Another big taxable damage case. $101 million wrongful imprisonment verdict announced.

In Boston Federal Court today US Judge Nancy Gertner announced a stunning verdict of $101 million in the wrongful imprisonment case brought in the notorious saga of the corrupt FBI arrangement with organized crime figures in the Boston area that has resulted in a string of admissions about the government knowing it's informants were killing other mob associates, but doing nothing about it.

In this particular case the four wrongly convicted men, the late Henry Tameleo and Louis Greco, and the still living Peter Limone and Joseph Salvati, had spent decades in prison doing time for the murder of Edward Deegan back in 1965 in Boston. They had been named by a former mob hit man, Joseph "The Animal" Barboza who was in fact lying in order to protect a fellow FBI informant, Vincent "Jimmy" Flemmi from being prosecuted for the murders. The FBI in Boston knew the four men were innocent, but kept silent in order to protect their corrupt ring of informants, thus allowing four innocent men to spend most of their lives in prison for a crime they never committed.

You can read news stories on this by going to the Boston Globe site and doing an archive search to access their years of reporting on this case.

However, what intrigues me is that once again, in less then a month since the Murphy vs IRS decision on July 3, 2007 we have a major $100 million or greater verdict on a taxable damages case, with the likelihood that these gentlemen and their estates are utterly unaware of the fact that they are about to face the further indignity of having to pay an enormous sum in taxes unless they and their attorneys elect to structure this award over several years.

The allocations according to news reports broke out to $26 million to Limone, $29 million to Salvati, $13 million to the Tamelo estate and $28 million to the Greco estate. Further the wives of Limone and Salvati and the estate of Tamelos deceased wife each were awarded slightly more then $1 million and the men's 10 children were each awarded $250,000.

So, lets once again do the gruesome match on taxable damages. Remember, unlike our prior illustration on the LA Archdiocese case where there was still some doubt as to maybe some of the damages might be tax free, in this case it is an absolute certainty that this is all going to be fully taxable.

Lets take Mr. Salvati as our example. His award of $29 million, coupled with $1 million to his wife would create a net taxable award of $30 million. Under the typical scenario his attorney is going to take at least a full third to 40% of the award as his fee, but as you will recall, under the Banks and Banatis supreme court rulings this fee is NOT tax deductible to Mr. Salvati or any of the others in this suit. Therefore, he must report the entire $30 million, even though he may only net $18 to $20 million after fees.

Still not bad you say? Well, lets do the very rough tax math here.

$30 million in taxable income. His federal tax rate is going to be 35% on the excess over $349,700. His state tax rate as a citizen of the Commonwealth of MA is going to be 5.3%. This is a combined top marginal tax rate of 40.3% on the vast majority of this income he is scheduled to receive. I think we can very safely assume that this individual is going to be facing at least a $12 million combined federal and state tax bill for his award for wrongful imprisonment.

So, if we deduct the attorney's fee of $12 million and his taxes of $12 million, our poor plaintiff and tax payer in this situation is left with $6 million net of his $30 million award. Talk about getting shafted by the US Government twice! First they take decades of his life due to FBI corruption and lying, and now the IRS and State Tax authorities receive twice the amount in taxes that this man will receive in his pocket!

Look at the tally here.

Attorney fee: $12 million

Taxes: $12 million

Plaintiff: $6 million

As I have written before, this is the single most grotesque distortion of the US Tax Code I can think of, and while most people are in utter disbelief that this is the truth, it absolutely is the case here. These plaintiffs are looking at tax bills well in excess of $10 million each.

So what can be done, if anything to minimize the financial trauma these families and their estates are about to experience at the hands of the federal and state tax men? As outlined in my previous blog post, they MUST engage a competent structured annuity expert with experience in handling taxable damage cases. They further must immediately get to work on obtaining the assistance of their attorneys in structuring the legal fees so the tax hits are spread out over several years, and then they need to look at structuring their own income out over several years as well. Go back and read my prior posts on the Archdiocese for the template on how to get this done.

Hopefully these men and their families get the planning assistance they desperately need, or come April 2008 they will be writing checks far in excess of what they could ever imagine and how is that justice for all they endured for so long? 

Options for Attorney's on taxable damage cases post Murphy.

