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.