ATTORNEY FEE DEFERRAL

March 11, 2021

Anthony F. Prieto, Jr., CFP®

Trial lawyers have been deferring fees into structured settlement products dating back to the early 1990s. The IRS challenged fee structure arrangements in Childs v. Commissioner.[1] In this seminal 1994 tax case, the IRS argued the fees should be taxed in the year earned; however, the lower court and the 11th Circuit affirmed the decision that the fees are not taxable in the year earned but in the year(s) payments are received from the attorney fee structure. The ruling is more in-depth, but this established the precedent allowing fee deferral solutions to be developed.

The basic concept of these solutions is an irrevocable assignment of a fee before it is earned. This creates separation and keeps the taxpayer from taking constructive receipt of the funds. [2] A portion of the fee (up to 100%) can be used to purchase periodic payments that are taxed in the calendar year that funds are received. The amount deferred is not limited like a traditional 401(k) or IRA program. The age funds can be received is also not limited, so payments can be made before age 59.5.

What does this mean to an attorney? Simply put, with proper planning an attorney can manage the timing of their income. This gives the attorney two ways to generate a return on their fee. The first way is to earn a return via the investment itself. The products available offer a variety of investment choices. An attorney can be as safe or aggressive as they choose from an investment perspective. Products are available that allow an attorney to place a fee in a variety of annuity or investment funds. The variety of options has increased over the last ten years and allows for most people to find a solution that meets their objectives. The return can be fixed or variable in these products. The interest earned is deferred.

The second way to earn return is to receive payments at a lower tax rate in subsequent tax years. Regardless of political views, almost every change in the White House comes with a new tax plan. The tax plan usually involves some changes to the marginal rates on earned income. President Biden has introduced a variety of tax-related items during the past year. One that he frequently referred to during his campaign was an increase on top earners. He has stated that he will seek an increase the marginal tax bracket from 37% to 39.6% for those earning over $400,000. He has also proposed moving the capital gains rate to 39.6% for those earning over $1,000,000. These two changes could allow an attorney to pay a lower amount in taxes if they can defer until tax rates are lower. Any reduction in tax payments creates an added return for the attorney.

If you can combine a positive return on your investments and a reduced tax burden, you have created two ways to benefit from deferring a fee. The products in place create powerful tools that are not available to most taxpayers. It can be used in combination with other retirement plans to create income without a penalty before age 59.5. It can be used to defer excess amounts when you reach your deferral limits, which is $19,500 in 2021.

Attorney fee deferrals have a lot of benefits and with proper planning can create a more comprehensive retirement plan for most attorneys. It is always a good exercise to review the options with your tax and planning advisors to see what plan matches your long-term goals.

 

[1] A summary of Childs v. Commissioner can be found here: https://www.irs.gov/pub/irs-wd/0836019.pdf

[2] An explanation of constructive receipt can be found here: https://www.law.cornell.edu/cfr/text/26/1.451-2

[3] The IRS’ contribution limits can be found here: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits

 

May 13, 2020

An often-overlooked issue for plaintiff attorneys is the management of taxation of their own contingent legal fees. As part of the normal rhythm of their practices, many attorneys experience peaks and valleys with their own personal income. This leads to concerns for trial attorneys about the unpredictability of their own income. However, attorneys have a unique opportunity, not available to others who earn professional fees, to take their contingent legal fees and invest them on a pre-tax and tax-deferred basis to smooth out income.

To learn more download at the link below.

Reduce Taxes and Save for Retirement with Attorney Fee Deferrals

A few months ago, a trial attorney in New York City had just settled a big case. He was like a lot of people reading this article; well-respected, successful, hardworking. But while he was excited about the result, he was frustrated with the massive amount of taxes he would have to pay. So, he decided to consider deferring his fee.

He learned that deferring fees is similar to the deferred compensation programs offered to top executives at Fortune 500 companies. Just like in a 401(k), you don’t pay taxes on the fee until you receive it. In the meantime, the money earns the returns of various investments that you or your financial advisor chooses – stocks, bonds, real estate, etc. But unlike a 401(k), there is no limit on how much you can defer.

This can significantly reduce your tax burden in two ways. First, as with a 401(k), when you pay taxes later, your money grows faster. Second, by spreading the income out over time, you can end up in a lower tax bracket.

In addition to reducing his tax burden, this attorney learned that deferring his fee enabled him to better meet his cash-flow needs.   While he wasn’t allowed to accelerate his scheduled distribution payments, he could choose to re-defer his payments within the rules of tax-deferred compensation.   In addition, fee deferrals can be used as “golden handcuffs” to retain key associates, whereby if they leave too soon their deferred bonus comes back to the firm.

Ultimately this attorney did his due diligence and decided to defer a $1,000,000 of his fee. He ultimately chose to defer to significantly reduce his tax burden and better control his cash-flow needs.

