Issue #7
March 21, 2005
Issue #7
March 21, 2005
INCOME TAX
ADVANTAGES OF STRUCTURING ATTORNEY FEES IN THIRD PARTY LIABILITY AND WORKER’S
COMPENSATION SETTLEMENTS
Introduction
Income Tax Benefits to Plaintiffs
Income Tax Benefits to Attorneys
Conclusion
By John J. Campbell, Esq., CELA, MSCC
The use of structured settlements to settle third party
liability (TPL) and worker’s compensation (WC) claims has increased greatly
over the past decade. This is, in part, because structured settlements help
to preserve the plaintiff’s settlement proceeds by providing a
stream of payments to the plaintiff over time, rather than a
single lump sum payment at the time of settlement. Structures also provide
the plaintiff with the advantage of deferring income tax on the
earnings of the settlement; and remove the burden of investing a lump sum.
The plaintiff’s attorney fees, which are most
often contingent on the outcome of the case, are generally paid to the
attorney in a lump sum if the attorney obtains a recovery for the plaintiff. The attorney pays income tax on his or her fee in the year the
fee is received.
The use of a structured settlement for a plaintiff creates the opportunity to structure the attorney’s fees as well.
The attorney then receives the fee in installments over time, just like the
plaintiff. If the attorney’s fee is structured properly, the attorney also
can defer income taxes on his or her fee over the life of the structured
payments.
In many cases where plaintiffs receive
structured settlements, their recovery is the result of physical injury and
they do not owe income taxes on the settlement. In these cases there is no
real benefit to the plaintiffs if the attorney fees are
structured. However, structures are being used more frequently in cases where
all or part of the settlement is taxable as income to the plaintiff.
Formerly, when an award to the plaintiff was taxable as
income, the plaintiff’s legal contingent fees may or may not have been
considered part of the award that was taxed to the plaintiff, depending on
the jurisdiction. The U.S. Courts of Appeals in the Fifth, Sixth, and
Eleventh Circuits have held that the portion of an award used to pay attorney
fees is not taxable to the plaintiff. See, Cotnam v. Commissioner, 263 F.2d
119 (5th Cir. 1959); Estate of Clarks v. United States, 202 F.3d 854 (6th
Cir. 2000); and Davis v. Commissioner, 210 F.3d 1346 (11th Cir 2000).
In these jurisdictions, the plaintiff was only required to
report the net amount of settlement, after deducting attorney’s fees, as
income. The plaintiff would realize the same tax consequences, regardless of
whether attorney’s fees were paid in a lump sum or structure.
However, the U.S. Courts of Appeals in the First, Second,
Third, Fourth, Seventh, Ninth, and Tenth Federal Circuits, as well as the
United States Tax Court, have held that attorney fees are taxable as income
to the plaintiff as part of the overall settlement proceeds. See,
Alexander v. U.S., 72 F.3d 938 (1st Cir. 1995); Raymond v. United States, 355
F.3d 107 (2d Cir. 2004); O’Brien v. Commissioner, 38 T.C. 707 (1962), aff’d
319 F.2d 532 (3d Cir. 1963); Young v. Commissioner of Internal Revenue, 240
F.3d 369 (4th Cir. 2001); Kenseth v. Commissioner of Internal Revenue, 259
F.3d 881 (7th Cir. 2001); Benci-Woodward v. Commissioner, 219 F.3d 941 (9th
Cir. 2000) cert. denied, 53 U.S. 1112 (2001); and Dye v. United States, 121
F.3D 1399 (10th Cir. 1997). In these jurisdictions, the plaintiff was
required to claim the entire award as income and deduct attorney fees as a
miscellaneous itemized deduction on his or her personal income tax return.
Thus, in these jurisdictions, structuring attorney’s fees as part of the
settlement offered a significant benefit to the plaintiff.
The United States Supreme Court has now resolved the conflict
between the various federal Circuits. On January 24, 2005, the Court issued
an opinion adopting the position of the First, Second, Third, Fourth,
Seventh, Ninth, and Tenth Federal Circuits. Commissioner of Internal
Revenue v. Banks, 125 S.Ct. 826 (U.S. 01/24/2005). Plaintiffs in
all jurisdictions are now required to claim their entire settlement or award,
including the portion allocated to attorney’s contingent fees, as income and
deduct attorney’s fees as a miscellaneous itemized deduction on their
personal income tax returns.
Section 703 of the American Jobs Creation Act of 2004 (AJCA),
signed by President Bush on October 22, 2004, granted some relief from this
requirement for plaintiffs who receive a settlement or award as the result of
a civil rights or employment discrimination case. In these types of
cases, the plaintiff is allowed to deduct the full amount of attorney’s fees
and costs regardless of whether the plaintiff itemizes deductions on his or
her tax return, instead of the plaintiff only being allowed to deduct those
attorney’s fees as a miscellaneous itemized deduction.
