INCOME TAX ADVANTAGES OF STRUCTURING ATTORNEY FEES IN THIRD PARTY LIABILITY AND WORKER S COMPENSATION SETTLEMENTS By John J. Campbell, Esq. Introduction 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. Income Tax Benefits to Plaintiffs 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. 2005 Law Offices of John J. Campbell, P.C. 1
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 s contingent 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 this 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 2005 Law Offices of John J. Campbell, P.C. 2
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 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 2005 Law Offices of John J. Campbell, P.C. 3
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. Income Tax Benefits to Attorneys 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). 2005 Law Offices of John J. Campbell, P.C. 4
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 2005 Law Offices of John J. Campbell, P.C. 5
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 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 attorney s 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, 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. Conclusion 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 ATM on a plaintiff receiving a large taxable settlement award in many cases. The attorney, too, can enjoy the tax 2005 Law Offices of John J. Campbell, P.C. 6
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). 2005 Law Offices of John J. Campbell, P.C. 7