March 11, 2021
Trial lawyers have been deferring fees into structured settlement products dating back to the early 1990s. The IRS challenged fee structure arrangements in Childs v. Commissioner.[1] In this seminal 1994 tax case, the IRS argued the fees should be taxed in the year earned; however, the lower court and the 11th Circuit affirmed the decision that the fees are not taxable in the year earned but in the year(s) payments are received from the attorney fee structure. The ruling is more in-depth, but this established the precedent allowing fee deferral solutions to be developed.
The basic concept of these solutions is an irrevocable assignment of a fee before it is earned. This creates separation and keeps the taxpayer from taking constructive receipt of the funds. [2] A portion of the fee (up to 100%) can be used to purchase periodic payments that are taxed in the calendar year that funds are received. The amount deferred is not limited like a traditional 401(k) or IRA program. The age funds can be received is also not limited, so payments can be made before age 59.5.
What does this mean to an attorney? Simply put, with proper planning an attorney can manage the timing of their income. This gives the attorney two ways to generate a return on their fee. The first way is to earn a return via the investment itself. The products available offer a variety of investment choices. An attorney can be as safe or aggressive as they choose from an investment perspective. Products are available that allow an attorney to place a fee in a variety of annuity or investment funds. The variety of options has increased over the last ten years and allows for most people to find a solution that meets their objectives. The return can be fixed or variable in these products. The interest earned is deferred.
The second way to earn return is to receive payments at a lower tax rate in subsequent tax years. Regardless of political views, almost every change in the White House comes with a new tax plan. The tax plan usually involves some changes to the marginal rates on earned income. President Biden has introduced a variety of tax-related items during the past year. One that he frequently referred to during his campaign was an increase on top earners. He has stated that he will seek an increase the marginal tax bracket from 37% to 39.6% for those earning over $400,000. He has also proposed moving the capital gains rate to 39.6% for those earning over $1,000,000. These two changes could allow an attorney to pay a lower amount in taxes if they can defer until tax rates are lower. Any reduction in tax payments creates an added return for the attorney.
If you can combine a positive return on your investments and a reduced tax burden, you have created two ways to benefit from deferring a fee. The products in place create powerful tools that are not available to most taxpayers. It can be used in combination with other retirement plans to create income without a penalty before age 59.5. It can be used to defer excess amounts when you reach your deferral limits, which is $19,500 in 2021.
Attorney fee deferrals have a lot of benefits and with proper planning can create a more comprehensive retirement plan for most attorneys. It is always a good exercise to review the options with your tax and planning advisors to see what plan matches your long-term goals.
[1] A summary of Childs v. Commissioner can be found here: https://www.irs.gov/pub/irs-wd/0836019.pdf
[2] An explanation of constructive receipt can be found here: https://www.law.cornell.edu/cfr/text/26/1.451-2
[3] The IRS’ contribution limits can be found here: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
