STRUCTURRED SETTLEMENT CASH PAYOUT

Attorney Fee Structures

Do You Have a Private Retirement Plan?
By Richard B. Risk, JD, CSSC
Reprinted with Permission
Attorney fees may be deferred either as part of a “qualified assignment” of the future payments due to the client, as a convenience to the client and to satisfy the attorney fee debt, or in a non-qualified assignment. The use of the non-qualified option gives the attorney flexibility to structure fees due from other than personal physical injury or physical sickness cases. For an attorney who does not practice in physical injury tort law or workers’ compensation, the non-qualified assignment option opens up the opportunity to structure fees due from many other types of cases. An attorney fee structure can be a personal discriminatory retirement plan.
Advantages of converting an attorney fee receivable into a deferred compensation plan are:
There is no limit on the amount an attorney can defer in any year.
There is no requirement to contribute to the plan in future years.
It can supplement qualified retirement plans, again with no deferment amount limits, unaffected by the amount contributed to the qualified plan.
It can be done in addition to a SEP or an IRA, with allowed deferments unaffected by the amount contributed to the SEP or IRA.
Each time you defer a fee constitutes a separate plan, and you can have as many deferred compensation plans as you wish.
You can layer income from different plans over the same payment period and, if the funding assets are issued by different companies, you achieve portfolio diversity.
There are no annual plan evaluations required, as there are in qualified plans.
There is no requirement to include law partners, and non-attorney employees
cannot participate except through separate deferred compensation agreements with the attorney.
There is no necessity to wait until age 59½ for distribution from the plan.
You can set up lump sum payments to cover known future needs such as college education for children or to build a retirement home.
The money inside the plan, whether invested in an annuity or funded with a reinsurance assumption agreement, is guaranteed to grow at a rate specified at the time the plan is established—unaffected by the future performance of the investment marketplace. The guarantee is made by a venerable financial institution—a highly rated life insurance company by the independent analysts, i.e. Moody’s, S&P, Fitch, A.M. Best—which holds the asset.
You can avoid the highest tax bracket in an extraordinary year by spreading out income.
The plan can survive bankruptcy or divorce.
It is easy to see why a client whose damage recovery for a physical injury or physical sickness is excluded from gross income would want to receive periodic payments. The benefit is obvious. All growth of the funding asset is tax-free to the payee as long as the payee never had actual or constructive receipt of the funds used to purchase the asset, and has no ownership rights to the asset. Not only does the client receive the amount paid by the defense free of income taxes, the client can also receive future growth of that money tax-free.
In contrast, attorney fees are always taxable to the attorney as income in the years in which the fees are paid, constructively received or if the attorney is deemed to have economic benefit of an amount set aside to make future payments. The benefit of structuring taxable payments may not be so obvious, but they are significant. The taxes that would be otherwise paid by the attorney on the income earned at the time the case is settled are deferred. That money grows along with the money that ordinarily would be left after taxes. When distributions are made, the entire amount distributed during a year is taxable for that year.
Because the deferred taxes have grown for the benefit of the payee, there will be more left over after taxes than there would have been if the taxes had been withheld on the original amount earned and taxes paid each year on the entire growth—assuming tax rates do not increase. This is the principle behind qualified and nonqualified defined contribution retirement plans.
An attorney due to receive a large taxable cash sum can benefit from periodic payments by avoiding the highest tax brackets. This is a legitimate reduction in income tax liability. The highest marginal federal income tax bracket in 2001 under the law for a married couple filing jointly was 38.6 percent on any amount over $288,350, and 30 percent on the amount between $105,950 and $161,450. By spreading the income out over several years—including the growth that would occur—the recipient levels income spikes and avoids paying taxes in the highest bracket. That is equivalent to guaranteed earnings. The earnings are more, if the overall tax rates are lowered—such as what happened in 2001—and income is shifted to future years when the tax liability is less.
Nonqualified deferred compensation plans are very common in the corporate world and are well settled in tax law. Traditionally, deferred compensation plans involve an agreement between the company and its higher compensated executives. However, the concept of deferred compensation plans between employer and employee extends to the relationship between client and attorney. If a fee is due to the attorney from a client—whether fee-based or from a contingent fee agreement—that fee can be deferred. The obligation of the client to make the future payments can be assigned by novation—an agreed substitution of parties—to a third-party obligor holding a funding asset issued by a venerable financial institution highly rated by the independent analysts.
The IRS once challenged the attorney fee structure concept in Childs v. Commissioner, arguing that the attorneys should have recognized income that they chose to defer at a time when their fees remained contingent on the future execution of settlement agreements and the entry of a final court order approving them. However, the U.S. Tax Court rejected the IRS argument, confirming that traditional deferred compensation plans extended to lawyers and their clients. U.S. Tax Court is a federal court that hears appeals by taxpayers from adverse IRS decisions about tax deficiencies. On appeal by the IRS, the Eleventh Circuit affirmed the Tax Court’s ruling, and that case remains the nationwide precedent for tax treatment of attorney fee structures. See Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without opinion, 89 F.3d 856 (11th Cir. 1996).