As mentioned in my prior two blog posts on the topic of taxable damage case after the Murphy vs IRS ruling on July 3, 2007, we are now looking at a situation where the definition of what is a taxable damage case is much easier to define, we have a great deal of certainty as to courts positions on the dual issues of taxable damages and deductibility of legal fee's on taxable cases and the scope of this ruling is likely going to impact several high profile cases such as the Los Angeles Archdiocese sexual abuse settlement.

I've tried to frame the problem, explain the tax history that led us to this stage and then give you the intellectual background as to what the Murphy case means for trial lawyers, plaintiffs, settlement and tax professionals. The question now is what are the various stakeholders to do when presented with evidence that strongly indicates that most, if not all, sexual abuses cases are quite likely taxable damages?

The options rest on using already established, but often neglected tools, to first buy breathing space so efficient planning can take place. Those options are as follows:

1. On most taxable damage cases be sure to establish a 468b Qualified settlement Fund prior to negotiating any settlement or going to trial for a verdict. The necessity of using a 468b fund to collect payments, negotiate allocations, pay liens and engage in planning is absolutely crucial in the vast majority of large taxable damage awards. You can search our blog for more information on how these funds work, but they are essentially special purpose, limited duration trusts that allow defendants to pay claims into them, get a full tax deduction and release of claims, but the client and their attorney is not in constructive receipt of the funds. This allows for a wide variety of options to collect all payments, determine all allocations, but most importantly in a taxable case, engage in cash flow planning via structured annuity contracts to attempt to reduce the long term tax hit on this award.

2. Engage a settlement professional with a strong back ground in handling taxable damage cases and is familiar with the options available to trial lawyers, plaintiffs and defendants. I don't want to disparage any of my fellow brokers but I can say with a great deal of certainty that the number of structured settlement experts who have worked with 468b settlement funds on taxable damage cases, AND structured annuities out of them is a mere fraction of the brokers in our industry. This should not be a learn as you go along process for a broker, and if your broker HASN'T done this before please suggest they contact and work jointly with someone who has. The implications of doing this improperly are pretty grave and you don't need to have your broker learning on the job.

3. Establish a dialogue early in the trial lawyer/client process about the impact of taxable damages and the negative aspects of the non-deductible attorney fee on the clients tax picture. The sad fact is most trial lawyers don't bring up the tax impact of their taxable damage award case until a settlement or verdict has been reached, and the client gets the "oh by the way" letter or phone call informing them just how seriously they are about to be taxed. In all fairness this has been an area in a state of flux as regards the tax status on certain types of cases, but we aren't in that situation any more. We know what is taxable, we know legal fee's aren't deductible and we know the client is going to get tagged big time on taxes. The trial lawyer MUST be proactive early in the case to inform the client and start the process of tax impact mitigation with a professional or risk serious client issues when the case settles or goes to verdict. It is ALWAYS better they hear it from the lawyer then someone else.

4. Determine if the trial lawyer is able to structure their fee over several tax years using a non-qualified structured attorney fee to take their contingency fee in a structured payment. A little known fact is that trial lawyers can structure their fees on both taxable and non-taxable settlements! This will be the subject of another post, and you can find more information over on my Wahlstrom Associates site, but it is totally possible for trial lawyers to take the amount of their fee and spread it out over several tax years via a structured legal fee, thus moving the tax hit into those future years as well. Why this is so important on taxable cases is because when a trial lawyer structures their fee, they most the CLIENTS tax hit on the value of their legal fee into future years as well! Remember the phantom tax that the client must pay on the legal fee, and that they must report the legal fee as income in the year in which the trial lawyer reports it. When structured properly, you have that income moved into future years for both the benefit of the trial lawyer AND the client so the impact of this transaction benefits both parties.

5. Once the legal fee structure is resolved, look at the options for the client to structure their settlement via a non-qualified structured annuity so as to spread taxable income into future tax years. If the trial lawyer agrees to structure their legal fee, then the client can look at the tax hit of the legal fee element of the plan with certainty. This allows them to work with their settlement and tax professional to then determine a structured annuity for their own situation knowing what they need to put aside each year for tax withholding payments, how much can be used as income and what the potential tax hit is each year. This advanced planning is crucial in reducing the tax impact of the taxable award and it takes time and team work to make it happen, so doing this in the last few days of a settlement typically doesn't work.

