Beyond Structured Settlements

SSP and NSSTA 2011 Annual Meetings - 3

Whether and when personal injury settlements are taxable to their recipients represents one of the most important structured settlement legal issues. Both the Society of Settlement Planners (SSP) and the National Structured Settlement Trade Association (NSSTA) featured multiple tax presentations during their 2011 educational conferences.

At the SSP conference, Robert Wood and Jeremy Babener each separately addressed multiple settlement tax issues. Wood discussed: "468B Qualified Settlement Funds" (QSFs) and "Common Settlement Tax Mistakes and How to Fix Them". Babener's SSP presentation addressed three topics:

• Maximizing the medical expense deduction;
• Emotional distress and the medical care exception; and
• Inheritance of personal injury proceeds.

The NSSTA conference also featured a QSF presentation by Martin Jacobson titled "The Ins and Outs of 468B Funds". In addition, NSSTA's Legal Committee Update included a summary of a 2011 tax case, Espinoza v. Commissioner, plus an introduction to IRC Section 5891 as part of a discussion about the secondary structured settlement market.

Wood, who has written both a textbook and a Tax Management portfolio about QSFs, utilized case examples to explain several QSF issues: when is a QSF available; formation of a QSF; who should serve as QSF administrator; what are the QSF administrator's responsibilities; determining QSF income and deductions; information reporting responsibilities; amounts to report and forms to use; reporting of structured settlements; and terminating a QSF.

In his presentation about identifying and fixing settlement tax mistakes, Wood highlighted several issues: the need for professional tax computations; interest is always taxable; punitive damages; attorney fees; tax allocations; miscellaneous itemized deductions; above-the-line deductions; the unclear scope of section 104; sex abuse and wrongful imprisonment cases; the Murphy case; constructive receipt; employment disputes; Form 1099; as well as qualified and non-qualified structured settlements. For related writing by Wood, see the Wood & Porter website as well as S2KM's structured settlement public policy wiki.

Like Wood, Babener is both a prolific writer about settlement tax issues, as evidenced by Babener's website and related commentary appearing on S2KM's structured settlement public policy wiki, and a frequent speaker at educational conferences sponsored by SSP and the National Association of Settlement Purchasers (NASP). Also similar to Wood, Babener's SSP presentation and handouts utilized case examples (as well as tables) to help communicate his analysis. Equally appropriate for their audience, both Wood and Babener emphasized settlement tax planning and incorporated structured settlements into their discussions.

Jacobson's QSF discussion at the NSSTA conference specifically addressed the single claimant issue. Jacobson focused his analysis on the statutory language of IRC 468B, related Treasury Regulation 1.468B-1(c) and related Revenue Procedure 93-34.

• Treasury Regulation 1.468B-1(c) requires and permits a QSF to be "established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability ..." (emphasis added).
• Revenue Procedure 93-34 sets forth the rules under which a QSF will be considered a "party to the suit or agreement" for purposes of Section 130 and includes a stipulation that all Section 130 requirements still apply (emphasis added).

Jacobson highlighted the issue of whether Revenue Procedure 93-34 means that constructive receipt and economic benefit apply to single claimant QSF-funded Section 130 Qualified Assignments. For purposes of the single claimant QSF issue, Jacobson identified what he termed "the real questions":

• Does a single claimant have economic benefit of the funds placed in the QSF?
• Does the single claimant have "unqualified availability" of those funds?
• Has IRC Section 130(c) been satisfied?
• Is there going to be an IRS ruling applicable to single claimant QSFs?
• In the continuing absence of such an IRS ruling, Jacobson quoted Robert Wood's recommendation to "avoid the single claimant controversy" by establishing QSFs with multiple claimants.

