Tax Reduction and Deferral Strategies for Trial Attorneys - Part 1

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Overview

Trial attorneys are extremely vulnerable to changing tax landscape which is quickly becoming hostile territory. As the Bush tax cuts are due to expire at the end of December 2012, the tax increases will further erode trial attorney income. The top federal bracket increases to 39.6 percent. Wealthy lawyers will face an additional 3.8 percent on investment income. Additionally, they will face 1-2 percent in additional taxation due to the phase out of itemized deductions.

State taxation in most states easily adds another 4-5 percent. Dividend income will be taxed as ordinary income. The long term capital gains rate increases to 20 percent and most states tax capital gains as regular income. On the estate tax front, the exemption equivalent decreases from $5.12 million to $1 million.

Qualified retirement plans are minimally beneficial to high income trial attorneys. The limit on contributions to defined contribution plans is $50,000 which is not much for an attorney with $10 million of income due to a settlement. The deferral into a 401(k) plan is $17,000 in 2012 with an additional available contribution for a taxpayer over age 50 or older. Again, these limits are pretty meaningless to the high income trial attorney. Similarly, the controlled group and affiliated service group rules that apply to qualified retirement plans limits the ability of the trial attorney to work around “rank and file” employees in the firm in order to increase contributions.

What is a wealthy trial attorney to do? Part I of this series will focus on the use of private placement variable annuities (PPVA) as a structured settlement option in order to defer contingency fee income. The combination of low cost and unlimited investment flexibility makes PPVA an excellent vehicle to use. The ability to defer contingency fee income is like a Super IRA for the trial attorney.

The use of private placement variable deferred annuities (PPVA) as an SSA is something completely new to the SSA marketplace. What is arguably the best solution in terms of costs and investment flexibility is not being offered by SSA brokers. What is arguably the best solution in terms of costs and investment flexibility is not being offered by SSA brokers.

Background

Structured Settlement annuities (“SSA”) have been recognized by federal law since 1983. The original use of these arrangements was for physical injury cases. The typical arrangement for cases involving physical injury and sickness as defined under IRC Sec 104 provides for the defendant to make a “qualified assignment” of the periodic payment obligation as prescribed under the settlement agreement between the plaintiff and defendant to a qualified assignment company.

The qualified assignment company is the applicant, owner, and beneficiary of the annuity contract which it uses to make payments to the plaintiff. The plaintiff receives tax-free annuity payments and the defendant or its casualty insurance company receives a tax deduction in the year the payment it made. The defendant is released from further liability or obligation in the year it is made.

The marketplace for these annuities has evolved to handle a wider range of cases workers’ compensation claims, employment claims, non-bodily injury property and casualty claims and other negotiated settlements. SSA arrangements have been used in commercial business transactions as well.

The previous drawback of using SSA arrangements for non-qualified cases (cases not qualifying under IRC Sec 104 as settlements related to physical injury or sickness), was the inability to avoid adverse tax treatment for the assignments. Life insurers have overcome this problem by creating assignment companies in Barbados. Article 18 of the U.S.- Barbados Income Tax Treaty provides for favorable taxation of annuity benefits overcoming the limitation of IRC Sec 72(u) dealing with annuities owned by a non-natural person. This adverse tax treatment is not applicable to SSA arrangements that qualify under IRC Sec104 and IRC Sec 130.

The premium volume for SSA arrangements was reported to be $6 billion in 2007 representing 10-15 percent of the total claims. The amount of settlement claims is reported to be in excess of $100 billion in 2007. Most of these SSA transactions have been for plaintiffs rather than attorneys deferring contingency fees.

According to Tillinghast, plaintiff’s attorneys earned $30 billion in 2007. Trial attorneys have not widely used SSA arrangements for a variety of reasons. First, the annuity contracts offer very conservative returns and in the current low interest rate environment, these returns have been very low. Second, plaintiff’s firms have tremendous upfront expenses to litigate a case. As a result, a plaintiff’s firm requires a large “war chest” to meet these upfront expenses. Third, most SSA brokers do not have the proper licensing with FINRA to offer a variable annuity solution to provide investment upside for the deferred contingency fee.

The typical contingency fee arrangement for attorneys in these cases is 30-40 percent of the settlement amount. Until recently the tax treatment of attorney deferral arrangements has been uncertain. Tax legislation and court decisions have provided the necessary tax and legal technical support for these arrangements.

The annuity contracts in the SSA marketplace include both deferred and immediate annuities. These contracts are issued by some of the largest life insurers in the country such as AIG, New York Life, Met Life and MassMutual. However, the annuity contracts used have been fixed annuity contracts where the policy’s crediting rate has been tied to the investment performance of the insurer’s general account assets. In the low interest rate environment, the investment appeal of the traditional structured settlement annuity has been very unappealing.

Tax Support for the Deferral of Attorney’s Fees

In Childs v. Commissioner, 103 T.C. 634 (1994), aff’d 89F3d 856 (11th Cir 1996), the Tax Court ruled in favor of an attorney fee deferral arrangement. This decision was the first and only case supporting the right of an attorney to defer contingency fee income. The Court ruled that the attorney did not have constructive receipt of the attorney’s fees because the attorney did not have any right to a fee until the settlement agreement was signed.

Federal tax legislation introduced IRC Sec 409A to the Internal Revenue Code in 2004. This tax legislation deals with the requirements for deferred compensation arrangements. The Treasury Department issued its “Guidance on Deferred Compensation” on December 21, 2004. The FAQ Section of the IRS notice provides that the limitations of IRC Sec 409A do not extend to attorney fee deferral arrangements.

Tax Requirements for Deferring Contingency Fee Income

An attorney must avoid the application of the constructive receipt and economic benefit doctrines.  An attorney should adhere to the following guidelines in structuring a deferred fee arrangement.