This relief is only available for settlements or awards
occurring after October 22, 2004, the date this legislation was enacted.
Further, this relief does not apply to other TPL settlements or WC
settlements, even where a portion of the settlement may be considered taxable
income to the plaintiff.
Some have questioned whether Section 703 of the AJCA applies
to cases pending as of October 22, 2004, but which have not yet been settled.
Some have also questioned whether the provisions of Section 703 of the AJCA
applies only to cases pending or settled after January 1, 2005, the effective
date of the act.
Section 703(c) of the AJCA states: “The amendments made by
this section shall apply to fees and costs paid after the date of the
enactment of this Act with respect to any judgment or settlement
occurring after such date.” Thus, a plain reading of the statute
would suggest that it applies to civil rights or employment discrimination
cases where both the settlement and the payment of attorney’s fees and costs
occurred after October 22, 2004, the date of enactment, regardless of when
the cases may have been commenced.
Since attorney’s fees would be deducted from the settlement
proceeds one way or the other, whether or not the entire settlement is considered taxable to the
plaintiff, it would seem that the tax consequences in either situation would
be the same. However, the complex and often forgotten Alternative
Minimum Tax rules come into play.
The Alternative Minimum Tax (AMT) is only due if the AMT is
more than normal income taxes. The AMT rates are less than the top income tax
rates, but under the AMT rules, miscellaneous itemized deductions, such as
attorney’s fees, are disregarded. IRC §§ 55 and 56(b)(1)(a). Therefore, the
larger the settlement is and the lower the plaintiff’s other income is, the
more likely the AMT will apply.
Section 703 of the AJCA eliminated this problem for
plaintiffs settling civil rights or employment discrimination cases after
October 22, 2004. However, in taxable settlements other than those
involving civil rights or employment discrimination cases occurring after
October 22, 2004, there is a potential tax benefit to the plaintiff if the
attorney receives his or her fees in the form of a structure instead of in a
lump sum. If the attorney fees are structured along with the
plaintiff’s settlement, taxes on all the payments will be deferred and spread
out over multiple years. Since the income is spread over multiple
years, the impact of the AMT on the plaintiff may be reduced or eliminated
altogether.
The benefits to an attorney of structuring the fees from a
TPL or WC settlement are that the attorney will receive a stream of income
and the tax benefits that go with it. Since the attorney only has to pay tax
on the fee income as it is received, the tax on the fee income is deferred.
Depending on the attorney’s other income and the length of the structure,
some or all of the proceeds may be taxed at lower marginal tax rates.
Further, since the attorney would have to earn investment income on a lump
sum distribution to match the total value of benefits received in a
structure, there is essentially a deferral of income tax on the investment
income portion of the structure as well.
In a series of Private Letter Rulings in 1991 and 1993, the
IRS stated that the value of an attorney’s right to receive structured fee
payments under an annuity must be included in the attorney’s gross income in
the year the annuity was purchased. PLR 9134004 (May 7, 1991); PLR 9134005
(May 7, 1991); PLR 9134006 (May 7, 1991); PLR 936001 (May 12, 1993). These
IRS rulings were based on the premise that the attorney was in constructive
receipt of an immediate economic benefit or property right (the client’s
contractual obligation to pay the attorney pursuant to the terms of the fee
agreement). According to the IRS, the economic benefit was realized by the
attorney at the time the client fulfilled his contractual obligation to
compensate the attorney for legal services by the purchase of the annuity.
However, in 1994, the United States Tax Court reached an
entirely different conclusion. Childs v. Commissioner, 103 T.C. 634 (1994),
aff’d without published opinion, 89 F.3d 856 (11th Cir. 1996).
In the Childs case, the Tax Court held that an attorney is
allowed to defer the recognition of income paid by an annuity contract until
the actual receipt of each annuity payment. The Court held that the annuity
in question did not constitute “property” includable as income under I.R.C.
§83 because the annuity was neither funded nor secured; and the doctrine of
constructive receipt did not apply because the attorney’s right to receive
attorney fees did not arise prior to the time the parties entered into the
structured settlement.
According to the Court in Childs, the right to receive
payment under the annuity is neither funded nor secured when: (1) under the
terms of the annuity, the attorney has no greater right against the owner of
the annuity than the right of a general creditor; (2) the attorney does not
own the annuity contract; (3) the owner of the annuity contract retains the
right to change the annuitant or the beneficiary; and (4) the attorney does
not have the right to accelerate, defer, increase or decrease the periodic
annuity payments. When the annuity is neither funded nor secured, the
attorney’s right to receive payments under the annuity does not meet the
definition of a property interest transferred in exchange for services. I.R.C.