With deference to Martin Jacobson for his valuable presentation and gratitude that NSSTA's educational programs have begun to address important and controversial industry issues, S2KM suggests these additional "real questions" concerning single claimant QSFs:

• Why haven't any NSSTA or SSP members applied for one or more IRS rulings applicable to single claimant QSFs?
• For example, what constitutes "multiple claimants" for purposes of QSFs - multiple family members as claimants? government liens? a plaintiff attorney's compensation claim?
• Does public policy favor or not favor single claimant QSFs? If not, why not?
• As Jeremy Babener addresses in his important QSF paper, how far has existing federal legislation eroded the applicability of the constructive receipt and economic benefit tax doctrines to structured settlements:
  • Technical and Miscellaneous Revenue Act of 1988 - allowing "secured creditor status"; and
  • Victims of Terrorism Tax Relief Act of 2001 - allowing transfers of payment rights ("factoring") pursuant to state protection statutes.

For additional information about:

• Structured settlement tax issues - see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J);
• Single claimant 468B QSFs - see S2KM's blog post "Single Claimant QSF Update"
• SSP and NSSTA 2011 Annual Meetings - see S2KM's structured settlement wiki.

Structured Attorney Fees

Robert W. Wood, the preeminent authority on "Taxation of Damage Awards and Settlement Payments", analyzes structured attorney fees in his second audio podcast interview with Ned Arthur (S2KM Podcast Tape 9).

Rob prefaces his analysis by noting that no specific Internal Revenue Code section addresses structured attorney fees. Instead, Rob views structured attorney fees as an accounting concept confirmed by case law - an attorney pays tax when he or she receives compensation.

According to Rob, when they are properly arranged, structured attorney fees allow a contingently-compensated attorney to:

• Defer portions of his or her compensation; and
• Pay tax upon receipt;
• Regardless of:
  • The type of case; or
  • Whether the client receives a lump sum or periodic payments.

Rob's podcast analysis of structured attorney fees addresses:

• Related tax history;
• Appropriate cases;
• Tax advantages and risks;
• Private annuity regulations;
• Public policy - for and against structured attorney fees.

For articles written by Rob Wood about attorney fee tax issues, see Wood & Porter's website generally including these specific articles:

• "Structuring Attorney Fees When You are Not a Solo";
• "New Regulations Address 1099s for Attorney Fees";
• "Contingent Attorney Fees in the Post-Banks Era";
• "Wood on the Private Annuity Regs and Structured Attorney Fees".

In a separate S2KM audio interview (S2KM Podcast Tape 8), Rob and Ned discuss Single Claimant 468B Funds from multiple perspectives including taxation, administration and public policy.

Rob's audio podcast interviews are featured on S2KM's Structured Settlement Public Policy Wiki.  They are also accessible directly from S2KM's blog (upper left) or subscribe to S2KM Podcast.

"Attorney Fees and Private Annuity Rules" Revisited

Robert W. Wood, a noted tax expert, has challenged two controversial conclusions presented by Burgess J.W. Raby and William L. Raby in their article titled "Attorney Fees and Private Annuity Rules" which appeared in the January 22, 2007 edition of "Tax Notes".  S2KM reviewed the Rabys' article in this January 23, 2007 blog post.

The issue addressed in the Raby's article: "When the fees paid to the attorney are spread over time under a structured settlement, do the proposed regulations changing the private annuity rules affect them?"

Their conclusions: "We think it highly likely that if the issue is raised, the structured payments to attorneys would fit within the private annuity rules - and for cases not within the scope of section 104(a), whatever the scope may turn out to be, so too would the payments to the successful plaintiffs."

In an extended January 30, 2007 Letter to the Editor of "Tax Notes", Wood disagrees with the Raby's conclusion stating: "...I do not believe even the IRS, in its wildest dreams, would think the proposed private annuity regulations could torpedo attorney fee structures."  Wood's letter is featured on the Wood & Porter website. Structured attorney fees, according to Wood, are generally unsecured and unfunded obligations entered into for the plaintiff's convenience without necessarily eliminating the plaintiff's obligation to pay the attorney fees.

