Tax Reduction and Deferral Strategies for Trial Attorneys – Part 7: The Law –SERP - Supplemental Retirement Plans for Plaintiff’s Firm

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I Overview

I am sure every trial attorney remembers his or her first trial and the first large verdict or settlement that represented the financial breakthrough , i.e. the day that everything changed financially and professionally.

Unfortunately, it is human nature to believe that success is the result of our own professional efforts without any assistance. Law firms are not immune to this problem. Law firms in general and particularly plaintiff’s firms are made up of mix of two different types of lawyers. One set of partners has excellent business acumen and business development skills. The other set of partners has excellent legal skills. Behind the scene of the law firm is a staff of excellent staff of professional and administrative support personnel who have a tremendous ability to put the case and evidence together for litigation. The settlement or verdict is the result of a team effort and not the result a single person’s efforts.

This article is designed to discuss the ability and importance of plaintiff’s firms to attract and retain key personnel – partners, associates, and key litigation staff in the plaintiff’s law firm. The article outlines a supplemental retirement plan as a long-term plan to ensure the retention and financial security of key personnel in the plaintiff’s law firm (Law-SERP or Law- Supplemental Executive Retirement Plan). The mechanism to finance the supplemental plan is the contingency fee which is the financial engine of the plaintiff’s law firm. The Law-SERP is a plan that supplements the firm’s qualified retirement plans.  I have discussed throughout this series that qualified retirement plans provide a small degree of long-term financial security due to the regulatory constraints of these plans.

II The Approaching Tax Storm

The tax environment for high income tax payers is set to undergo a substantial change in a few months. 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 rate by 1-2 percent. State marginal tax rates can add another 4-10 percent to the overall tax rate. What all of these changes mean is that many trial attorneys will have a combined marginal tax rate in excess of 50 percent.

III The Limitation of Qualified Retirement Plans

The current economic environment has placed a strangle hold on many law firms and their ability and commitment to make contributions to employer-sponsored retirement plans. As a result, many law firms have limited their qualified retirement plan to a 401(k) plan which allows a firm employee to defer up to $17,000 on a pre-tax basis with a catch up contribution of $5,500 for employees over age 50. The firm may make matching contributions of fifty cents on each dollar contributed to the plan or a dollar-for-dollar matching contribution up to three percent of the employee’s earnings.

The same regulations that provide for non-discrimination regarding participation and contributions are the same regulations which limit the ability of a law firm to provide meaningful long-term benefits not only for retirement but other important milestone obligations – children’s college education or  the purchase of a home or second home. As a result, the plaintiff’s law firm is in a unique position to provide exceptional long-term financial security for key personnel – lawyers as well as paralegals.

Unlike a qualified retirement plan arrangement, the Law-SERP with respect to the trial attorney does not have a cap on contributions to the non-qualified plan 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 non-qualified 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.

IV What is the Law-SERP?

The Law-SERP is a non-qualified deferred compensation arrangement or supplemental retirement plan for plaintiff’s law firms. The Plan is a contractual arrangement between the law firm and a group of key employees (lawyers and paralegals) to provide supplemental benefits over and above the firm’s qualified retirement plan and benefit plans. The cost of the Law-SERP is informally funded by contingency fees that are deferred from case settlements and verdicts. Contingency fees payable to the law firm will be deferred within  a Qualified Settlement Fund (“QSF”) whenever it can be used or an assignment company. The plan will also allow partners to defer their compensation as part of the Law-SERP.

The goal of the Law-SERP is to provide certain key members of the firm with supplemental retirement and compensatory payments along with death benefit payments. The Law-SERP provides for funding levels that go well beyond the limitations of ERISA-based plans and a vesting schedule that serves as a “golden handcuff” to key firm members that participate in the Plan. The Plan provides for a forfeiture of benefits if an attorney or key employee terminates employment prior to a specified age or goes to work for a competing firm or an attorney becomes a key competitor.

Under the Law-SERP, the participants are not taxed on benefits until the participant actually receives a distribution from the plan. The Plan benefits will grow on a tax-deferred basis through the use of private placement variable annuities and life insurance as the funding vehicles within the Plan.

Generally speaking, non-qualified deferred compensation arrangements in traditional law firms would be funded with after-tax dollars due to the corporate structure of most law firms. Many firms are structured as limited liability partnerships (LLP) which are pass-through entities for tax purposes. The contingency fee nature of the Plaintiff’s law firm and the ability to structure these fees for payment on a deferred basis places these law firms in a unique situation.

V Basic Requirements for the Law-SERP

The foundation of the  Law-SERP is a firm resolution authorizing a legal agreement between the firm and participating employees within the firm. The agreement specifies promises by the firm to make specified payments upon the occurrence of certain triggering events such as death, retirement, long-term disability as non-traditional events such as down payment for a purchase of a home, college tuition of children). These payments are conditioned upon the continuing services of the attorney or employee. The firm’s resolution notes the importance of the employee to the firm.

A second firm resolution authorizes the purchase of private placement variable deferred annuities (PPVA) or private placement life insurance (PPLI) to indemnify the firm for the significant costs it will incur at the death of the employee before retirement. The managing member of the firm and the participating employee together sign the deferred compensation agreement. The assets to fund the plan are held in the QSF. The firm files a one-page ERISA notice which is filed with the Department of Labor. 