6. After tax and cash flow planning has been completed be sure that documents and procedures out of the 468b qualified settlement fund are carefully executed and processed so as to insure full tax compliance. Again, this goes back to having a qualified professional settlement expert work with you on these cases. The combination of a 468b settlement fund, a structured legal fee and a structured client award take a lot of time and effort between trial lawyer, client and the respective tax professionals for the attorney and the client. It also requires careful compliance to make sure the documents meet the requirements of the funding life insurance company, provide for the full release of the defendants and avoid constructive receipt. Remember, this isn't one you need your settlement broker learning how to do these on at your expense! Ask them if they have done this before, ask for references and if they haven't, suggest they partner with someone who has or find another broker.

The bottom line is that if a trial lawyer engages a settlement professional with extensive experience in the area of Taxable structured settlements and the use of 468b settlement funds, a great deal of planning can get done, the client can be well served, the attorney can do tax/cash flow planning and the entire transaction has the same level of safety and security as any other structured settlement annuity.

The name of the game is to move a very large one year taxable event into future years where appropriate tax planning can move the plaintiff and attorney into lower marginal tax brackets, as well shift income into years where off setting business and personal deductions can be utilized to further reduce the inevitable tax hit.

Keep in mind, that this is not a tax shelter! This is totally legal and conservative tax deferral in which you will eventually be required to report all income, plus interest, and pay taxes at the rate prevailing in the year you receive the taxes. However, with careful planning through a professional settlement expert you have the ability to conserve a great deal of principal by shifting income to future tax years and it is essential that every trial lawyer working on taxable damage cases be sure to communicate this option to their clients so they can decide whether or not they wish to proceed.

We will of course continue to follow up on the Murphy v IRS decision and cases impacted by it, but this should generate enough through among trial lawyers and others as to the necessity of using structured settlements on taxable damages in most, if not all, large taxable damage awards.  

Tax saving options for trial lawyers and plaintiffs post Murphy v IRS

In part two of my three part series on the fall out from the Murphy v IRS decision of July 3, 2007 in which the issue of taxability of damages in a wrongful termination suit was reviewed by the US Federal Appeals court, we will look at the implications for trial lawyers, plaintiffs and settlement professionals.

First, as stated in my first blog post on this topic, it is highly likely that, given the special attention that the Court paid in the Murphy decision to the origin of claim issue in determining whether a case fell under the tax free provision of section 104(a)(2), most cases that are not clearly originated due to an outwardly visible physical injury or sickness are going to be taxable. That means cases such as defamation, wrongful imprisonment, wrongful termination, qui tam/whistleblower cases, sexual harassment, molestation, sexual abuse and other non-physical injury cases are in all likelihood going to be treated as taxable events by the IRS upon examination. The implications for a group of plaintiffs such as the recipients of the recent Los Angeles Archdiocese sex abuse settlements are quite profound as many of those cases would appear from news reports to clearly fail to meet the test of demonstrable outward physical injury. It's horrible, it's unfair and unjust but pretending otherwise is potentially dangerous for attorneys, tax professionals and plaintiffs alike.

So if we are now living in a post Murphy world, in which the gray area on taxable damages is now rather black and white, what are trial lawyers, plaintiffs and settlement professionals to do when faced with a case that falls outside the tax free protection of section 104(a)(2)? How significant are the problems on large taxable damage cases and what issues are we facing?

1. If a case is taxable damages, and is not an employment discrimination claim or FFCA case, the attorney fee the client must pay as part of their settlement is NOT tax deductible and thus they must report the full amount of the settlement on their tax return in the year in which they receive it. Yes it is double taxation and patently unfair, but those are the facts under the current law as this issue was clearly decided with the Banks and Banatis Supreme Court decisions. Therefore the client needs to know that their entire award is taxable, not just the amount they clear after legal fee's are deducted.

2. The impact of these payments typically creates a situation where the dreaded Alternative Minimum Tax rate kicks in. While the marginal rate is the same as regular calculations, the real harm comes in the phase out of otherwise deductible items on the tax payers tax return, thus raising the effective rate of taxation to an even higher level.

3. If plaintiffs aren't aware of this tax situation at the time their funds are disbursed they can often fail to report income, or under withhold tax payments for the year, resulting in a situation where they trigger penalties and interest on taxes due but not paid in a timely fashion, further adding injury to an already unfair situation.

