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.