Surviving Bankruptcy and Divorce
Whether a structured settlement, including an attorney fee structure, survives bankruptcy or divorce depends on specific facts and how they are applied to the governing law. Bankruptcy debtors were allowed to keep their structure payments in a 1998 ruling by the U.S. Bankruptcy court for the Northern District of Texas, Lubbock Division. They had lost their two children and were receiving periodic payments through a qualified assignment of the future payment liability. In re: David Lynn Alexander and Lyndia Kay Alexander, 227 B.B. 658. In a case involving both divorce and bankruptcy, the structured settlement payments were held to be exempt from bankruptcy creditors, including an ex-spouse, under Louisiana law. Shortly after marrying, the husband suffered closed-head injuries in an automobile accident leaving him permanently brain damaged. The couple sued for damages and settled for periodic payments to the husband, the obligation being assigned to a third party under Code section 130. They later divorced, and the husband agreed to a property settlement under which the wife would receive monthly payments for a specified period. The husband defaulted; the wife received a judgment for arrearages; the husband filed a bankruptcy petition. The annuity payments were listed as assets of the estate but were claimed to be exempt under state law, which in relevant part shields payments under annuity contracts from seizure.
The bankruptcy court denied the wife’s objection and the district court affirmed. A divided three-judge panel of the Fifth Circuit reversed. The panel majority’s judgment was then vacated and the case was reheard en banc, holding for the husband. In the Matter of: Paul William Orso, No. 98-31008, 5th Cir. (2002).
In some states, for example, marital property at the time of divorce is the property acquired by the parties during the marriage by the industry of the husband and wife. Structured settlement payments could be considered separate property, if the settlement occurred before the marriage. If the settlement had been for a cash lump sum, even if before marriage, it runs the risk of transmutation if the court finds that the property changed character because the parties acted in a manner that indicates their intent to change the character of the property. A structured settlement decreases the probability of a transmutation finding, because the payee has no power to change the character of the payments. The states are not uniform in how they treat marital property.
Constructive Receipt and Economic Benefit
For income deferment to work, the attorney may not take receipt of the funds—either actual or constructive receipt—and may not have economic benefit of the amount set aside to make the future payments. Section 451(a) of the Tax Code (26 U.S.C.) provides that the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer, unless, under the method of accounting used in computing taxable income, such amount is to be properly accounted for as of a different period.
Constructive receipt is defined at section 1.451-2(a) of the Income Tax Regulations (26 C.F.R.), which provides that income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
Constructive receipt generally occurs when a taxpayer receives “an unqualified vested right to receive immediate payment,” Childs, supra, quoting Martin v. Commissioner, 96 T.C. 814 (1991). Constructive receipt also occurs when a taxpayer makes a “voluntary choice not to receive payment” at a time when the taxpayer “was able to collect,” Sainte Claire Corp. v. Commissioner, T.C. Memo 1997-171 (1997).
“Disclosure by defendant of the existence, cost, or present value of the annuity will not cause … constructive receipt of the present value of the amount invested in the annuity,” Priv. Rul 83-33035.
“Knowledge of the existence, cost, and present value of the annuity contract used to fund the settlement offer … will not cause … constructive receipt of the amount payable under the annuity contract or the amount invested in the annuity contract,” Priv. Rul 90-17011.
Under the principle generally known as economic benefit, the creation by an obligor of a fund in which the taxpayer has vested rights will result in immediate inclusion by the taxpayer of the amount funded. A “fund” is created when an amount is irrevocably placed with a third party, and a taxpayer’s interest in such fund is “vested” if it is nonforfeitable. This is a common law doctrine, attributable to the landmark case Sproull v. Commissioner, 16 T.C. 244 (1950), aff’d 194 F.2d 541 (6th Cir. 1952). The 1988 amendment to section 130(c) of the Code allowing a security position in qualified assignments ahead of general creditors “was intended to allow assignments of periodic payment obligations without regard to whether the recipient has the current economic benefit of the sum required to produce payments.” Priv. Rul. 97-03038 (1997).
Attorney fee structures traditionally have been based on assignment of future payment obligations created in settlement agreements between the plaintiff and defendant that provided for the attorney fee to be paid by the obligor as a convenience to the plaintiff. However, considering these guidelines defining when constructive receipt and economic benefit are triggered, a plaintiff client may settle a claim against a defendant and receive a lump sum, then distribute the attorney fees in periodic payments. The transfer of the client’s obligation can be made to a third party under a nonqualified assignment to an offshore entity, assuming the entity is comfortable that constructive receipt has not occurred and agrees to accept the assignment. Note that, even if the damage recovery to the plaintiff is excluded from the plaintiff’s gross income under section 104, any obligation to the plaintiff’s attorney cannot be transferred as a “qualified assignment” under section 130 once the plaintiff takes receipt of the funds. This nonqualified assignment arrangement would not require the cooperation of the defendant or its insurer, if the plaintiff settles for a single cash lump sum.