§83.
The IRS has never acquiesced to the ruling in Childs.
However, if attorney’s fees are structured as part of any TPL or WC
settlement, and the structure closely follows the four points relied on by
the Court in Childs, the attorney will likely be entitled to defer reporting
income from the fee structure until the years in which payments are actually
received.
Additional tax implications arise when the annuity which
funds a structured attorney fee is owned by a “non-natural person,” such as
an assignment company or insurer. Such annuities are governed by I.R.C. §72u,
which holds that such annuities are generally not considered to be “annuity
contracts,” so that the investment or interest income on the contract must be
reported in the year(s) received or accrued.
To exempt the annuity from the requirements of I.R.C. §72u,
the annuity should be set up to conform with one of the exceptions found in
I.R.C. §72u(3). Of these exceptions, the two most likely applicable would be
the exception under I.R.C. §72u(3)(C) for an annuity which is a “qualified
funding asset” under I.R.C. §130(d) (without regard to whether there is a
qualified assignment); or the exception for an “immediate annuity” under
I.R.C. §72u(3)(E).
An annuity which funds the structured attorney’s fees is not
required to involve a qualified assignment to be considered a “qualified
funding asset” for purposes of the §72u(3)(C) exception. However, the
attorney’s fees must still be considered part of the damages paid to the
plaintiff as the result of physical injury or sickness. Now that the
Supreme Court has resolved the split among the federal Circuits on whether
attorneys fees are included as part of the plaintiff's damages, the §72u(3)(C) exception will be available in all jurisdictions,
but only in WC settlements and settlements involving damages as the result of
physical injury or sickness.
The §72u(3)(E) exception
will also apply in all jurisdictions if the attorney’s fee structure
qualifies as an “immediate annuity." To be an “immediate annuity,” the
annuity must be purchased with a single premium or annuity consideration. (I.R.C.
§72u(4)(A)). The annuity must also begin paying out no later than one year
after it is purchased and must pay out in substantially equal payments at
least annually over the life of the annuity. (I.R.C. §72u(4)(B) & (C)).
Finally, the attorney's fees funding the annuity need not be part of a
plaintiff's damages due to a WC claim or a claim for physical injury or
sickness.
In the majority of settlements involving structured attorney fees, the
annuity funding the structured fees will be owned by a “non-natural person.” The safest course in these cases will be to use an annuity which meets the
definition of an “immediate annuity” under I.R.C. §72u(4); or, in WC or
physical injury cases, an annuity which meets the
requirements of the §72u(3)(C) exception as a “qualified funding asset”
(regardless of whether there is a qualified assignment). In either
situation, the annuity will also need to
meet those requirements set out by the United States Tax Court in Childs.
If attorney’s fees are properly and carefully structured as part of the
overall settlement of a TPL or WC claim, the attorney, and sometimes the
plaintiff as well, can realize income tax advantages from the arrangement.
Structuring the attorney’s fees can lessen the impact
of the AMT on a plaintiff receiving a large taxable settlement award in many
cases. The
attorney, too, can enjoy the tax advantage of deferring income tax liability
over the life of the structure.
Where attorney’s fees are structured as part of a TPL or WC settlement, it
will be important that the annuity funding the structure comply with the
criteria set forth in the Childs case. If the annuity is owned by a
“non-natural person,” such as an insurer or assignment company, the annuity
should also be carefully crafted to conform to the requirements in either IRC
§72u(3)(C) or IRC §72u(3)(E).
John J. Campbell, the founder and principal attorney of the Law Offices of John J. Campbell, P.C., has practiced law for 19 years and has practiced in the area of Medicare Set Asides since 1996. Mr. Campbell is certified as an Elder Law Attorney by the National Elder Law Foundation;* and is a Medicare Set-Aside Consultant Certified (national certification through the Commission on Health Care Certification).* Mr. Campbell is licensed to practice law in Colorado and is also licensed and on inactive status in Missouri. He is a member of the Colorado Bar Association (Trust & Estate Section and Elder Law Section), the Arapahoe County Bar Association, the Missouri Bar Association, the National Academy of Elder Law Attorneys, The National Structured Settlements Trade Association and the National Alliance of Medicare Set-Aside Professionals. His areas of concentration include elder law; estate, disability and long term care planning; probate; guardianship and conservatorship; Medicare, Medicaid, Medicare Set Aside Arrangements, and the preservation of public benefits in catastrophic third party liability and worker’s compensation settlements. Mr. Campbell has published numerous articles and has presented numerous seminars on issues relating to Medicare Set Aside Arrangements across the country.
*
The State of Colorado does not certify attorneys as experts in any field
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