Many attorneys have questions when it comes to how to avoid the spikes in income and the accompanying taxation common with contingent legal fees. There are custom tailored solutions for attorneys who work on a contingent fee basis to avoid these issues. Attorney fee structures and deferred compensation arrangements allow lawyers to avoid taking income all in one taxable year when they earn a large fee. These solutions are pre-tax and tax-deferred investment vehicles only available to an attorney prior to resolving a case and earning the fee. They have to be explored and decided upon prior to signing a release. While these solutions may seem complex, they are actually quite simple. Having an expert advisor such as Synergy who can provide you with different options is critical. The remainder of this blog answers some frequently asked questions about deferral of contingent legal fees.
What is an “Attorney Fee Deferral”?
Attorney’s that work on a contingency fee basis can defer taxation of their fees through the use of several products. An attorney can utilize high end deferred compensation, traditional structured settlement annuities, and offshore assignment programs.
How is it different than a 401(K) or any other retirement plan?
There are two main differences from traditional plans. Traditional plans have deferral limits and a penalty for early withdrawal (prior to 59 ½). To compare:
Deferral Limits: There is no limit on the amount an attorney can defer using these products. Traditional plans are restricted by annual guidelines issued by the IRS. In October, the IRS issued Notice 2017-64 for the calendar year 2018. It reviews the current year 415 plan guidelines. Most of the plans are capped at contributions of $18,500 for this year.
Withdrawal Limitations: Attorney Fee Deferral programs do not have pre-fifty-nine and a half withdrawal penalties or limitations. An attorney can defer his fees early on and start to take distributions with no penalty at any age. In a traditional plan, you would incur a 10% tax penalty for early withdrawal unless you met one of the few exceptions.
How come my CPA or Tax Professional does not know about it?
These programs cater to a very small percentage of the overall US population. Not only is it specific to attorneys, it is specific to the subset that works on a contingency fee basis. Many CPAs aren’t aware of niche tax decisions such as the Childs v. Commissioner decision described below. Once a CPA is educated about these solutions, they quickly see the immense value to the attorney clients they work with on a regular basis.
What is the underlying legal basis that allows this to be done?
In 2001, the Richard A. Childs, et al. v Commissioner of Internal Revenue ruling held that attorneys can defer their fees and pay taxes in the calendar year they are actually received. Under Childs, a lawyer is allowed to defer his or her fees and be paid out over time using a periodic payment schedule and only pay taxes on the amounts as they are received. The programs available all utilize this in their plan design.
Where does my fee go and does it earn interest?
The fee paid over to a life insurance company or trust company which then either funds an annuity contract or investment account. The annuity insurance contract earns a fixed return. The investment account would earn variable interest based on market performance. Similar to most retirement plans, there are a variety of investment choices from fixed interest to high-risk stock portfolios.
Do I need to defer my entire fee?
No, in fact, it is very common to defer as little as $25,000 of a fee. Many attorneys defer portions of several fees each year while others defer in large amounts.
Will deferring my fee guarantee I pay less taxes?
No, the use of a fee deferral does not guarantee that you will pay less in taxes. It does allow more of your money to work for you over time but nobody can predict the future tax tables. The taxes paid will be upon receipt. Some plans do allow you to extend deferrals which may allow you to plan around new tax changes.
Are there limitations I need to consider?
Yes, the main limitation is with accelerating or changing the payment plan. The plan you set up is a part of the underlying settlement agreement and release. It cannot be changed without selling the payments on the secondary market which will result in a loss. Some products do offer loan provisions.
What are some ways you have seen attorneys use the programs?
The primary use of deferred fees is to create a flow of income that can be used for retirement. However, we have clients that use them for a variety of reasons:
- Create recurring cash flows to cover law firm costs
- Create golden handcuffs for associates
- Spread out the tax implication of a large fee
- Bridge retirement income between ages 50 and 59 ½
Conclusion
Tax deferral mechanisms for lawyers are a great way to smooth out those income spikes caused by larger fees or just take better control over the timing of income. Because of the variety of options, there is likely something that will best suit your needs and investment preferences. It no longer is just limited to a fixed investment vehicle. Explore these options so that you can take back control over your income. Learn more by visiting https://partnerwithsynergy.com/service/attorney-fee-deferral/
