Structured settlement attorney fees are great deferral strategies. But only if they are structured correctly and avoid IRS issues.
The ability to spread a settlement fee over several years allows an attorney to optimize their tax bracket and facilitate financial planning.
In this post, we will show you how these plans work. We often combine them with cash balance plans for the ultimate tax deferral.
Let’s dive in:
Deferred Compensation Summary
Deferred compensation is simply the recognition of income later than when it was earned. When a person earns income, it must be recognized, and taxes must be paid either as quarterly contributions or at the end of the tax year.
However, contingency fee attorneys may elect to receive their fee as follows:
- Lump-sum cash payment
- Deposited to a Qualified Settlement Fund
- Future periodic payments, funded by a structured settlement annuity
- Future periodic payments, funded by an index-linked structured settlement annuity (capped)
- Future periodic payments, funded by an index-linked structured settlement annuity (uncapped)
- Non-qualified deferred compensation plan, or
- Any combination of the above
Lump Sum Cash Payment
If a lump sum cash payment is chosen, the attorney or firm will receive a check. As a result, all income is taxable in the year received.
Just taking the income with no deferral strategy can make sense in the following situations:
- The settlement fee is a low amount
- You need the money immediately and do not mind the tax liability
- You will use a retirement deferral like a cash balance plan or other defined benefit plan
A cash balance plan is a great tax deferral strategy for attorneys looking to maximize their retirement savings while minimizing their tax liabilities. Unlike traditional defined benefit or defined contribution plans, a cash balance plan allows participants to contribute substantial pre-tax amount.
Another advantage of a cash balance plan as a tax deferral tool is that it allows for higher contribution limits compared to other retirement plans. The annual contribution limits for cash balance plans are typically much higher than those for traditional 401(k) plans.
In some situations, contributions can be as high as $500,000. This can reduce taxes, while still allowing remaining income for lifestyle needs.
A cash balance plan offers an attractive tax deferral strategy for attorneys looking for a tax deferral but do not want to use the structured settlement approach.
Qualified Settlement Fund (QSF)
A qualified settlement fund (QSF) is a unique entity created under IRC §468B to assist in efficiently resolving lawsuits.
A QSF helps resolve a lawsuit by allowing a litigation recovery to be “parked” in the QSF. At the same time, plaintiffs take time to make important financial and legal decisions without being subjected to immediate income tax.
The QSF allows defendants to obtain a release from liability and an immediate income tax deduction. The plaintiffs’ counsel can use the QSF to hold their attorney’s fees and not have to treat the funds as received for income tax planning purposes. Thus, plaintiffs’ counsel can accomplish deferred compensation planning by utilizing a QSF.
The primary benefit to the plaintiff is that, while the litigation recovery is held in a QSF, the plaintiff is not deemed to have actual or constructive receipt of the funds, nor have they received an “economic benefit” for tax planning or public benefit eligibility purposes. This unique feature of the QSF allows the plaintiff time for:
- Financial planning, i.e., deciding whether to utilize structured settlement annuities;
- Public benefits planning, i.e., deciding whether to establish an SNT and finding an appropriate trustee;
- Resolving funds distribution issues, i.e., determining the allocation of settlement among several plaintiffs;
- Negotiating liens on settlement, i.e., Medicare or Medi-Cal liens.
From the defendant’s perspective, a QSF is attractive because the defendant can pay the disputed claim and obtain a current-year tax deduction (if applicable) for payment of the claim. After all, payment to the QSF is considered “economic performance.”
The defendant may then obtain a release, receive indemnity concerning lien resolution (if applicable), and withdraw from the litigation, even if the plaintiff has outstanding issues to resolve before the litigation can be terminated.
Structured Settlement Attorney Fees
If a structured settlement is chosen, the attorney will elect to receive a portion, or their full fee, in the future as periodic payments rather than as a single lump-sum payment. This will be accomplished through a qualified assignment and the purchase of an annuity.
With a structured settlement, income taxes will be due when the income is received, not earned. Therefore, their income taxes will be deferred. Additionally, the life company making the monthly payments will pay the firm or the attorney individually.
Deferring compensation makes sense when income can be deferred to a time when the attorney will not be in the highest marginal tax bracket. If this can be accomplished, the tax savings can be dramatic.
An attorney fee structure is best for attorneys with fixed or determinable expenses. If liquidity is a concern, there may be better options than structured settlement annuities, as structured settlement annuities are not flexible and intended to be permanent. However, structuring a portion of the fee rather than the full fee may give the attorney the flexibility and liquidity they require.
Non-qualified Deferred Compensation Plan
This option requires the irrevocable assignment to a trust of a percentage or amount of the contingency fee. JurisPrudent Deferral Solutions, LLC provides this deferral solution. The custodian of the trust assets is the Bank of New York Mellon, the world’s largest trustee and custodian. The deferred comp plan administrator is The Newport Group, the world’s largest administrator of deferred compensation plans for executives.
This option allows unlimited deferral, investment in the stock market, and the opportunity to achieve significantly higher returns. In addition, future withdrawals are more flexible, allowing quarterly benefits to be received or deferred indefinitely.
A non-qualified deferred compensation plan is best for attorneys with longer investment horizons and wanting to achieve market-based returns.
To assist you in becoming more familiar with fee deferral and attorney fee structures, please find our “Attorney Fee Deferral – Supporting Documents” due diligence package that includes:
- RICHARD A. CHILDS, ET AL., Petitioners v. COMMISSIONER OF INTERNAL REVENUE
- Internal Revenue Service – Private Letter Ruling – Dated 06/02/08
- Article – Structuring Attorney Fees: Kingdom of Heaven? – Robert W. Wood, Esquire
- Article – Structuring Your Attorney Fees When You’re Not a Solo – Robert W. Wood, Esquire
- Article – Can Class Action Attorney Fees be Structured? – Robert W. Wood, Esquire
This gives you a more detailed understanding of your contingency fee deferral options.