1.   Settlement Agreement- The settlement agreement must certify that a contingency fee arrangement between the plaintiff and attorney is in place and that deferred payments are directed to the attorney for the benefit and convenience of the plaintiff to meet the plaintiff’s attorney’s fee obligation. The amount and timing of the payments should be specified in the agreement.

2.   Assignment –  The settlement agreement contain an obligation of the defendant to assign the settlement obligation to an assignment company. The assignment terminates the defendant’s obligation to make periodic payments. The life insurer issuing the annuity company typically owns the assignment company. The settlement agreement should contain a provision that the assignment company maintains all ownership rights and control of the annuity.

3.   Annuity Purchase – Under the terms of the assignment agreement, the assignment company purchases an annuity contract from an affiliated life insurance company to fund its obligation.

Private Placement Deferred Annuity (PPVA) Contracts

PPVA contracts are institutionally priced variable deferred annuity contracts for accredited investors and qualified purchasers as defined under federal securities law. Unlike retail variable annuity contracts, these contracts are unbundled and transparent. The contracts have no surrender penalties and are essentially “no load/low load” contracts. The policy assets are not subject to the claims of the life insurer’s assets (bankruptcy remote).

These contracts provide for the ability to customize the investment options of the contract to include alternative investments such as hedge funds, private equity, and commodities.

The investment performance of the PPVA contract is a direct pass-through to the policyholder, the assignment company. The increased account value within the annuity may increase the attorney’s future periodic payments.

The attorney may recommend an investment advisor to the insurance company that subsequent to the insurer’s due diligence review of the advisor, may enter into an investment management agreement with the insurer to manage the assets of the annuity contract. Tax laws prevent the lawyer from controlling the investment decision-making authority of the investment advisor.

The IRS issued a favorable PLR 9943002 to Met Life regarding the qualification of a variable annuity as a valid SSA. In the PLR, the IRS importantly ruled that “variable” payments still meet the definition of “fixed and determinable” payments under IRC Sec 130(c)(2)(A). Lastly, the variable annuity qualifies as a “qualified funding” asset under IRC Sec 130(d).

Case Study

The Facts:

Joe Smith, age 50, is a plaintiff’s attorney with multiple cases throughout the Southeast. Smith has a personal net worth of $20 million.  Joe is married with two children.

The Smith Law Firm has five partners. The firm in a typical year is involved in legal cases that result in settlements and decisions with damage awards of $5 million or more. The law firms estimated revenue is $50 million.

Joe currently has a new  tort case. The potential damages are conservatively valued at $10 million. Joe would like to like to defer the entire amount of his contingency fee (estimated to be $4 million).

The Strategy:

Joe’s fee agreement provides for a contingency payment of 40 percent. The agreement provides that the claimant may elect to pay these fees as periodic payments over a period of time for the convenience of the claimant. Joe elects to defer all of his legal fees that might be paid as a result of his representation of his client, Juanita Valdez.

The case settles after much negotiation for $10 million. The contingency fee of $4 million will be deferred. The defendant’s casualty insurance carrier enters into an assignment arrangement with Acme  Assignment, Ltd,  a wholly owned subsidiary of Acme  Life.  Acme is located in Barbados. Under the terms of the assignment agreement, Acme Assignment agrees to pay Joe $3 million. Payments will begin in ten years and will be paid over the joint life expectancy of Joe and his wife. Under the terms of the agreement, any investment return associated with the deferred fees is to be paid to Joe as part of the assignment.

Acme Assignment is the applicant and owner of a PPVA contract issued by its parent Acme Life. The assets of the policy are not subject to the claims of Acme’s creditors. Under Barbados law, the assets of the annuity are not subject to the creditors of the assignment company. Article 18 for the U.S.-Barbados Income Tax Treaty provides that the annuity benefits are not subject to U.S. income and withholding tax and will only be taxed to the recipient, Joe Smith, when payments are received in the U.S.

The policy provides for a several investment fund options featuring structured products featuring principal protected notes. These funds offer exposure a wide array or asset classes including alternative investments such as private equity and hedge funds.

The investment performance over the next ten years achieves a ten percent return (net of fees). At the beginning of year ten, the annuity’s account value is $10.375 million. The annuity will be annuitized using variable payments. The expected annuity payments will be a minimum of

$775,000 at the beginning of each year. Payments may increase based upon good investment performance within the annuity. The joint life expectancy of Joe and his wife is 16 years.

 Summary

The combination of private placement deferred annuity contracts and structured products provide        an exciting solution for plaintiff’s attorneys who wish to defer their legal fees. The deferral in virtually every case crosses the breakeven threshold immediately. The deferral of contingency fees is a powerful alternative above any of the qualified plan benefits available to the lawyer through the law firm firm’s sponsored benefits.

These arrangements utilize customized annuity contracts that are institutionally priced. The investment strategy guarantees the protection of the investment principal (the amount of the deferred fees) while providing an exciting upside in investment returns through exposure to a wide array of sophisticated investments.

Law firms may use these arrangements to manage provide for retention of key employees and attorneys. A law firm may manage the occasional financial insecurity of the law firm’s cash flow by anticipating overhead expenses and structuring payments to meet these obligations.

The use of PPVA contracts with structured investment products provides an opportunity to revolutionize the use of deferred fee arrangements for plaintiff’s attorneys. Trial attorneys have not actively utilized SSA arrangements due to the lack of investment flexibility performance. The PPVA opens the way for strong reconsideration.

Published In: General Business Updates, Finance & Banking Updates, Insurance Updates, Professional Practice Updates, Tax Updates

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Osborne & Osborne, PA | Attorney Advertising

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