The funding assets technically remain on the firm’s books as a firm asset subject to the claims of the firm’s creditor. However, in many respects the QSF functions as a form of Rabbi Trust which has been traditionally used in corporate non-qualified deferred compensation arrangements. A separate article in this series will discuss the jurisdiction for the trust.

II   What is a Qualified Settlement Fund (QSF)?

QSFs are trusts that are designed to resolve litigation and satisfy the 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 could 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.

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 to work out the details of their distribution.

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.

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, estate and municipal securities under IRC Sec 115 is also excluded. A QSF may take deductions for its administrative costs, 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 Private Placement Life Insurance and Variable Annuities

Previous installments in this series have discussed ad nauseam the benefits of private placement insurance products – institutional pricing, unlimited investment flexibility and the tax advantages of life insurance and annuities.

VII   Strategy Example

A. The Facts

Joe Smith, age 50, is a partner is a plaintiff's law firm Smith Associates, LLP. The firm is established as a Delaware limited liability partnership. The firm has five partners including Joe and five associates. The firm also has five paralegals that provide important litigation support. The firm is expecting a $10 million dollar contingency fee this year from a product liability case that is expected to settlement before year’s end.

The firm currently provides a 401(k) plan and provides matching on a dollar-for-dollar basis. Joe and his fellow partners would like to create a non-qualified retirement plan that provides long-term financial security for key personnel for the following contingencies – long-term disability, death and retirement. The partners would also like a plan that will provide distributions for key lifetime events such as the purchase of a home as well as tuition payments for children.

The partners would like a plan that serves as a “golden handcuff” for plan participants by requiring them to remain with the firm at least twenty years while preventing plan participants from working for competitors by terminating benefit payments. Benefits are 100 percent vested in the event of death or long-term disability.

Firm  Census

Name                              Position          Earnings                   Years of Service

Joe Smith                       Partner          $2 million                        10

Bob Jones                       Partner          $1.75 million                   10

Alex Johnson                 Partner          $1.25 million                     7

Maria Gonzalez             Partner          $750,000                            5

Mary Axelrod                Paralegal        $100,000                           5

Sally Pearson                Paralegal        $100,000                           5

Eddie Rodriguez            Associate       $225,000                           5

Sy Goldstein                  Associate        $375,000                           5

 

B.Solution

The firm seeks to adopt the Law-SERP as a non-qualified deferred compensation solution for key partners, attorneys and paralegals within the firm. The firm will initially invite all five partners, two associates that have been with the firm at least five years and two key paralegals that have been with the firm at least five years into the Plan.

The Plan provides for retirement, long-term disability, and a death benefit provisions. The plan is a defined contribution style of plan that will provide for plan contribution equal to 100 percent of the participant’s earnings in the current year. The plan will also have a schedule of contributions based upon the amount of contingency fee deferral made by the firm. The plan will provide for a vesting schedule that provides for 50 percent vesting after ten years of service with the firm and 100 percent vesting after twenty years with the firm.

Plan participants will forfeit benefits if they leave the firm to work for a competing law firm during this time period. Agreements not to compete may be unenforceable in the legal industry but should not affect the termination of benefit payments pursuant to a non-qualified deferred compensation agreement. The Law-SERP’s non-compete provisions do not relate to a lawyer’s ability to practice law but terminate benefit payments under the non-qualified plan of the former firm.

The will also provide for long-term disability payments of the participant’s account balance over a ten year period following an elimination period equal to the elimination period under the firm’s long term disability program. The Law-SERP provides for a lump sum death benefit to a designated beneficiary of the plan participant equal to 10 times earnings in the current year.

The trustee of the QSF purchases private placement life insurance insuring the life of each plan participant in order to fund the death benefit provisions of the plan. The life insurance will also serve as the funding vehicle for payment of future benefit distributions. The insurance will provide for tax-free accumulation of investments within the QSF. The policy is structured as an endorsement split dollar arrangement with each participant. The QSF is the applicant, owner and beneficiary of the policy. The trustee of the QSF has an interest in the policy cash value and death benefit equal to the greater of cash value and premiums. The excess death benefit is endorsed to the plan participant who may irrevocably endorse the plan’s death benefit to an irrevocable trust.

The plan participant will have reportable taxable income each year for the economic benefit of the death protection under the plan. The economic benefit is measured by the term insurance cost of the death benefit. The amount of taxation is minimal compared to the participant’s benefits under the plan.

The trustee will be able to access the policy cash value to make plan distributions for lifetime contingencies or alternatively, use the life insurance as a cost recovery vehicle in order to reimburse the firm for its costs under the plan.

Summary

The Law-SERP is a unique deferred compensation plan designed for the Plaintiff’s law firm. The plan is able to use pre-tax dollars from contingency fees that are structured for deferral using Qualified Settlement Funds or assignment companies to finance the benefits of the law firm with its participating attorneys and firm employees under the agreement. The agreement provides for flexible and substantial plan benefits for death and retirement as well as specialized distributions for college education and the purchase of a home (or second home). More importantly, it can overcome the ability to use “golden handcuffs” with plan participants by cutting off substantial benefits for the attorney or key paralegal that is looking to walk across the street to work for the firm’s biggest competitor.

The next several installments  will focus on different aspects of the Law-SERP. Stay tuned!