Key Takeaways

  1. Attorneys can defer compensation like Fortune 500 executives do, to reduce their tax burdens
  2. Tie your fee to the returns of investments that you select – stocks, bonds, real estate, etc.
  3. Exercise better control over the timing of payments, and the resulting taxation.
  4. Use “golden handcuffs” to retain key associates, whereby if they leave too soon their deferred bonus comes back to the firm.

This attorney is one of the hundreds that have deferred fees in recent years. In fact, the concept has been around for decades. A lawyer’s right to defer fees was established by the U.S. Tax Court in Childs v. Commissioner (1994) and affirmed two years later by the 11th Circuit U.S. Federal Appeals Court. The IRS also cited the Childs case favorably in Private Letter Ruling 200836019.

From a legal perspective, fee deferrals are materially subject to the same body of tax rules that govern Nonqualified Deferred Compensation (NQDC), namely the constructive receipt and economic benefit doctrines. As mentioned earlier, Fortune 500 companies have been using NQDC for many decades to attract and retain their top executives.

So, what are the steps to defer? The steps are quite simple – and similar to a traditional fee structure. The attorney must enter into a Deferred Payment Agreement before the final settlement (i.e. before signing the release). Each partner decides how much to defer and for how long. This is the most critical part of the process.

It is also recommended that deferral language is added to the fee agreement with your client providing the client’s consent to fee deferrals and that the defendant is instructed to wire the deferred amount directly to the trustee and custodian. Payment instructions are often included in the release agreements, as well.  In some cases, settlement monies are first paid into a Qualified Settlement Fund (QSF) and form there wired to the trustee and custodian.  A QSF is basically an escrow account or trust that provides the necessary time for proper settlement planning and liens negotiation.  In essence, it gives both the clients and the attorneys more time to figure out what to do with the settlement monies without the involvement of the defendant.

Fee deferrals can offer a range of benefits, from reducing an attorney’s tax burden to increasing their access to cash and helping them retain key associates. Deferring fees is not for everyone, however, particularly if an attorney needs the money now. And if an attorney does want to defer, selecting the right provider is critical to the safety of the deferral.

According to Yahoo Finance, in 1998 59% of Fortune 500 companies offered traditionally defined benefit pension plans to new hires.  However, by 2017 Yahoo reported that only 16% of those same companies offered a traditional defined benefit pension plan.  Defined Benefits Pensions typically pay a retiring employee a percentage of their average earnings for the remainder of their life based on the years with a company.

However, Trial Lawyers are in a unique position to create their own “pension” backed by some of the highest-rated life insurance companies in the world.  A lawyer can do so by electing to enter into an attorney fee structure.  In 1996, the 11th Circuit case Childs v. Commissioner was decided which rejected the Internal Revenue Service’s attack on attorney fee structure annuities.  Since then, the IRS hasn’t again challenged a lawyer’s ability to invest their fees on a pre-tax and tax-deferred basis.  As a result of Childs, like your 401(k) or IRA, an attorney can enter into a fee deferral program and defer the taxation until the funds are withdrawn.  The real benefit is there is NO LIMIT on how much you can defer in a calendar year.  You can defer $10,000 or $10,000,000 on the same pre-tax basis. So it is really a Super IRA.

Structured attorney fees work very much like a non-qualified deferred compensation plan.  The taxes that would be otherwise paid on the fee earned at the time the case is settled are deferred, and that money grows without tax on the growth.  When distributions are made, the entire amount distributed during a year is taxable for that year.  Based upon a taxpayer’s tax bracket, there may be some distinct tax advantages to entering into this type of arrangement as opposed to being taxed on the entire fee in the year it was earned and investing it after tax.

Time is of the Essence

The most important factor in your retirement planning is time.  The interest rate you earn on the funds is helpful but starting early is more valuable.  At a recent state trial lawyer convention, they were discussing membership and the host said 8% of their membership responded to a survey that they would retire in the next 5 years.  That sparked our interest.  We went to the Department of Labor and Statistics to see the workforce demographics reported in 2018 and extrapolated some data to make assumptions about the Trial Lawyer community.

For demographic purposes, you can make the estimation that about 90% of all trial lawyers are between 24 and 65 years of age.

Ages 25 to 34:                                                    23%

Ages 35 to 44:                                                    25%

Ages 45 to 54:                                                    25%

Ages 55 to 64:                                                    19%

If we assume that most attorneys will receive $30,000 from Social Security at age 65, you will need to create another $70,000 to reach six figures.  Here is the cost to defer today and set up an annual payment of $70,000 a year at age 65 guaranteed for the remainder of your life.

