September 14, 2023
Trial lawyers typically have large swings in their income based on the cases that settle in a calendar year. Unfortunately, it is hard to control the day a settlement will occur or when the settlement will be paid. This presents a problem in higher income years which create higher income tax liabilities. Fortunately, an increasing number of programs and processes are available for attorneys to plan for these income fluctuations.
These swings in income make it harder to plan for your retirement. In the past we have consulted with attorneys who were hesitant to use a deferral program because they were unsure about future years’ income. In other instances, they want to use the influx of revenue to offset costs on other cases in their inventory. These difficult decisions arise when there is not enough time to plan. The best plans are created when experts in various strategies work together to meet your specific needs.
Deferral Plans & Tax Financing Programs
Let’s first explore two ways to plan for higher income years: deferral plans and tax financing programs.
The traditional solutions use several different tax deferral programs such as:
- Employer-sponsored plans (401k, Simple IRAs, profit-sharing programs)
- Annuity-based structured attorney fee programs
- Deferred compensation programs
Trial attorneys can invest all or part of their contingent legal fees on a pre-tax and tax deferred basis using employer sponsored plans, annuity-based attorney fee structures or deferred compensation plans. These pre-tax investment options allow attorneys the unique ability to control the timing of their income in any given taxable year.
Benefits of tax deferral programs:
- Tax deferred growth: The full value of the funds put into a tax deferral program are invested on a pre-tax basis. This allows for more funds to be working for you.
- Lower current tax liability: The majority of tax deferred programs lower the amount of current year income. The amount placed in the program is considered income in the withdrawal year, not the deferral year.
- Control over timing: Deferring income to future years allows you more time to plan around the withdrawal years. You can consult with your tax advisors to potentially create a plan that will allow a lower tax liability in the year of withdrawal when compared to what was due in the year of deferral.
- Beneficiary and estate planning: Deferral programs can benefit your heirs (beneficiaries). The beneficiary will be responsible for the taxes, but they can potentially use programs to stretch the growth for a longer time frame.
Tax financing is a new way for an attorney to pay the tax in full through a financed arrangement. As opposed to using your own funds to pay the liability in the year due, you borrow the funds and pay those back on a three-to-five-year schedule. For example, if you have a $1,000,000 fee. We will assume you owe at a combined rate of 35%. The $350,000 tax bill is due for that year which limits the amount of funds you can invest. If you were to take a loan for $350,000, you would invest the full fee and pay the loan back over time. This allows you to have your full $1M fee working for you to potentially create a better monetary outcome.
Benefits of financing tax obligations:
- Cash flow management: The use of a financing vehicle allows you to spread the tax obligation over multiple years vs a one-time immediate year payment. You will pay more overtime but in smaller amounts over a longer period.
- Preserving more liquidity: Financing in general allows you to keep more money now and pay over a longer period. This allows you to keep more of your cash now and maintain a larger amount of liquidity.
- Deployment of capital: The funds that would have been used to pay the current tax liability can be deferred to other investments.
- Retaining assets: The ability to finance might allow you to keep an asset that would have been needed to cover the tax due.
- Credit rating: If you finance a tax liability through a traditional note, you may increase your credit score by making payments on time.
The two strategies can be used in conjunction with each other. For example, you can use them both in one year: You can defer a portion of your fee and finance your remaining tax obligation. This would allow you to lower the current year taxes due by reducing your ordinary income and maintain liquidity by financing a tax obligation.
Third Strategy (Stack with an Insurance Product)
Alternatively, you can stack the strategies together and add in a third layer (leveraging insurance) to create optimal income streams in the future. For example, an attorney could use a deferred compensation program in year one and receive five equal payments in years two through six. The payments can be used to purchase an insurance policy (*life insurance or annuity). Spreading payments over five years might create a lower overall tax rate reducing the amount of tax that will need to be paid. The tax due in years two through six can be financed, allowing for the deployment of more funds into the insurance contract. The funds in the insurance contract can be received as loans (as opposed to income) and do not create a tax liability unless the policy is terminated. This three-tiered approach could minimize the overall taxes paid.
In combination, these three programs could provide the following benefits:
- Potential reduction of income tax due (tax deferral and insurance plan)
- Greater liquidity (tax financing)
- Tax-free cash flows (insurance plan)
- Death benefit protection (life insurance plan)
- Estate planning (tax deferral and insurance plan)
*Life insurance contracts are typically subject to medical underwriting.
The foregoing plans and programs have been used independently to plan. The use of all three may be a solution that works for you and your law practice. Creating a comprehensive plan to protect yourself from paying too much taxes on contingent legal fees while providing sufficient liquidity and cash flow are a prudent part of your overall financial planning process.
Turn to Synergy as trusted partner for your firm in mitigating the impact of taxation of contingent legal fees. Through a consultative process, we can build a strategic plan for reducing the tax burden on a year-to-year basis for fees as well as provide greater control over the timing of income. Consider us your guide to cutting edge tax deferral strategies for your firm. Learn more and contact us here.
IRS CIRCULAR 230 NOTICE: In compliance with IRS requirements, we inform you that any U.S. tax advice contained in this communication (or in any attachment) is not intended or written to be used, and cannot be used, for (a) the purpose of avoiding penalties under the Internal Revenue Code or (b) promoting, marketing or recommending to another party any transaction or matter addressed in this communication (or in any attachment).