Income Tax reduction and Deferral strategies for Trial ... - JD Supra by zhouwenjuan


									I N C OM E Ta x R E DuCT IO N a N D DE f E RRal STRaTEg I ES I P OI NT T O r ememBer

Income Tax reduction and Deferral strategies for
Trial Attorney Contingency Fee Income
Part 1—structured settlement Annuities using Private
Placement Variable Deferred Annuities
By Gerald r. nowotny1

Overview                                         assignments. life insurers have              is 30%–40% of the settlement amount.
Structured settlement annuities (SSa)            overcome this problem by creating            until recently the tax treatment of
have been recognized by federal law              assignment companies in Barbados.            attorney deferral arrangements has been
since 1983. the original use of these            article 18 of the u.S.–Barbados Income       uncertain. tax legislation and court
arrangements was for physical injury             tax treaty provides for favorable taxation   decisions have provided the necessary
cases. the typical arrangement for cases         of annuity benefits, overcoming the          tax and legal technical support for
involving physical injury and sickness as        limitation of section 72(u) dealing with     these arrangements.
defined under section 104 provides for           annuities owned by a non-natural                the annuity contracts in the SSa
the defendant to make a “qualified               person. this adverse tax treatment is not    marketplace include both deferred and
assignment” of the periodic payment              applicable to SSa arrangements that          immediate annuities. these contracts are
obligation as prescribed under the               qualify under section 104 and                issued by some of the largest life
settlement agreement between the                 section 130.                                 insurers in the country, including aIG,
plaintiff and defendant to a qualified              the premium volume for SSa                new york life, Met life, and
assignment company.                              arrangements was reported to be $6           MassMutual. However, the annuity
   the qualified assignment company is           billion in 2007, representing 10%–15%        contracts used have been fixed annuity
the applicant, owner, and beneficiary of         of the total claims. the amount of           contracts where the policy’s crediting
the annuity contract, which it uses to           settlement claims was reported to be in      rate has been tied to the investment
make payments to the plaintiff. the              excess of $100 billion in 2007.              performance of the insurer’s general
plaintiff receives tax-free annuity              according to tillinghast, plaintiff’s        account assets.
payments and the defendant or its                attorneys earned $30 billion in 2007.           the use of a private placement
casualty insurance company receives a            nevertheless, most of these SSa              variable deferred annuity (PPva) as an
tax deduction in the year the payment is         transactions have been for plaintiffs        SSa is something completely new to the
made. the defendant is released from             rather than for attorneys deferring          SSa marketplace. What is arguably the
further liability or obligation in the year it   contingency fees.                            best solution in terms of costs and
is made.                                            attorneys have not widely used SSa        investment flexibility is not being offered
   the marketplace for these annuities           arrangements for a variety of reasons.       by SSa brokers.
has evolved to handle a wider range of           First, the annuity contracts offer very         PPva contracts are institutionally
cases—workers’ compensation claims,              conservative returns and in the current      priced variable annuities that offer
employment claims, non-bodily injury             low interest rate environment, these         investment flexibility to customize the
property and casualty claims, and other          returns have been miniscule. Second, a       investment options within the PPva.
negotiated settlements. SSa                      plaintiff’s firm has tremendous upfront      these contracts may provide the ability
arrangements have been used in                   expenses to litigate a case. It requires a   for a lawyer to use his current investment
commercial business transactions                 large “war chest” to meet these upfront      advisor while providing access to
as well.                                         expenses. third, most SSa brokers do         investment classes such as hedge funds
   the previous drawback of using SSa            not have the proper licensing with FInra     that are currently unavailable within
arrangements for non-qualified cases             to offer a variable annuity solution to      SSa contracts.
(cases not qualifying under section 104          provide investment upside for the               this article describes an enhanced
as settlements related to physical injury        deferred contingency fee.                    SSa solution for attorneys who elect to
or sickness) was the inability to avoid             the typical contingency fee               defer contingency fee income.
adverse tax treatment for the                    arrangement for attorneys in these cases

1 long Gray line Consulting, llC, avon, Ct.

