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.
- Attorneys can defer compensation like Fortune 500 executives do, to reduce their tax burdens
- Tie your fee to the returns of investments that you select – stocks, bonds, real estate, etc.
- Exercise better control over the timing of payments, and the resulting taxation.
- 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.