contingency fee trap under tax reform: hidden settlement...
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Contingency Fee Trap Under Tax Reform: Avoiding Hidden Settlement Obstacles and Malpractice Issues
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WEDNESDAY, AUGUST 8, 2018
Presenting a live 90‐minute webinar with interactive Q&A
Glen Armand, Chief Executive Officer, Chief Compliance Officer, Eastern Point Trust, Warrenton, Va.
Lawrence J. Eisenberg, Attorney, Lawrence J. Eisenberg, P.C., Bethesda, Md.
Phillip M. Krause, CSSC, CLMP, Managing Director of Strategic Planning, Ringler Associates, Ft. Lauderdale, Fla.
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Contingency Fee Trap Under Tax Reform: Avoiding Hidden Settlement Obstacles and Malpractice Issues
Wednesday, August 8th, 2018
Glen Armand, CEO, COO, Eastern Point Trust Company
Lawrence J. Eisenberg, Esq., Lawrence J. Eisenberg, P.C. / Benefits Law Group
Phillip M. Krause, CSSC, CLMP, Managing Director of Strategic Planning, Ringler Associates
What is the Contingency Fee Trap?
Would you want to pay taxes on amounts you don’t receive?
Neither do your clients.
But they do, because of the Contingency Fee Trap.
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What is the Contingency Fee Trap?
Your successful plaintiffs must pay their attorneys ‐ and when the proceeds are taxable ‐ the IRS as well.
Your successful plaintiffs must report as taxable income both the recovery they receive and the attorney fee that they don’t.
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Before 2018, attorney fees were deductible (subject to limitations that prevented a full income tax deduction).
Now, beginning in 2018, and at least through 2025, attorney fees paid by individuals are not deductible – AT ALL
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This is the Contingency Fee Trap.
Successful plaintiffs who receive a taxable recovery must report full income without a corresponding deduction for the attorney fee. This is – essentially ‐ a double tax!
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A Simple Example
Taxable judgment ‐ $1,000,000, Contingent attorney fee – 40% ($400,000)
Plaintiff reports $1,000,000 as taxable income, even though only $600,000 is actually
received.
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A Simple Example (Continued)
Assuming a 40% Federal and State combined income tax rate, the plaintiff pays $400,000 in taxes.
The Plaintiff ends up with $200,000 – ONLY 20 CENTS ON THE DOLLAR.
The effective tax rate on the plaintiff’s “actual recovery” –what he or she actually receives: 66.67% ($400,000/$600,000)
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The Contingency Fee TrapHow We Got Here and Where We Are Going
Commissioner v. Banks. The Supreme Court held that when a plaintiff’s recovery
constitutes taxable income, his or her taxable income includes not only the recovery received but also the attorney’s legal fee
(including contingent fees).
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Slide 12
EL4 Make the Title Bold and Center itEisenberg, Larry, 8/7/2018
The Contingency Fee Trap ‐ How We Got Here and Where We Are Going (Continued)
Pre‐2018 Tax Law. Legal fees were deductible as a “miscellaneous itemized deduction”. Miscellaneous itemized deductions were subject to significant limitations (2% AGI limitation, the itemized deduction phase out, and not deductible for alternative minimum tax purposes). The result? The legal fee deduction did not fully offset what was included in income. (This was bad enough.)
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The Contingency Fee Trap ‐ How We Got Here and Where We Are Going
(Continued)
2018‐2025. Miscellaneous itemized deductions – including legal fees ARE
NOT DEDUCTIBLE AT ALL.
After 2025?....
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The Contingency Fee Trap ‐ How We Got Here and Where We Are Going (Continued)
RESULT: The combination of Banksand the revised income tax law is VERY ADVERSE for plaintiffs. By having to include the attorney fee portion of the recovery in gross income without any corresponding deduction, the result to a successful plaintiff is substantially higher federal and state income taxes.
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Cases Impacted
Virtually all cases involving an individual plaintiff where there is a taxable recovery.
These include:
* Punitive damages / interest* Fraud, negligence or breach of contract
* Intentional infliction of emotional distress.* Interference property or contract rights.
* Employment related cases. * Marital cases.
* Wrongful arrest or imprisonment. * Reputational damage or defamation. * Legal or accounting malpractice
* Investor fraud.* Whistleblower cases other than IRS, SEC or CFTC
cases. * Legal or accounting malpractice.
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What About “Above‐The‐Line” Legal Fee Deductions?
The Internal Revenue Code (“Code”) allows certain legal fees to be deducted “above‐the‐line”, which would serve as a true offset to the plaintiff’s taxable income.
These include legal fees related to unlawful discrimination (e.g., civil rights, ADA, Age Discrimination, ERISA, Title IX, etc.), Federal and State False Claim Acts, and IRS, SEC and CFTC whistleblower cases. Are these deductions still safe after the 2017 tax law changes?
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What About “Above‐The‐Line” Legal Fee Deductions?
Are these deductions still safe after the 2017 tax law changes?
Perhaps not!
Because of the way the Code is written, it is quite possible that attorney fees (including contingent fee cases) related to these cases are also not deductible. (Was this intended?)
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Cases Not Affected
Code Section 104(a)(2) physical injury cases, which are income tax‐free (except for punitive damages and interest).