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                             POINT TO rememBer I INCOME Ta x REDuCTION aND DEfERR al STR aTEgIES

tax Support for the Deferral                 adhere to the following guidelines in            (QSF) under section 468B until the
of attorney’s Fees                           structuring a deferred fee arrangement.          annuity is purchased. the funds are
In Childs v. Commissioner, 103 t.C.          1. settlement Agreement. the                     deemed not to be constructively
634 (1994), aff’d, 89 F.3d 856 (table)           settlement agreement must certify            received while parked in the QSF.
(11th Cir. 1996), the tax Court ruled in         that a contingency fee arrangement
favor of an attorney fee deferral                between the plaintiff and attorney is     PPva Contracts
arrangement. this decision was the first         in place and that deferred payments       PPva contracts are institutionally priced
and only case supporting the right of an         are directed to the attorney for the      variable deferred annuity contracts for
attorney to defer contingency fee                benefit and convenience of the            accredited investors and qualified
income. the court ruled that the                 plaintiff to meet the plaintiff’s         purchasers as defined under federal
attorney did not have constructive               attorney’s fee obligation. the amount     securities law. unlike retail variable
receipt of his fees because the attorney         and timing of the payments should         annuity contracts, these contracts are
did not have any right to a fee until the        be specified in the agreement. this       unbundled and transparent. the
settlement agreement was signed.                 agreement must be made in writing         contracts have no surrender penalties
Before signing the settlement agree-             before the fees are earned (before the    and are essentially “no load/low load”
ment, the attorney agreed to receive his         settlement documents are signed).         contracts. the policy assets are not
fee over time. the attorney also did not         the election must be irrevocable.         subject to the claims of the life
have any economic benefit—i.e., no               the lawyer’s fee agreement                insurer’s assets (and thus are
funds were accessible by the attorney            with the client should allow the          bankruptcy remote).
before the agreement. the life insurer’s         lawyer to receive all or a portion of        these contracts provide for the ability
guarantee did not meet the definition of         contingency fees in the form of           to customize the investment options of
property under section 83. the Service           periodic payments.                        the contract to include alternative
acknowledged the holding in Childs in a                                                    investments such as hedge funds,
                                                the agreement should contain the
discussion of constructive receipt in FSa                                                  private equity, and commodities.
                                                attorney’s acknowledgement that the
200151003.                                                                                    the investment performance of the
                                                SSa payments “cannot be acceler-
   Section 409a, which was added to                                                        PPva contract is a direct pass-through
                                                ated, deferred, increased or de-
the Code in 2004, deals with the                                                           to the policyholder, the assignment
                                                creased by the attorney; nor shall the
requirements for deferred compensation                                                     company. the increased account value
                                                attorney have the ability to sell,
arrangements. the Service issued a                                                         within the annuity may increase the
                                                mortgage, encumber or anticipate
notice entitled “Guidance under § 409a                                                     attorney’s future periodic payments.
                                                the periodic payments or any part
of the Internal revenue Code” on                                                              the attorney may recommend an
                                                thereof, by assignment or otherwise.”
December 20, 2004. notice 2005-1,                                                          investment advisor to the insurance
                                             2. Assignment. the settlement                 company that—subsequent to the
2005-1 C.B. 274. the notice’s question
                                                agreement must require the defen-          insurer’s due diligence review of the
and answer section provides that the
                                                dant to assign the settlement              advisor—may enter into an investment
limitations of section 409a do not
                                                obligation to an assignment com-           management agreement with the insurer
extend to this type of fee deferral
                                                pany. the assignment terminates the        to manage the assets of the annuity
                                                defendant’s obligation to make             contract. the lawyer cannot control the
   In January 2005, the Supreme Court
                                                periodic payments. the life insurer        investment decision-making authority of
issued a decision in the consolidated
                                                issuing the annuity typically owns         the investment advisor.
cases of Commissioner v. Banks and
                                                the assignment company. the                   In november 1998, the Service
Commissioner v. Banaitis, 543 u.S.
                                                settlement agreement should contain        issued a favorable letter ruling regarding
426 (2005). the Court ruled that
                                                a provision that the assignment            the qualification of a variable annuity as
attorneys do not have a property interest
                                                company maintains all ownership            a valid SSa. Plr 199943002 (released
in the settlement recovery. this ruling is
                                                rights and control of the annuity.         Oct. 29, 1999). In the ruling, the
a critical element enabling an attorney’s
ability to defer fees.                       3. Annuity Purchase. under the terms          Service ruled that variable payments still
                                                of the assignment agreement, the           meet the definition of fixed and
tax requirements for Deferring                  assignment company purchases an            determinable payments under section
Contingency Fee Income                          annuity contract from an affiliated life   130(c)(2)(a). the ruling did not address
an attorney must avoid the application          insurance company to fund its              whether the variable annuity qualifies
of the constructive receipt and economic        obligation. Funds can be temporarily       as a qualified funding asset under
benefit doctrines. an attorney should           held in a Qualified Settlement Fund        section 130(d).

