Plaintiff attorneys are continuing to gain an understanding of the benefits of structuring their attorney fees, a unique tool, solely available to their profession, that offers an exclusive and excellent way to enhance financial security, both now and in the future.
Structured attorney fees, which can defer taxes on contingency fees, allow plaintiff attorneys to leverage their careers, time and income to build better, more productive practices and to fund some of their retirement needs.
The completely customizable nature of a structured settlement is appealing, due to the fact that the duration, amount and frequency of guaranteed payments is established at the onset, allowing for significant tax savings and a way to forward plan for personal expenses and business continuity.
Independent Life has previously published a “Summary Guide” for plaintiff attorneys about structuring their attorney fees.
Because this market continues to expand for structured settlement annuities and other deferral products, the Society of Settlement Planners (SSP) has wisely decided to offer a presentation titled “Deferred Compensation for Trial Attorneys”, featuring Pacific Life's John Meaney as presenter, during its upcoming 2021 virtual Annual Conference.
Anticipating this presentation, we have decided to expand our own online contribution to the discussion of structuring attorney fees by further addressing two landmark tax cases – Childs v. Commissioner and Novoselsky v. Commissioner.
Childs v. Commissioner
Childs appears to be the only tax case in the United States to have addressed structured attorney fees. Although the Tax Court is bound by Childs only in the Eleventh Circuit, respected tax attorney Robert Wood has referred to the Childs decision as “benchmark authority” and pointed out that “the only structured legal fee case … is Childs" in his article “Do Some Structured Legal Fees Fly Too Close to the Sun?", available for download on Wood's website. In addition, the IRS has subsequently cited the Childs case with approval.
The attorney fees in Childs were structured as follows:
- Each of three plaintiff attorneys were separately named as annuitants and payees under multiple annuity contracts funded by defendants’ liability insurers using qualified assignments. However, the original obligors also remained liable for the periodic payments.
- Note: unfortunately, the court’s descriptions of rights and obligation under the funding arrangements are confusing and probably incorrect.
- For example: “The Jones release agreement allowed [liability insurer] to assign its obligation for the structured payments under the Jones release agreement to Manulife Service Corp. (Manulife). Manulife would then become directly responsible for the structured payments, and Manufacturers Life would guarantee the structured payments. In the case of such an assignment, the Jones release agreement provided that [liability insurer] would remain obligated as a secondary guarantor after Manufacturers Life's guarantee.” (emphasis added)
- The annuity contracts were issued to third-party assignment companies to hold as sole owners with all rights of ownership including the right to change the payee, and the contracts were subject to the claims of the assignment companys’ general creditors.
- The attorneys had no rights under the annuity contracts greater than those of a general creditor, and had no rights to accelerate, defer, increase, decrease or assign the scheduled payments or to reduce the payments to present value.
- The attorneys had agreed to structure their fees prior to signing the settlement agreement, and the beneficiaries were pre-set as the respective attorney’s estate
The IRS made alternative arguments that the attorney fees should be taxable in the year the attorneys entered into their structured fee agreements because either:
- the attorney fees were “funded” and “secured” and therefore met the definition of property under IRC section 83 (i.e. economic benefit)or;
- they constructively received the funds.
The Childs court dismissed those arguments and specifically addressed the “guarantee” issue stating: “the mere fact that several insurance companies guaranteed the payments to petitioners is irrelevant to our determination of whether petitioners' right to receive the future payments was secured.”
The Childs case not only confirmed that contingent fee attorneys could defer their fees and the related income tax liability, the court also provided a roadmap for how such deferral could be accomplished. The attorneys in Childs:
- Did not have any ownership in the structured settlement annuities or any rights traditionally associated with ownership of an asset;
- Did not have any right to change the designated annuity beneficiary;
- Could not accelerate, defer, increase, decrease or assign the future periodic payments agreed upon at the time of settlement;
- Did not have any rights against the obligor or its assignee greater than those of a general creditor; and
- Had agreed to the payment of their fees in structured format prior to settlement.