This concept works only if the lump sum check is not payable to the attorney or the attorney’s trust account. Attorneys have a comfort level in and are used to depositing case settlement payments into their trust account, where they control distribution, ensuring that all expenses are covered and liens satisfied, including their own attorney fee, before the plaintiff gets what is left. To change this procedure and allow the settlement check to be made payable only to your client might require an adjustment on your part.
But, this does not preclude the check from being delivered to you, where you will hold it pending satisfaction of liens and seeing that it is deposited in the client’s bank account—as long as the check is payable to your client and you have no power to deposit or otherwise negotiate it. (Note: Contact the structured settlement broker before you proceed with this arrangement to be sure there is a willing assignee under the particular set of facts.)
Payment of an attorney fee by a client from the client’s own funds, even when no damages were recovered from a defendant in the underlying case, can be deferred and the obligation transferred to an offshore assignee. Again, this assumes that the intended assignee is satisfied that constructive receipt or economic benefit has not occurred.
Selecting the Funding Asset, Method of Assignment, and Insurer to Issue the Asset
There are several considerations that will determine the type of funding asset to be chosen, the method of assigning the future payment obligation, and the selection of the company to issue the funding asset:
Is this a fee for services with no amount being recovered by your client from another party?
If the funds from the client are being recovered as damages from another party, what is the underlying event that gave rise to the claim? Physical injury, physical sickness or death? Nonphysical injury, i.e., defamation, punitive damages, psychological or emotional distress, breach of contract, property damage, fraud, harassment, other intentional torts, etc.?
Will your client also be deferring part of the damage recovery?
Who will be paying the funds? Your client? A self-insured defendant? A liability insurance company?
If the funds are coming from a defendant or liability insurer, will that party cooperate by creating a future payment obligation to be assigned and by allowing you to designate the broker to handle the transaction?
Qualified Assignment: If the attorney fee will be paid from funds recovered by the client as workers’ compensation or for a personal physical injury or physical sickness, both of which are excluded from the claimant’s income under section 104 of the Internal Revenue Code [26 U.S.C. § 104], the future payment obligation for attorney fees can be transferred to a third party under what is called a “qualified assignment” under Code section 130 on the theory that the funds being deferred belong to the plaintiff until they are paid to the attorney. While the attorney fee is technically an obligation between the attorney and the client, the payments are made directly from the third-party obligor to the attorney “as a convenience to the plaintiff.” Section 130 permits the future payment obligation to be funded either with an annuity or a government obligation. Virtually all qualified assignments are funded with annuities. Until recently, the only way an attorney could defer a fee from a client, if the client’s obligation was to be assigned to another party with stronger financial credentials, was if the client’s damage recovery was excluded from taxable income. A qualified assignment under the authority of section 130 was the only way, until some creative life insurance companies invented some alternatives.
Reinsurance Assumption Agreement: If the attorney fee will be paid from funds recovered by your client as taxable tort or contractual damages not excluded from your client’s taxable income under section 104, a qualified assignment under section 130 may not be made. However, the future payment liability may be assumed by a third party under a nonqualified assignment, which is still a novation and involves a substitution of parties, relieving the original obligor of all obligation. An annuity is not usually a viable funding vehicle for nonqualified assignments because of the 10 percent penalty imposed on premature distributions from annuity contracts “not held by natural persons” by Code section 72(u), unless the distribution falls into one of the exceptions under section 72(q)(2). To avoid the penalties associated with annuity ownership, when there is no applicable exception, some creative life insurance companies use a reinsurance assumption agreement, where the life insurance company assumes the future payment obligation of the original obligor, as long as the original obligor is also an insurance company.
Reinsurance agreements are between insurance companies, including some self-insured risk pools that have been assigned an identification number by the National Association of Insurance Commissioners. Reinsurance assumption agreements were first introduced to assume obligations for workers’ compensation claims filed before August 5, 1997, when section 130 was amended to include workers’ compensation claims in the field of eligibility for qualified assignments. Reinsurance agreements offered for the purpose of assuming future payment obligations are priced like single premium immediate annuities, and their payment streams can be designed just like their annuity counterparts, including lifetime payments with period certain guarantees. In fact, most companies that offer them use the same quoting software for both vehicles, the only difference being the type of contract that is issued to promise the future payments.