Where the plaintiff’s legal fees may be treated as a trade or business expense.
“Opt‐out” class actions.
Where the plaintiff's legal fees may be capitalized.
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Previously Proposed Solutions
In a search for a solution to this problem, others have suggested various purported solutions,
including:
Pay the attorney separately. Will not work!
Form a partnership between the plaintiff and the attorney. Will not work!
The lawsuit as a trade or business. Will not work!
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Previously Proposed Solutions
In a search for a solution to this problem, others have suggested various purported solutions, including:
Pay the attorney separately. Will not work!
Form a partnership between the plaintiff and the attorney. Will not work!
The lawsuit as a trade or business. Will not work!
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A Vetted Solution
The claim – which is an asset ‐ is assigned to a specially designed non‐grantor non‐qualified “split interest” charitable trust.
THE TRUST MUST BE ESTABLISHED AND FUNDED WITH THE CLAIM PRIOR TO FINAL SETTLEMENT. THE EARLIER THE BETTER TO AVOID AN IRS ARGUMENT THAT THE SETTLEMENT WAS ALREADY “EARNED” BY THE PLAINTIFF.
The plaintiff is a beneficiary of the trust. The plaintiff’s interest is converted from owning an asset to having a beneficial interest in the trust.
The attorney fee is fully paid.
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A Vetted Solution
The tax benefits significantly exceed the cost of providing a charitable benefit and the trust expenses.
Result ‐ Substantially higher after‐tax recovery for the plaintiff.
Little downside to the plaintiff for using this solution.
The trust must be prepared precisely.
Vetted by a major law firm.
Tax opinion available.
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An Example of the Vetted Solution Benefits
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Conclusions
The combination of the Banks Supreme Court case and onerous tax law provisions results in the Contingency Fee Trap.
This can have a devastating effect on a successful plaintiff’s net recovery.
There now is a vetted solution that plaintiffs may consider in appropriate cases.
Contingent fee attorneys who already achieve extraordinary results for their clients can take their efforts one step further by helping them understand that the tax law will significantly and adversely affect their recovery, and letting them know that a vetted solution exists.
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What’s Next
Now that you understand the
Contingency Fee Trap, how do you explain it to
your clients?
In addition, there is still a question as to how you and your client are going to further defer the tax liability of both the attorney’s fees and
net settlement proceeds.
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Without CFT, Lump Sum Payment Case Study
For example, assume the gross settlement amount is $2,000,000.00 with a 40% contingency fee. The client
lives in a state without state income taxes and chooses to accept the settlement as a lump sum
payment. After paying the contingent attorney fee, the client would have an approx. $670,499.00 federal
tax liability while only receiving $1,200,000.00.
That’s a net settlement amount of $529,501.00
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Without CFT, Lump Sum Payment Case Study
For example, assume the gross settlement amount is $2,000,000.00 with a 40% contingency fee. The client lives in a state, like Rhode Island, with state income taxes and chooses to accept the settlement as a lump
sum payment. The client would have an approx. $670,499.00 federal and $117,376.00 state tax liability while only receiving $1,200,000.00.
That’s a net settlement amount of $412,125.00
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After Using CFT, Case Study
After using the CFT, the client will now net $1,080,000.00, and if they choose to receive a lump sum payment their tax liability in a state without
income taxes will be approx. $330,099.00, instead of $670,499.00.
That’s a net settlement amount of $869,901.00, an improvement of $340,400 net of fees.
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After Using CFT, Case Study
After using the CFT, let’s again assume that the client will net $1,080,000.00. If they choose to receive a lump sum payment, then their tax liability in a state with state income taxes will be approx. $392,367.00,
instead of $787,875.00.
That’s a net settlement amount of $687,633.00, an improvement $275,508 net of fees.
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Additional Deferral Options
Now that you have successfully avoided the Contingency Fee Trap, and maximized the recovery to your client, there is still an opportunity to defer the current tax liability of both your attorney’s fees and the claimant’s net settlement proceeds over a period of time to further reduce federal and state taxes.
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Case Study – Installment Payments
After using the CFT, let’s assume the client will now net $1,080,000.00 if they choose to receive a lump sum payment. Their assumed tax liability in a state without
state income taxes with be $330,099.00.
If the client chooses to receive installments over ten years, they can further reduce their income tax liability to
approx. $107,220.00.
That’s an additional tax savings of $222,879.00. By receiving the income over time the client has reduced
their marginal federal tax rate from 37% to 22%.
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Case Study – Installment Payments
After using the CFT, let’s assume the client will now net $1,080,000.00 if they choose to receive a lump sum payment. Their assumed tax liability in a state without
state income taxes with be $392,367.00.
If the client chooses to receive installments over ten years, they can further reduce their income tax liability to approximately $141,250.00. This is because the income
is spread out and taxed at lower rates.
That’s an additional tax savings of $251,117.00. By receiving the income over time the client has reduced their marginal federal tax rate from 46.79% to 26.75%.
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Questions?
THANK YOU!
Glen Armand, CEO, COO, Eastern Point Trust Company
Lawrence J. Eisenberg, Esq., Lawrence J. Eisenberg, P.C. / Benefits Law Group
Phillip M. Krause, CSSC, CLMP, Managing Director of Strategic Planning, Ringler Associates
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