"More frightening", according Wood, is the second part of the Rabys' conclusion which Wood characterizes as "a doozy".  Wood reacts with shock to the Rabys' suggestion that plaintiff structured settlement arrangements might also be impacted by the proposed private annuity regulations calling that conclusion "an even more extreme a position than is their take on structured attorney fees."

Wood attacks the Rabys' conclusions on several fronts.

• He disagrees with their argument that an exchange of property occurs when an attorney agrees to look solely to a defendant for payment of legal fees. 
• He questions the Rabys' factual understanding of a structured attorney fee transaction and offers examples of sample settlement document language to support his position. 
• He criticizes the Rabys' assumption that the Child's case was incorrectly decided. 

In summary, Wood concludes the proposed private annuity regulations neither address nor impact structured settlements or structured attorney fees.

NSSTA 2007 Winter Regional Meeting-3

S2KM's coverage of the National Structured Settlement Trade Association (NSSTA) 2007 Winter Regional Meeting includes two prior blog posts:

NSSTA-1 summarizes progress reports from two NSSTA-sponsored initiatives and highlights NSSTA's new strategic priority to recapture the structured settlement brand.

NSSTA-2 summarizes five experts who spoke about factoring at the NSSTA 2007 Winter Regional Meeting.

This S2KM blog post addresses the remaining presentations from NSSTA's educational programs:

All Things Considered (ATC) - Formerly known as "The Tax Posse", this presentation features topics and presenters selected by NSSTA's Legal Committee. In addition to two factoring presentations (see NSSTA-2), the ATC panel addressed three issues in Santa Fe:

• NSSTA Lobbying
  
  • NSSTA lobbyist Eric Vaughn summarized the challenges NSSTA faces with the new Congress including change of control and new membership for both the House Ways and Means Committee and the Senate Finance Committee. 
  • Vaughn did not discuss two lobbying issues which have become increasingly important for NSSTA - government benefits (Medicaid and Medicare) and state laws including: settlement transfer protection acts, state periodic payment of judgment statutes and state Medicaid rules. 
  • One member of NSSTA's government affairs committee stated privately that for the first time in NSSTA history, NSSTA representatives, including Vaughn, recently met with CMS.
  • Two other speakers (Craig Ulman and Peter Vodola) referenced proposed judicial rules which could impact the Pennsylvania structured settlement protection act.

• Tax Issues - Tax specialist Tom Ronce addressed three topics. Ronce warned against potential offsets in current bills in Congress which could impact structured settlements. Ronce provided an update of Murphy v. IRS in which the D.C. Circuit Court of Appeals has agreed to revoke its controversial 2006 decision and to rehear the case in 2007.  Ronce summarized proposed federal tax regulations, including private annuity regulations, which could potentially prevent the structuring of attorney fees.  For additional information about the attorney fee issue, read this prior S2KM blog post.

• Agent Responsibilities and Exposures - Attorney Mike Miller summarized the Law of Agency as it relates to structured settlement consultants. Miller's comments also included a review of the 2006 Saltzburg and Chemerinsky memorandums plus an update on two class actions lawsuits, Macomber v. Travelers and Spencer v. Hartford.  For additional information about the Saltzburg and Chemerinsky memos, read and listen to this "Jack Meligan Interview". For additional information about Macomber v. Travelers, read this prior S2KM blog post.

Supporting Casualty Claims - Ismael Acevedo, Vice President of AIG's Structured Settlement Division delivered an educational primer for structured settlement consultants who represent (or want to represent) casualty claim departments. Acevedo's presentation summarized the results of an AIG survey of 1000 claims adjustors.  In addition, Acevedo announced a new AIG initiative to make its structured settlement program "more transparent". Acevedo did not specify whether or how this new AIG initiative will apply to such issues as factoring and/or to informed consent by injured claimants for structured settlement compensation arrangements.