Nonqualified Assignment: One creative thinking company figured that the 10 percent tax penalty on annuities would have no effect on a non-natural person owner, if the annuity were owned in an environment where the tax penalty is not imposed—a “tax haven.” Taxable obligations funded with an annuity from a U.S. life insurance company are assigned to an “offshore” entity. To allay any concerns that collection from a foreign entity might be difficult in the event of default, the performance of the obligor is guaranteed by a surety bond issued by a U.S.-based property and casualty company. Since, the annuity is simply the funding asset behind the foreign obligor’s periodic payment promise and is not owned by the claimant or the attorney, there are no tax penalties that apply to the payee. Each payment received by the claimant or attorney is fully taxed, but only in the year in which that payment is received.
Two other U.S. life insurance companies followed suit, creating their own offshore entity, securing future payment obligations with a U.S. corporate guarantee.
While there is a lot of flexibility under both reinsurance agreements and offshore annuity ownership, neither device can be used to assign damages that represent wages subject to FICA and FUTA. This is the reason why a deferred compensation agreement between the client and attorney works, while an agreement between the attorney’s own law firm and the attorney will not. There may also be constructive receipt considerations in an arrangement between a law firm of a solo practitioner and the attorney, since they are the same, or if an attorney to receive the deferred compensation is also the managing partner of a multiple-attorney law firm.
The selection of the company to issue the annuity or reinsurance assumption contract will depend on a lot of factors specific to the case on which your fee is based. For example, some life insurance companies are still not comfortable with the concept of assigned attorney fees and will not accept them—even though they are approved by the U.S. Tax Court and have withstood a challenge by the IRS in one of the circuits of the U.S. Courts of Appeal. Other companies will not accept attorney fee assignments if the plaintiff does not also structure at least a part of her or his damage recovery—with varying explanations for this policy from different companies. Some companies will allow lifetime payments to an attorney, based on the attorney being the “measuring life,” while others restrict to periodic payments for a fixed number of years or deferred lump sums. There is a growing trend of more life insurance companies willing to accept assigned attorney fee structures—a sign that the companies are becoming more confident that they will not endure an adverse tax ruling.
Some companies will provide a liquidation of the present value of future guaranteed payments at the death of the attorney, for estate planning purposes—others will not. This is called a cash refund option. If an attorney warrants a rated age based on the attorney’s health history, which can increase life-contingent payment amounts, the funding asset should be purchased from a company that will assign rated ages. And, companies that offer reinsurance assumption contracts and offshore annuity ownership provide options when the damage recovery is taxable to your client. Not all companies are equal in financial strength, making the ratings by the independent analysts an important consideration. Secondary guarantees of the payment obligation are also worthy selection criteria. Therefore, annuity pricing is not the only consideration when selecting a company.
Available Payment Options
Various payment options can be combined to match the specific future needs of the attorney(s). Some of the payment options that may be offered by an annuity issuer are:
Period Certain—Regularly repeating payments of a specified amount. The payment amount may be level or increasing regularly (usually annually) by a percentage (i.e., 3% compounded) or in fixed steps to help keep pace with inflation. Payment intervals can be weekly, monthly, quarterly, semiannually, annually, or longer.
Lump Sum—A single payment of a specific amount on a specified amount.
Life (With or Without Period Certain)—Annuity payments are made for as long as the annuitant lives or for the “Period Certain,” whichever is longer. Payments may be level or increasing regularly.
Temporary (Life Contingent)—Annuity payments are made for specific fixed period or for as long as the annuitant is alive, whichever is shorter.
Endowment (Life Contingent)—A “Lump Sum” payment which will be paid only if the measuring life (annuitant) is living on the date the payment is due.
Joint (With or Without Period Certain)—Annuity payments are made for as long as at least one of the annuitants is living on the date the payment is scheduled to be made. This contract will terminate upon either the date of the last surviving annuitant’s death or the date the last guaranteed payment is made, whichever is longer. Some companies offer a different percentage of the benefit (i.e., 50%, 200%, etc.) to be paid to the survivor after the first death.
Installment Refund—Annuity payments are made for as long as the annuitant lives. Payments terminate when the annuitant dies, unless total benefits paid at that time are less than the cost of the annuity. In that event, annuity payments will be made until the total benefits equal the cost of the annuity.
Cash Refund—Annuity payments are made for as long as the annuitant lives. Payments terminate when the annuitant dies, unless total benefits paid at that time are less than the cost of the annuity. In that event, a lump sum will be made for the difference between the total benefits paid to date and the original cost. (Some companies might use a different method of calculating the cash refund amount.) This option provides for estate liquidity.
As noted earlier, because different annuity issuers have varying interpretations of the Tax Code, not all companies offer attorney fee deferrals, and those that do vary in their offerings. For example, some companies will not issue annuities for attorney fees based on the attorney’s life expectancy. The offerings of the individual company are a factor that the broker must consider in the selection of the company to be presented for consideration.