I could go on but those are the key elements of concern just to start. The question now is, what can the trial lawyer or client do to minimize or smooth out these payments?

The first option is to have set up a 468b Qualified Settlement Fund out of which payments are to be paid by the various defendants in a case. The reason this is important is that very often you have multiple defendants or payers who are paying various elements of damages, and each time one settles and makes a payment to the trial lawyer on behalf of a clients claim, a taxable event is triggered. If however, a QSF is established, as I am sure was done in the LA Diocese case, you have the ability to collect all payments, pay all expenses, determine net allocations for each plaintiff and then devise the most equitable and tax efficient payment plan by which that claim can be paid. ( I'll discuss the particulars of this option in part three of this series.)

The second option, assuming the QSF is in place is for both the trial lawyer and the plaintiffs to examine the possibility of  structuring their payments through the use of a non-qualified structured settlement contract. Now, don't let the term non-qualified scare you off, it just refers to the fact that the structure doesn't qualify for TAX FREE payment under section  104(a)(2), but instead is a structured annuity payment stream for a taxable case instead. The benefits of the structured annuity on a taxable case is readily apparent once you examine the tax impacts of taking a lump sum vs. the structure.

With structured payments of the plaintiffs money, as well as structured payment of the attorneys legal fee, you spread out the taxable impact of the award over a set and determined period of time. For example lets just assume that someone has an award of $1,300,000 as reported in the LA Archdiocese case, and instead of paying all the taxes in 2007 they elect to structure that payment over 20 years to reduce the tax impact. What they would do is look at options that paid them monthly amounts for 20 years, which assuming a net after fee amount of $800,000 would translate into roughly $5335 monthly for 20 years at todays rates. The net impact of this would be to spread their tax hit over 20 years, with taxable income each year of approximately $64,000 a year under this scenario, which would in most cases bring the marginal tax rate well under the maximum they would pay now, plus get them under the AMT limits and allow them to keep more of their deductions.

A good solution you say? Well sure, except for that nasty fact that the attorneys fee is fully reportable to the plaintiff in the year in which the attorney takes their payments. So, while the plaintiff might want to obtain tax relief, lets go back to our $1,300,000 award scenario and look at the impact of the trial lawyer taking their entire fee up front on the clients cash flow and tax situation. Remember, the $500,000 fee the attorney takes is fully taxable to the client in that year, which would result in a tax bill of approximately $200,000 to the plaintiff on the phantom income they must report. So, instead of our client having $800,000 to put into their 20 year structured annuity, they only have $600,000. However it gets worse. As they need to use cash to pay those taxes, they have to report $200,000 in income in 2007 to make the tax payment on the attorney fee element, thus bumping up their own tax bill by approximately $80,000 in the process as well, necessitating more cash out of the structure so that our client is probably at best left with $500,000 to structure over time to fund their annuity payments and spread out the tax hit. This would result in payments of $3,335 per month for 20 years, or a reduction of $2000 monthly for the 20 year period. A loss to the client of $480,000 in potential benefits.

So what is the solution here? Obviously, if at all possible the trial lawyer must consider structuring their fee on this case in order to reduce the phantom tax bill to their client.  Now, I realize this is going to raise some real concerns among trial lawyers, but lets try to face this head on. I've done several taxable cases and in most of them I have recommended that the attorneys structure their legal fee over a period of years so that they can reduce their own tax hit, but primarily to provide relief to their clients by spreading out the phantom tax hit they have to deal with. Remember, the taxpayer only has to report what the attorney receives in a particular tax year in a properly designed and underwritten non-qualified structured settlement program that includes a structured legal fee.

Is this all making your head spin now? I'm sure it is, and unfortunately the reaction of many trial lawyers and plaintiffs is to pretend the situation doesn't exist and they just take the cash and hope that the IRS doesn't come calling at some future point. The fact is, post Murphy v IRS your ability to take that position as a legal professional, or as a settlement professional, is built on a foundation of sand so it is far better to be proactive and really dig in to work out a solution to this issue.

In part three of this series I'll walk you through an actual case I worked on in which we did a non-qualified structured annuity for a multi-claimant group of plaintiffs, and illustrate how a cooperative trial lawyer was able to dramatically reduce the tax harm to their client, while also locking in their own financial planning future using these innovative tools.