The Non-Qualified Market - Speaker Dennis Drexler recommended that structured settlement consultants should consider the market for non-qualified annuities used to fund installment sales of businesses, professional practices or real or personal property. The benefits for a purchaser, according to Drexler, can include: deferred payment of capital gains, the ability to customize a payment stream, and the improved credit worthiness of the obligor.

Settlement Trust Workshop - For the second consecutive conference, NSSTA devoted half-a-day of its educational program to settlement trusts. Three trust experts, David Cover, Brad Cantwell and Jay Sangerman analyzed the relationship of annuities and trusts in the context of three case studies.

• Cover, a trust officer, pointed out the lack of knowledge most trust officers have about structured settlements as well as the important role of special needs attorneys when government benefits are an issue.
• Cantwell, a structured settlement consultant and Chairperson of NSSTA's Educational Committee, described how blended products (trusts and annuities) improve settlement planning.
• Sangerman, a special needs attorney, discussed the use of annuities to fund special needs trusts. Responding to this author's question, Sangerman insisted the Deficit Reduction Act of 2005 (DRA) does not apply to structured settlement annuities.
• Read these prior S2KM blog posts for additional information about:
  • Settlement trusts;
  • The DRA and structured settlements.

Review of "Attorney Fees and Private Annuity Rules"

Burgess J.W. Raby and William L. Raby have written a controversial article titled "Attorney Fees and Private Annuity Rules" which appears in the January 22, 2007 issue of "Tax Notes". 

Their issue: "When the fees paid to the attorney are spread over time under a structured settlement, do the proposed regulations changing the private annuity rules affect them?"

Their conclusion: "We think it highly likely that if the issue is raised, the structured payments to attorneys would fit within the private annuity rules - and for cases not within the scope of section 104(a), whatever the scope may turn out to be, so too would the payments to the successful plaintiffs."

A summary of their analysis:

• "...until last October, the lawyer did not have to worry that receipt of the defendant's promise to make a series of payments would result in immediate recognition of taxable income" because of "Rev. Rul. 69-74, 1969-1 C.B. 43, the so-called private annuity ruling." 

• "However, on October 18, 2006, the IRS published proposed regulations with a proposed effective date of October 18, 2006....".

• "The result, if the proposed regulations are adapted unchanged, will be that the attorney will be immediately taxable on the present value of the future payments as determined under section 7520, which provides for the interest rates to be used in making the present value calculation."

• "The unsecured nature of the obligation, the financial position of the obligor, and even the presence or absence of any collateral security or funding mechanism will be irrelevant to that calculation. "

The article, which includes valuable analyses of Childs v. Commissioner, "the benchmark case in this area", Commissioner v. Banks, and Vincent v. Commissioner, questions whether the Childs' holding is still valid.

For more about structured settlements and attorney compensation, see this link.

Plaintiff Attorney Compensation

The recently enacted American Jobs Creation Act of 2004 includes important results for two issues relating to plaintiff attorney compensation. The first issue addresses deferred compensation.  The second issue concerns the deduction of attorney fees by plaintiff employees in discrimination cases. 

Deferred Compensation

I.                    Background

            Historically, when their clients have agreed to a structured settlement, some plaintiff attorneys have elected to receive a portion of their fee on a deferred basis.   Although the factual circumstances vary depending upon the terms of the settlement documentation and the attorney’s fee agreement, the tax question is whether the attorney should be required to recognize income before receiving the future payments. 

            The IRS has challenged attempts by plaintiff attorneys to defer their fees in structured settlement cases beginning in 1991 when it issued three separate Technical Advice Memoranda.  In each of these cases, the IRS utilized the doctrine of constructive receipt to determine income was received in the year the settlement occurred although the attorney received no actual cash.  In 1994, however, in Childs v. Commissioner, the Tax Court ruled in favor of deferred attorney fees for five different plaintiff attorneys in two separate structured settlement cases.  Although the IRS continues to challenge attempts by attorneys to defer fees in structured settlement cases, many plaintiff attorneys and several structured settlement annuity providers view the Childs case as authority permitting deferred compensation arrangements. 