The tax risk, of course, remains with plaintiff attorneys. Following the Childs decision, however, structured settlement annuity providers have become comfortable in general with structuring attorney fees for plaintiff attorneys who wish to do so.
Note: Release 69 of “Structured Settlements and Periodic Payment Judgments”, available in late February 2021, will feature a more detailed analysis of the Childs case and deferred attorney fees, guest authored by attorney Ronald Walters, Jr.
Novoselsky v. Commissioner
Litigation funding (aka litigation finance), whereby an otherwise uninvolved third party helps a plaintiff or plaintiff attorney litigate a claim in exchange for a share of the recovery, is a relatively new development in the United States. Historically, it was prohibited by the common law doctrines of champerty and maintenance.
Litigation funding, which originated in Australia and England, first emerged in the United States in the early 2000s and gained increasing acceptance and popularity among attorneys and investors following the 2008 recession. Today there are dozens of U.S. companies that prominently exhibit litigation products and services at national and state trial attorney conferences.
These transactions are generally made on a non-recourse basis with an investor earning a substantial return for a successful case but having no recourse beyond the value of that potential recovery. Until the Novoselsky case, plaintiff attorneys have generally documented such payments as non-taxable loans, paid exorbitant “interest rates” and treated them as loans for tax purposes.
That was how the plaintiff attorney characterized his arrangement in Novoselsky. If the litigation was successful, he was required to repay the upfront advance, plus a substantial premium (characterized as interest), but not more than the total attorney fees he received if the litigation was successful. If the litigation was not successful and therefore he earned no fees, he had no repayment obligation.
The IRS argued the upfront payments represented current income to the plaintiff attorney and the court agreed applying a seven-factor test originally identified by the Ninth Circuit Court of Appeals to assess whether a transaction is a true loan.
The court concluded these test factors did not support loan treatment for the litigation funding payment in the Novoselsky case which instead constituted immediate income and the court therefore added substantial penalties. Among the court’s reasons:
- The attorney did not execute a formal promissory note.
- No fixed schedule for repayments was established.
- The attorney provided no collateral or security.
- No interest or principal or other amount was ever re-paid.
- The counter-parties viewed the attorney’s personal ability to repay as irrelevant.
- The loans were non-recourse, with the advances being repayable only out of future litigation proceeds.
- Most importantly, the parties did not conduct themselves as if the transactions were bona fide loans. They agreed the attorney had no obligation to repay unless the litigation was successful.
Why is the Novoselsky case important, or potentially important, for structured attorney fees?
Although the impact of the Novoselsky case on the type of litigation funding that specifically offers non-recourse “loans” directly to contingent fee plaintiff attorneys must still be determined, full recourse loans (a.k.a. Structured Attorney Fee Loans) using structured attorney fees from prior cases as collateral could offer an attractive alternative.
In his 2016 article referenced above, Robert Wood discusses three “increasingly flexible offerings” related to structured attorney fees that he cautions “may be outside the comfort zone established by Childs.” One of the “increasingly flexible offerings” is “borrowing” which could potentially represent a competitive alternative to the type of litigation funding arrangements disallowed by the Novoselsky decision.
Referring to borrowing as “the elephant in the room,” Wood states: “[t]he reality is that attorney fee structures are increasingly likely to permit borrowing or to recognize that a borrowing facility may be allowed, subject to conditions.”
What are those conditions? The best fact pattern, according to Wood, who wrote his article prior to the Novoselsky decision, involves:
- Independently owned structured companies and loan funding entities;
- Parties that act in a commercially reasonable manner;
- Traditional loan application requirements including credit reports;
- Maximum arm’s length relationships.
Why would Structured Attorney Fee Loans be good for structured settlements?
Although substantial amounts of money are earned as contingent attorney fees, the variety and types of products to help recipients best manage this money is woefully lacking. These contingency fees come from individual personal injury cases but also non-personal injury cases and mass tort cases and could substantially expand the current non-qualified structured settlement market.
For additional analysis about the Novoselsky case, see "Do-It-Yourself Litigation Funding" by Robert Wood and Donald Board, available for download on Robert Wood's website.
This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.