At Emparion, you know we are a big fan of tax strategies. Our favorite is probably the cash balance plan. But structured settlements are not far behind.
In this post, we take a close look at structured settlements and how attorneys can use them to reduce taxes and improve financial planning. In the right situation, they can be a home run. Let’s dive in.
Table of contents
What is a structured settlement and how do they work?
Structured settlements for attorneys are now commonplace. The landmark case was Childs v. Commissioner. In this case, the 11th circuit ruled that lawyers can use settlement structures to defer legal fees and recognize the cash payments in the year that they are received. Let’s just say that the IRS was not thrilled with this decision.
But first some background. The case itself involved a lawsuit between a gas company that was sued over a home explosion. The explosion killed one person and severely injured another. Upon the subsequent settlement of the case, three of the attorneys decided to structure their fees.
What does the IRS say?
The IRS sued the lawyers arguing that the fees should be included in income based on the year the settlement agreement was signed. They argued the structure met the definition of property under § 83’s definition of property. In addition, the IRS also maintained that each attorney constructively received the total settlement fee in the year the annuity was purchased. They argued the taxable fee amount was equivalent to the purchase amount of the annuity.
But the tax court disagreed with the IRS and held the following position:
- the annuity purchase price should not be included in each attorney’s income in the year the settlement was executed because the settlement was not deemed “property” under §83 of the IRS code; and
- each attorney did not take “constructive receipt” of the applicable funds, because they had no right of receipt of the money prior to the execution of the agreement that fixed the terms of the structured settlement.
The IRS (under Code § 83) states that “property” must be included in a taxpayer’s taxable income in the year it is received. Property as defined includes a promise to pay money at some date in the future that is either secured or funded.
The court subsequently relied on this precedent and concluded that funding is deemed to occur when the policy proceeds are able to be distributed to the beneficiary (in this case the attorney) with no action required by the obligor (Assignee or Carrier). This is true even if the proceeds will be distributed at some date in the future.
Structured Settlement: The Court’s Conclusion
In this case, the court concluded the settlements were not “funded” because:
- the attorneys did not actually own the policies;
- the attorneys were not able to accelerate, increase, decrease or otherwise defer the payments;
- the rights of the attorneys were no greater than those of a general creditor; and
- the Assignees did have the right to change the beneficiary or annuitant without the attorney’s consent. At the end of the day, the Assignees held a level of control over the structured settlement.
The court also took a look at whether the payments were considered “secured” as defined. The court held that an insurance company that maintains reserves was not the same as property securing the guaranteed funds.
As such, the court deemed that the settlements were unfunded and unsecured promises. They were not deemed property under the tax code. As such, they are not included as taxable income in the year that the settlement was initially structured.
Next, the court examined whether the lawyers had constructive receipt of the fees. The IRS considers income to be constructively received in the year it is:
- set apart for the taxpayer;
- credited to the taxpayer’s account;
- or is made available so that the taxpayer can draw upon it with notification.
The Result
A taxpayer does not have constructive receipt if the control of its receipt is subject to substantial restrictions or limitations. However, a taxpayer will be assumed to have constructive receipt if he has a vested and unqualified right to immediate payment. Said differently, they should have an unrestricted right to receive the payment immediately.
In the Childs case, the attorneys and plaintiffs entered into a contingency fee agreement. It stated that if the case was won, the attorneys would get a specified percentage of the award or settlement. The attorneys had not claim for their fee until that specific time. As a result, the funds were not actually available at the attorneys “unfettered demand” as defined. Accordingly, the court determined the fees were not in constructive receipt.
Bottom Line
In summary, the Childs court stated that the attorney fees do not meet the definition of property under § 83 (using “funded” and “secured”) and were not constructively received by each attorney. As a result of this case and future clarifications, an attorney can request his or her fees to be utilized to purchase a structured settlement.
The payments will not be included in the attorney’s income in the year the settlement agreement is signed. Instead, the individual payments are included in taxable income in the future years that they are received.
