment company as part of a structured settlement annuity arrangement. The QSF is taxed at the maximum tax rate for trusts. As a practical matter the QSF will have a combined marginal tax rate of 43.4-50 percent. The PPVA is an institutionally priced variable deferred annuity that provides for customized investment options. The open architecture of the PPVA has an unlimited array of investment choices that can include investment management by the attorney’s investment advisor that is appointed to manage a portfolio for the life insurer within the policy. The PPVA provides for tax deferral until such time distributions are made to the trial attorney.
V QSFs – A Better Option for Trial Attorneys than a Qualified Retirement Plan
Qualified retirement plans are limited in benefit for high income trial attorneys. As previously noted, only $250,000 of annual compensation can be considered for contributions. The maximum contribution for a defined contribution plan is $50,000. The 401(k) deferral is $17,000 in 2012 with a catch up provision of $5,500 for taxpayers age 50 or older .
None of this makes much of a dent for retirement purposes for the trial attorney living in the “Big House” and intending to remain there in retirement. Spending habits don’t seem to fade away with time either.
Defined benefit plans are generally too expensive at the firm level because of the contribution requirements for firm employees and associates. At any rate the maximum annual retirement benefit is only 200,000 which is not much if your lifestyle is $1 million per year.
Congress incorporated sophisticated regulations and testing requirements designed to prevent discrimination in benefit levels and contributions in favor of the highly compensated. Other rules prevent the creation of new entities in an attempt to bypass contributions for firm employees or the creation of multiple plans. In a word, the highly compensated trial attorney does not have to worry about the application of any of the qualified retirement plan rules to the QSF.
Unlike a qualified retirement plan arrangement, the QSF with respect to the trial attorney does not have a cap on contributions to the QSF or a limit on the amount of trial attorney income that can be considered. The rules do not have minimum contribution or participation rules for other employees of the law firm. The QSF arrangement does not have early withdrawal penalties for distributions made before age 59 ½. The QSF does not have minimum distribution requirements at age 70 ½. The QSF rules are not statutorily restricted in the length of time they can exist. The cost of operating and administering the QSF are miniscule in comparison to the tax advantages to the trial attorney.
The trial attorney (or his firm) can inexpensively create and maintain multiple QSFs in regard to cases and settlements. The trial attorney can allocate a percentage of each case in a manner similar to a defined contribution such as 25 percent of his compensation into a structured settlement arrangement within the QSF. In the same manner, a pension actuary can easily replicate a defined benefit design in order to determine the level of annual commitment necessary to fund a fixed retirement benefit (including a benefit designed to increase by an inflation factor) at retirement age.
Like a pension plan contribution, the defendant’s transfer of insurance proceeds to the QSF is tax deductible. The use of the PPVA creates the same tax deferral of a qualified retirement plan. The significant difference is that the lack of limits on contributions and benefits along with an absence of contribution and non-discrimination requirements.
In the current tax environment, this is the time for trial attorneys and plaintiff’s law firms to incorporate the use of the QSF as a retirement plan and deferred compensation vehicle.
IV Strategy Example
Joe Smith, age 50, is a partner is a plaintiff's law firm. Joe has a professional corporation with four additional partners. The firm’s partnership agreement provides that the partner who wins a trial gets a 60 percent compensation credit on the contingency fee with the remaining partners getting a 20 percent compensation credit. The firm allocates the remaining 20 percent to cover the firm’s fixed expenses and to fund future cases.
His combined marginal tax bracket for federal, state and city purposes is 40 percent. Joe recently settled a product liability case with a $60 million settlement. The fee agreement provides for a $19.8 million contingency fee to the firm. Joe receives a compensation credit equal to $11.88 million. The other partners receive a compensation credit equal $1.32 million each.
During the course of settlement discussions, the firm, claimant, and defendant agree to create a QSF. The defendant likes the fact that it can take a deduction for its transfer of insurance proceeds to the QSF rather than taking a deduction as the claimant receives payment. The firm petitions the probate court in the firm’s hometown to issue an order authorizing the creation of the QSF. Southern Trust Company will serve as the trustee. The CEO of Southern is Joe’s neighbor. The probate judge belongs to Joe’s country club and business club. Joe’s CPA and his firm will serve as administrator for the QSF.
The QSF trust document does limit the term of the QSF. The trustee enters into a structured settlement arrangement with Acme Life, a specialty life insurer issuing private placement insurance products. Acme owns an assignment company which is a qualified assignment company under IRC Sec 130. The assignment company purchases a PPVA contract issued by Acme.
The PPVA features an insurance dedicated fund managed by Good Investments, a registered investment advisor. Good Investments manages Joe’s investment portfolio along with several of the other partners along with the firm’s retirement plans. The investment mandate of the PPVA’s fund allows the investment manager a large degree of investment discretion and authority to invest in a wide range of asset classes including alternative investments.
The annuity provisions in Joe’s contracts provide for distributions in five years for a five year period when his daughter enters college. She plans to attend graduate school. The estimated cost is $250,000 or $50,000 per year. Beyond those interim annuity payments, the annuity settlement provisions provide for a joint and survivor annuity beginning at age 70.
The annuity payout provides for variable payouts based upon an assumed interest rate of 5 percent. If the investment performance within the PPVA exceeds this benchmark, annual annuity payments will increase. The annuity payments will cease at the death of the joint annuitant.
The projected value of the annuity in twenty years assuming an investment return of eight percent per year is $53.37 million. The projected joint and survivor annuity is $3.03 million per year. At the death of the surviving annuitant, nothing will be included in the taxable estate for federal estate tax purposes.
Joe’s partners are also age 50. Their projected value of each annuity at age 65 is $4.2 million. The projected joint and survivor annuity for each partner and their spouses is approximately is $244,000 per year.
The QSF plan assets are segregated from the claims of the firm’s creditor and personal creditors. Under state law, annuity payments are also exempt from the claims of creditors. The joint and survivor payout will also result in no inclusion for federal estate tax purposes.
The ability to use QSFs and its predecessor Designated Settlement Funds, has existed for some time. Trial attorneys and their tax advisors have missed a powerful planning opportunity in the use of these structures. QSFS certainly have a legitimate use and business purpose in facilitating the settlement of a legal case and the disbursement of funds. However, the existing law and structure provides trial attorneys with something that no other professional or business owner has – a pension plan with no limits or contribution or salary caps. The use of PPVA provides the tax deferral available in qualified retirement plans.
The next installment (Part 5) will focus on structured settlement life insurance for trial attorneys. Stay tuned!