12 I aBa SeCtIOn OF taxatIOn neWSQuarterly
I N C OM E Ta x R E DuCT IO N a N D DE f E RRal STRaTEg I ES I P OI NT T O r ememBer

Case Study                                     in Barbados. under the terms of the          of each year. Payments may increase
The Facts                                      assignment agreement, acme                   based upon good investment
Joe Smith, age 60, is a plaintiff’s            assignment agrees to pay Joe $3              performance within the annuity.
attorney with multiple cases throughout        million. Payments will begin in ten years
the Southeast. Joe is married with two         and will be paid over the joint lives of
                                                                                               the combination of private placement
children and has a personal net worth of       Joe and his wife; their joint life
                                                                                            deferred annuity contracts and structured
$20 million.                                   expectancy is 16 years. under the terms
                                                                                            products provide an exciting solution for
   the Smith law Firm has five partners.       of the agreement, any investment return
                                                                                            plaintiff’s attorneys who wish to defer
In a typical year it is involved in legal      associated with the deferred fees is to be
                                                                                            their legal fees. the deferral in virtually
cases that result in settlements and           paid to Joe as part of the assignment.
                                                                                            every case crosses the breakeven
decisions with damage awards of $5                acme assignment is the applicant and
                                                                                            threshold immediately. the deferral of
million or more. Its estimated revenue is      owner of a PPva contract issued by its
                                                                                            contingency fees is a powerful alternative
$50 million.                                   parent acme life. the policy assets are
                                                                                            to any of the qualified plan benefits
   Joe currently has a new tort case. the      not subject to the claims of acme’s
                                                                                            available to the lawyer through the law
potential damages are conservatively           creditors. under Barbados law, the
                                                                                            firm firm’s sponsored benefits.
valued at $10 million. He would like to        assets of the annuity are not subject to
                                                                                               these arrangements utilize customized
like to defer the entire amount of his         the creditors of the assignment company.
                                                                                            annuity contracts that are institutionally
contingency fee (estimated to be $4            article 18 of the u.S.-Barbados Income
                                                                                            priced. the investment strategy
million).                                      tax treaty provides that the annuity
                                                                                            guarantees the protection of the
                                               benefits are not subject to u.S. income
The strategy                                                                                investment principal (the amount
                                               and withholding tax and will only be
   Joe’s fee agreement provides for a                                                       of the deferred fees) while providing an
                                               taxed to the recipient, Joe Smith, when
contingency payment of 40%. the                                                             upside in investment returns through
                                               payments are received in the u.S.
agreement provides that the claimant                                                        exposure to a wide array of
                                                  the policy provides for several
may elect to pay these fees as periodic                                                     sophisticated investments.
                                               investment fund options featuring
payments over a period of time for the                                                         law firms may use these
                                               structured products and principal
convenience of the claimant. Joe elects                                                     arrangements to provide for retention of
                                               protected notes. these funds offer
to defer all of his legal fees that might be                                                key employees and attorneys. a law firm
                                               exposure a wide array of asset classes,
paid as a result of his representation of                                                   may manage the occasional financial
                                               including alternative investments such as
his client.                                                                                 insecurity of the law firm’s cash flow by
                                               private equity and hedge funds.
   the case settles after much                                                              anticipating overhead expenses and
                                                  the investment performance over the
negotiation for $10 million. the                                                            structuring payments to meet these
                                               next ten years achieves a 10% return
contingency fee of $4 million will be                                                       obligations.
                                               (net of fees). at the beginning of year
deferred. the defendant’s casualty                                                             the use of PPva contracts with
                                               ten, the annuity’s account value is
insurance carrier enters into an                                                            structured investment products provides
                                               $10.375 million. the annuity will be
assignment arrangement with acme                                                            an opportunity to revolutionize the use of
                                               annuitized using variable payments. the
assignment, ltd, a wholly owned                                                             deferred fee arrangements for plaintiff’s
                                               expected annuity payments will be a
subsidiary of acme life. acme is located                                                    attorneys. n
                                               minimum of $775,000 at the beginning

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