Tax Planning Deferral Strategies for Trial Attorneys Using Private Placement Variable Deferred Annuities
There is never a shortage of lawyer jokes. It is commonly known that everyone hates lawyers except their own attorney. If a person asks for an attorney referral, he will usually send him to his ex-wife’s attorney. Trial attorneys (plaintiff’s attorneys) are blamed for everything from the high cost of healthcare to being the cause of the Bubonic Plague. It might be due to envy. The actuarial consulting firm Tillinghast did a survey of trial attorney income. In 2007 trial attorneys collectively made $40 billion for medical malpractice and personal injury cases. Trial attorneys made an additional $40 billion in the same year for employment discrimination, and securities litigation. Not Bad, right!
The money does not come so easily. Trial attorney s incur substantial risk pursuing a case on a contingency basis. The law firm incurs large financial investment to litigate the case. The case may not go to trial or settle for a number of years. Depending upon a firm’s case load, a lawyer may settle a large case every two or three years.
The current and future tax environment is not so kind to the trial attorney. Contingency income is taxed at ordinary rates. The Bush tax cuts are due to expire at the end of 2012. The top marginal tax bracket will increase to 39.6%. A new Medicare tax of 3.8 percent will apply to unearned income in excess of $250,000. All of this occurs before tax reform. Additionally, state and municipal governments are looking to increase income tax rates as well. If you live in New York or California, trial attorneys will pay income taxes at a rate of close to fifty percent.
Qualified retirement plans are not of significant benefit high to trial lawyers. The annual compensation limit is only $250,000. The maximum contribution limit for defined contribution plans is $50,000. If you make $3 million in a year, the defined contribution maximum limit is not much of a dent on personal income taxes. Furthermore, the controlled group and affiliated service group rules largely handcuff the ability to skew pension contributions in favor of partners in the law firm.
The structured settlement annuity marketplace is a small but very well organized association of insurance producers who primarily sell structured settlement annuities to plaintiffs. These annuities are fixed annuities. The payments are guaranteed by the full faith and credit of the life insurer issuing the annuity. The annuity payout is based upon the insurance company’s general account investment performance.
The ability for trial attorneys to defer contingency fee income has existed since about 1995. However, the deferral of contingency fees has not represented a large part of the settlement broker’s business. There are probably several reasons for this- (1) The lawyers need to retain money in the firm’s “war chest” to finance future cases. (2) Trial attorneys have expensive lifestyles (3) investment performance and investment control. The current low interest environment is not sufficiently enticing for trial attorneys. Also, the trial attorney has no ability to change investment strategies in the typical structured settlement arrangement.
In the future tax environment, trial attorneys will be further starved for tax reduction and deferral strategies. This article is a brief overview of several different strategies for trial attorneys to consider.
II Structured Settlement Annuities using Private Placement Variable Deferred Annuities
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 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.
III 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. Before signing the settlement agreement, the attorney agreed to receive his fee over time. The attorney also did not have any economic benefit, i.e. no funds were accessible by the attorney before the agreement. The life insurer’s guarantee did not meet the definition of property under IRC Sec 83.
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.
In January 2005, the U.S. Supreme Court issued a decision in the consolidated cases of Commissioner V. Banks, and Commissioner V. Banaitis. The Court while focusing on the issue of attorney’s fees to the plaintiff. In reaching this decision, the Court reasoned that attorney’s do not have a property interest in the in the settlement recovery. This aspect is a critical element enabling an attorney ability to defer fees.
IV 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 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. This agreement made in writing before the fees are earned (before the settlement documents are signed). The election must be irrevocable. The lawyer’s fee agreement with the client should allow the lawyer to receive all or a portion of contingency fees in the form of periodic payments.
The agreement should contain the attorney’s acknowledgement that the SSA payments “cannot be accelerated, deferred, increased or decreased by the attorney; nor should the attorney have the ability to sell, mortgage, encumber or anticipate the Periodic Payments or any part thereof, by assignment or otherwise.”
2. Assignment – The settlement agreement contain an obligation of the defendant to assignment 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 usually 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. Funds can be temporarily held in a Qualified Settlement Fund (QSF) under IRC Sec 468B until the annuity is purchased. The funds are deemed not to be “constructively received” while parked in the QSF.
V Private Placement Variable 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.
Joe Smith, age 60, is a plaintiff’s attorney with multiple cases throughout the Southeast. Smith has a personal net worth of $20 million. He has generated most of this wealth over the last 10 years due to the success of cases. Joe is married with two children.
The Smith Law Firm has five partners. The firm is structured as a limited liability partnership. 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. Each of the partners is in a 40 percent marginal tax bracket for federal tax purposes.
Joe currently has 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 $3 million).
Joe’s fee agreement provides for a contingency payment of 30 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, Ramiro Ortega.
The case settles after much negotiation for $10 million. The contingency fee of $3 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 notes in all of the funds are issued by investment grade banks. The notes all have a ten-year duration which is the targeted payout under the deferral arrangement. Once the periodic payments begin, the investment advisor will use a series of laddered maturities to ensure ongoing protection of the investment principal.
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 $7.78 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.
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.