This article was adapted from the book The Art of Settlement, written by Jason D. Lazarus.
Peaks are beautiful when they’re part of a mountain range, but they’re decidedly less beautiful when they’re part of your income taxes. No one wants to see sky-high taxes, followed by valleys of income. Yet, that’s exactly what many plaintiff attorneys fall victim to when it comes to managing the taxes on their own contingent legal fees. As part of the normal rhythm of their practices, many attorneys experience these highs and lows with their own personal income, which leads to concerns for trial attorneys about the unpredictability of their own income.
However, attorneys have a unique opportunity, not available to others who earn professional fees, to take their contingent legal fees and invest them on a pre-tax and tax-deferred basis to smooth out their income. This article answers some frequently asked questions about attorney fee structures and deferral of contingent legal fees.
Attorney Fee Structures
Attorney fee structures are annuities, and they work very much like a nonqualified deferred compensation plan. The taxes that would be otherwise paid on the fee earned at the time the case is settled are deferred, and that money grows without tax on the growth.
When distributions are made, the entire amount distributed during a year is taxable for that year. Based upon a taxpayer’s tax bracket, there may be some distinct tax advantages to entering into this type of arrangement as opposed to being taxed on the entire fee in the year it was earned and investing it after tax.
Depending on how much the fees are, current tax bracket rates, and any other sources of income, stretching out the payment of fees can result in a potentially smaller tax burden.
An attorney fee structure allows an attorney to set up a personally tailored retirement plan without the monetary and age restrictions or other drawbacks of a qualified plan. The attorney can defer taxes on his or her fees as well as the interest that those fees earn until the year in which a distribution is actually received from the fee structure.
The fee structure can help a lawyer avoid the highest tax brackets by leveling off income spikes due to large fees and spreading the income out over several years. An attorney who otherwise would have an unusually high income in one taxable year, but elects to spread the income over several years, avoids paying taxes in the highest bracket. Couple the tax savings with guaranteed earnings on the deferred funds, and the benefits of an attorney fee structure become very obvious.
Since fee structures are pre-tax and tax-deferred investment vehicles, a major benefit is the compounding effect of deferring payments over longer periods of time. The longer an attorney waits for payments or the longer the duration of the distribution term, the better the financial result and possibly the tax result as well.
Payments can start right away, but don’t have to. They can be deferred for any length of time and then can be paid out over a duration of years or for life. There are almost infinite possibilities in terms of the different types of arrangements that can be set up.
Deferred Compensation Plans for Attorneys
A non-annuity deferred compensation arrangement is another mechanism that trial lawyers can use to invest the contingent legal fees they earn on a pre-tax and tax-deferred basis. Like Fortune 500 executives who defer their compensation, you can defer all or a portion of your fees until you are ready to start receiving them. Using this kind of solution, you have flexibility with investments as well as more control over the timing of income.
For example, if you wanted to defer a $500,000 fee in the current taxable year by splitting the fee plus the investment gains into twenty quarterly payment buckets, you could do so. Thirteen months prior to any scheduled quarterly payment, you can elect to withdraw it. However, if you don’t need the payment, the payment bucket will automatically roll forward to the end of the line. By laddering payments in this way, you can effectively manage your cash flow and better control the timing of taxation.
From a legal tax perspective, fee deferrals are subject to the same body of tax rules that govern Nonqualified Tax-Deferred Compensation (NQDC). So, this means that the deferrals must avoid the application of the constructive receipt and economic benefit doctrines. NQDC has been used for decades by Fortune 500 companies as a way to attract, retain, and further compensate their top-level executives. These deferred compensation plans rely upon the same decisions as attorney fee structures, Childs. Since the legal underpinnings are the same and are well established, the risk is relatively similar to attorney fee structure annuities.
Smooth out the Spikes
Attorney fee structures and deferred compensation arrangements allow lawyers to avoid taking income all in one taxable year when they earn a large fee. While these financial products may seem complex, they are actually quite simple. Still, having an expert advisor who can provide you with different options is critical.
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. Attorney fee deferral solutions allow a plaintiff lawyer to not only defer receipt of (and tax on) fees until received, he or she can have the deferred fees invested, and have the income produced from it also taxable over time rather than immediately.
Due to the variety of options, there is likely something that will best suit an attorney’s needs and investment preferences. Attorneys should explore these options to take back control of the timing of income.
For more advice on attorney fee deferral, you can find The Art of Settlement on Amazon.