II.                  New IRC Section 409A

For plaintiff attorneys, a significant issue under the American Jobs Creation Act of 2004 is whether new IRC Section 409A applies generally to vendors providing services to multiple customers under a commission or other event-based compensation arrangement.  Although Section 409A applies primarily to employer-employee situations, the Conference Report for this legislation indicated that the application of the new IRC Section 409A deferred compensation rules were not limited to arrangements between an employer and an employee. 

In general, Section 409A provides that all amounts deferred under a nonqualified deferred compensation plan are currently included in gross income to the extent not subject to a substantial risk of forfeiture and not previously included in gross income unless certain requirements are met.  One of these requirements, a special timing rule for elections with respect to “performance-based compensation” related to services performed over a period of at least 12 months, would create problems for plaintiff attorneys because their compensation does not follow the flow of services as in the traditional employer-employee situation.

III.                IRS Guidance

            On December 20, 2004, the IRS published initial guidance on Section 409A.  This guidance includes the following language recommended by the National Structured Settlement Trade Association (NSSTA) to address the situation of plaintiff attorneys and other similarly situated service providers:

"Section 409A also does not apply to arrangements between a service provider and a service recipient if (a) the service provider is actively engaged in the trade or business of providing substantial services, other than (I) as an employee or (II) as a director of a corporation; and (b) the service provider provides such services to two or more service recipients to which the service provider is not related and that are not related to one another." 

This exception to IRC Section 409A, however, does not mean that plaintiff attorney’s can now automatically defer their compensation in structured settlement cases.   The December 20, 2004 IRS guidance also includes the following language:

“… Section 409A does not alter or effect the application of any other provision of the Code or common law tax doctrine.  Accordingly, deferred compensation not required to be included in income under Section 409A may nevertheless be required to be included in income under Section 451, the constructive receipt doctrine, the cash equivalency doctrine, Section 83, the economic benefit doctrine, the assignment of income doctrine or any other application of the Code or common law tax doctrine.”

IV.               Conclusion

Despite the IRC Section 409A exclusion, the tax issues for deferring plaintiff attorney compensation remain complex.  Plaintiff attorneys should expect continuing challenges from the IRS and should retain tax counsel to review any potential deferred compensation arrangement.

Deduction of Attorney Fees in Discrimination Cases

In addition to new IRC Section 409A, the American Jobs Creation Act of 2004 also includes the Civil Rights Tax Relief Act.  One important result of the Civil Rights Tax Relief Act is the elimination of attorney fees from a successful plaintiff employee’s gross income in discrimination cases.  Tax relief under this legislation applies to settlements and judgments that occur after October 22, 2004. 

Prior to enactment of the Civil Rights Tax Relief Act, it was uncertain whether a plaintiff’s gross income from the proceeds of discrimination litigation included the portion of his recovery paid to his attorneys pursuant to a contingent fee agreement.  Although plaintiff employees could generally deduct these amounts as itemized deductions, the IRS claimed the alternative minimum tax required successful plaintiff employees to pay income taxes on their entire award including attorney fees and court costs.  For example, if a victorious plaintiff in a discrimination case won a $100,000 verdict and paid $30,000 in attorney fees, the IRS required the plaintiff to pay income taxes on $100,000 while his attorney also paid taxes on $30,000.  Although this result had been challenged in court prior to the enactment of the Civil Rights Tax Relief Act, several federal appellate courts had split on the issue. The US Supreme Court had granted certiorari in two cases where the results favored the plaintiffs prior to enactment of this legislation.

     Additional information about plaintiff attorney fee compensation in structured settlement cases is available in “Structured Settlements and Periodic Payment Judgments”.