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Gross Income

Ten things CPAs need to know about structured legal fees.

July 2008
by Robert Wood/The Tax Adviser

The importance of form, knowing exactly how to do something, is extraordinarily important in federal income tax law. Accountants know that some deferred payment mechanisms work for tax purposes and some do not. Although that is true across virtually the entire federal income tax system, it seems particularly true with issues relating to the timing of income.

Top 10 Points

Despite a more than 10-year track record of structuring legal fees, many accountants remain confused about what they can do, what they cannot do and what is most important in securing structures’ financial and tax benefits. Here are the top 10 things accountants should know about structuring legal fees for their lawyer-clients.

  1. Timing is everything: If a lawyer-client wants to structure legal fees, begin the process before the lawyer has a right to the fee. The attorney must elect to defer his or her fees before they are earned in order to avoid running into constructive receipt issues (see, e.g., FSA 200151003). Once the settlement agreement is signed, it is too late to structure fees. Fortunately, however, the authorities have been reasonably liberal on this issue: It is not necessary to have the legal fee agreement contemplate periodic payments from the time it is originally executed.
  2. Consider the legal fee agreement: The lawyer should generally consider revising his or her generic contingent fee agreement to contemplate periodic payments expressly for all cases. Exactly what wording to use in a generic fee agreement is a matter of opinion. The fee agreement can provide that the attorney will specify which payment type — and the amount — in writing before the case goes to judgment or is settled.
  3. Client recovery structuring vs. legal fee structuring: Some lawyers believe they can structure their fees only if their client structures his or her own recovery. This is not true. Some life insurance companies will structure legal fees only if the client is also structuring, but others will structure “stand-alone” legal fees.
  4. Annuities vs. other alternatives: A legal fee structure should follow a tried-and-true format. There is great flexibility in the types of payment structures that can be obtained, but they all use life insurance annuity products.
  5. Qualified settlement funds: A Sec. 468B trust, also known as a qualified settlement fund (QSF), is often set up to be the repository of moneys involved in the settlement of a case. QSFs were originally designed so defendants could pay money into a settlement trust and take an immediate tax deduction, while the various plaintiffs continued to argue over the allocation of the settlement payment.

    A QSF is relatively easy to set up and involves a trust document with a trustee. CPAs often serve as trustees. The plaintiffs’ lawyer should not be the trustee. The important point is that a court must supervise the trust. The supervising court might be the one with jurisdiction over the case; however, any court will do.

    Properly set up, a QSF delays receipt of settlement money by the lawyers and their clients.

  6. Payment alternatives: Make sure lawyer-clients carefully consider how they want to receive their payments over time. There is an almost infinite variety of options. However, once the payment structure is set, it cannot be changed. This may make a QSF attractive because it allows the lawyer more time to consider the alternatives before having to make a permanent decision.
  7. Contingent fees only: Structuring legal fees generally applies only in cases that are taken on a contingent basis and then settled out of court. However, it may be possible to interpose a fee structure in some cases going to judgment or in cases in which a court awards attorneys’ fees.
  8. Work with a broker: A qualified settlement broker has access to the life insurance markets and the various annuity tables the CPA will need to review. CPAs should regard brokers as allies, not competitors, in this instance. A broker earns a commission on the sale of the annuity product, but usually earns nothing unless the transaction closes. Brokers therefore have an incentive to provide lawyers and their accountants with all the necessary data.

    Interestingly, bypassing a broker will not save you the broker’s commission because none of the major life insurance companies that issue annuities for structured legal fees will reduce a commission even if one deals with them directly.

  9. Do not get creative: Although there is almost infinite flexibility in payment streams for structured legal fees, this is not a time to get creative with the legal structure. An income stream, blips in the stream and unusual disbursements are all possible, but do not try to invent a new form of legal fee structure. Stick with annuities to ensure that the arrangement is respected for tax purposes.
  10. Consider firm arrangements: If the lawyer-client is a solo practitioner, structuring legal fees is usually simple. In a law firm, additional legal protocols should be observed. Questions that need to be answered include:
    • Will the firm buy the structure and then receive the periodic payments, paying them to the individual lawyer as they are received?
    • If the firm has the relationship with the lawyer ’s client (so the firm is technically entitled to the legal fee), is it acceptable to have an individual lawyer take his or her share of the attorneys’ fees the firm receives as an annuity?

Conclusion

With the right preparation, a structured legal fee agreement can be an excellent tax planning tool for plaintiffs’ lawyers. Even in the case of large law firms, it is usually possible to set up a successful structure, although it may require extra time and care. Accountants play a key role in the process. There is no right answer for everyone, but it is important to consider the legal structure, the lawyer-client relationship and matters such as control, firm management and moneys that might pass to an estate.

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Robert W. Wood, J.D., Wood & Porter, San Francisco, CA is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA, the AICPA Corporate Taxation Insider or The Tax Adviser.

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