Age:       33                                           Cost:      $479,889.20

Age:       43                                           Cost:      $659,381.80

Age:       53                                           Cost:      $908,812.80

If you placed the amount above in a traditional attorney fee structure, you would receive $70,000 annually each year for the remainder of your life starting at age 65.  For female attorneys, the costs would be slightly higher because females tend to live longer; however, the percentages are the same.  If you wait until 43, you will need to invest 37% more to achieve the same payments at retirement age.  If you wait until 53, you will need to invest 89% more to achieve the same result.

As you have read in our other Attorney Fee blog posts, there are many ways to defer your fees. This link describes some of the pros and cons of the various options you have available to you.

It is important to understand that regardless of the rate, the longer you wait to start the more you will have to invest to achieve the same benefits.  The amount of money you need to invest to achieve your desired goal will always increase.  Every delay in starting costs you more money.

The risk you take with the deferrals is very specific to your own personal market experience and tolerance.

Defer Fees on Your Terms

You can start to build your plan with $25,000 or $50,000.  You can do it one time or one hundred times.  You can defer one year and not the next.  One partner in the firm can defer and the other can take their fee now. There really is no limitation to how you use deferral program.  The options are endless.

Warren Buffet said, “The rich invest in time.  The poor invest in money.”  The most important thing to do is start now.  Your age does not matter because every day you wait will cost you more for the same plan.  The more time you have the less money you need to invest!

 

Investing your fees in a pre-tax and tax-deferred attorney fee deferral program is a very smart way to plan for the future. Attorney fee deferral programs are created for a variety of reasons. Based upon your specific planning needs and objectives, you can defer your contingent legal fees to accomplish any of the following:

  • Cover future fixed costs of your law firm
  • Reduce present-day tax burdens by receiving income over time
  • Create “golden handcuffs” for key firm employees
  • Pay for future personal expenses (for example, college expenses for your children)
  • Retirement planning needs

Most attorneys use fee deferrals for traditional retirement planning purposes. Attorneys can utilize normal retirement plans as part of their overall portfolio. They can use IRAs, Roth IRAs, 401(k)s or other traditional options available to non-lawyers. These options are usually the starting point for a retirement savings plan. However, attorneys can utilize fee deferrals to uncap the amount they can invest pre-tax each year and eliminate early withdrawal penalties associated with traditional retirement plans.

The benefits and ways to use attorney fee deferrals are many. The problem is that attorneys generally do not leverage them the way they should. In an industry that creates billions of dollars of contingent legal fees each year, a very small percentage are deferred using attorney fee deferral programs. When it comes to retirement planning, the one mistake you cannot make is doing nothing at all. You must do something!

Choosing the right plan or deferral time frame isn’t as important as creating a systematic program of deferring fees and sticking with it. The program can be modified and new deferrals can account for changes that might become necessary in the future. If you defer too long, you can defer your next one for a shorter time frame. If you defer too short, you can defer your next fee for a longer period. If you think the rate of return in one program is low, you can utilize a different plan the next time. You can change the plans and adapt along the way. The one thing you cannot change is the missed opportunity if you fail to defer.

The power of deferral is a function of two variables: time and interest rate. The earlier you defer and the longer the duration, the more exponential growth you will experience. To illustrate, take a hypothetical 45 year old lawyer whose birthday is July 28. If he or she defers a $25,000 fee on October 1, 2018, here are the numeric differences at 5 year intervals using an assumed 5% interest rate:

Age 50: $31,803.43
Age 55: $40,815.21
Age 60: $52,380.55
Age 65: $67,223.04

As you can see, the compounding of interest starts to multiply very rapidly after 10 years. The 5% used above is a very conservative assumed interest rate. The average rate of return of the S&P 500 over the last 90 years is over 9%. Here is the same $25,000 fee deferral at 9% assumed interest rate:

Age 50: $38,529.18
Age 55: $60,624.42
Age 60: $94,448.88
Age 65: $147,876.70

The rate of return has a big impact but time is the equalizer. You must do something now to capitalize on the programs available. For my fellow Generation X readers, a study by Nationwide showed that 52% of us do not utilize a financial advisor or seek financial guidance. This percentage is very troubling when coupled with the fact that we are in our prime earning years. We are earning more money and not seeking or receiving any guidance. If you don’t have a plan – you are not going retire the way you want.

Financial stability is also a driver in your mental and physical health. According to the Gallup-Healthways Well Being Index and other studies, Americans with greater financial stability are in better physical and mental condition. Good health into your retirement years can create a longer income-generating life and decrease your overall health costs in retirement. Developing a plan is a win/win!

Fee Deferral must start today if you want to be prepared for when you retire. The decisions about plan design are less important and can be changed as you grow into your plan. The decision to defer a $25,000 fee is not going to have a major impact on your life in 20 years. However, if you wait 5 years to start it will be far less impactful. The Washington Post reported that the biggest regret for Americans was not saving for retirement. Do not become a statistic. Start your fee deferral program today.

 

Want more?

 

Watch our previously recorded Third Thursday Webinar.

 

For more information on the types of programs available to attorneys see our previous blog posts:

Defer Taxation of Your Legal Fees and Take Control of Timing of Income

The Benefits of Attorney Fee Deferral Programs

Now Is the Time to Defer Taxes on Contingent Legal Fees: When does a 0% rate of return make sense?

Many attorneys have questions when it comes to how to avoid the spikes in income and the accompanying taxation common with contingent legal fees. There are custom tailored solutions for attorneys who work on a contingent fee basis to avoid these issues. Attorney fee structures and deferred compensation arrangements allow lawyers to avoid taking income all in one taxable year when they earn a large fee. These solutions are pre-tax and tax-deferred investment vehicles only available to an attorney prior to resolving a case and earning the fee. They have to be explored and decided upon prior to signing a release. While these solutions may seem complex, they are actually quite simple. Having an expert advisor such as Synergy who can provide you with different options is critical. The remainder of this blog answers some frequently asked questions about deferral of contingent legal fees.

What is an “Attorney Fee Deferral”?

Attorney’s that work on a contingency fee basis can defer taxation of their fees through the use of several products. An attorney can utilize high end deferred compensation, traditional structured settlement annuities, and offshore assignment programs.

How is it different than a 401(K) or any other retirement plan?

There are two main differences from traditional plans. Traditional plans have deferral limits and a penalty for early withdrawal (prior to 59 ½). To compare:

Deferral Limits: There is no limit on the amount an attorney can defer using these products. Traditional plans are restricted by annual guidelines issued by the IRS. In October, the IRS issued Notice 2017-64 for the calendar year 2018. It reviews the current year 415 plan guidelines. Most of the plans are capped at contributions of $18,500 for this year.

Withdrawal Limitations: Attorney Fee Deferral programs do not have pre-fifty-nine and a half withdrawal penalties or limitations. An attorney can defer his fees early on and start to take distributions with no penalty at any age. In a traditional plan, you would incur a 10% tax penalty for early withdrawal unless you met one of the few exceptions.

How come my CPA or Tax Professional does not know about it?

These programs cater to a very small percentage of the overall US population. Not only is it specific to attorneys, it is specific to the subset that works on a contingency fee basis. Many CPAs aren’t aware of niche tax decisions such as the Childs v. Commissioner decision described below. Once a CPA is educated about these solutions, they quickly see the immense value to the attorney clients they work with on a regular basis.

What is the underlying legal basis that allows this to be done?

In 2001, the Richard A. Childs, et al. v Commissioner of Internal Revenue ruling held that attorneys can defer their fees and pay taxes in the calendar year they are actually received. Under Childs, a lawyer is allowed to defer his or her fees and be paid out over time using a periodic payment schedule and only pay taxes on the amounts as they are received. The programs available all utilize this in their plan design.

Where does my fee go and does it earn interest?

The fee paid over to a life insurance company or trust company which then either funds an annuity contract or investment account. The annuity insurance contract earns a fixed return. The investment account would earn variable interest based on market performance. Similar to most retirement plans, there are a variety of investment choices from fixed interest to high-risk stock portfolios.

Do I need to defer my entire fee?

No, in fact, it is very common to defer as little as $25,000 of a fee. Many attorneys defer portions of several fees each year while others defer in large amounts.

Will deferring my fee guarantee I pay less taxes?

No, the use of a fee deferral does not guarantee that you will pay less in taxes. It does allow more of your money to work for you over time but nobody can predict the future tax tables. The taxes paid will be upon receipt. Some plans do allow you to extend deferrals which may allow you to plan around new tax changes.

Are there limitations I need to consider?

Yes, the main limitation is with accelerating or changing the payment plan. The plan you set up is a part of the underlying settlement agreement and release. It cannot be changed without selling the payments on the secondary market which will result in a loss. Some products do offer loan provisions.

What are some ways you have seen attorneys use the programs?

The primary use of deferred fees is to create a flow of income that can be used for retirement. However, we have clients that use them for a variety of reasons:

  • Create recurring cash flows to cover law firm costs
  • Create golden handcuffs for associates
  • Spread out the tax implication of a large fee
  • Bridge retirement income between ages 50 and 59 ½

Conclusion

Tax deferral mechanisms for lawyers are a great way to smooth out those income spikes caused by larger fees or just take better control over the timing of income. Because of the variety of options, there is likely something that will best suit your needs and investment preferences. It no longer is just limited to a fixed investment vehicle. Explore these options so that you can take back control over your income. Learn more by visiting https://synergysettlements.com/service/attorney-fee-deferral/

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