Reimagining the Tax Planning Paradigm for Trial Attorneys
It never occurred to me before or after law school to become a litigator. Nevertheless, my experience as a litigator has been a little bit like the greater writer of blessed memory George Plimpton. He was a New York City elitist who went to the best schools, Phillips Exeter, and Harvard, but was somewhat of a Walter Mitty in the sports realm.
His father was the managing partner of a fancy New York City law firm. He was a mediocre athlete at best but who chronicled his foray into professional sports. He wrote about his experience with the NFL in The Paper Lion, and Mad Ducks and Bears. He wrote about his experiences traveling with the PGA tour in the The Bogey Man. He wrote about his experience sparring with the former heavyweight champion Archie Moore. However, his best sports journalism was The Curious Case of Sidd Finch.
The story of Hayden Siddartha Finch originally appeared in Sports Illustrated in 1985 unbeknown to readers as an April Fool’s story. Plimpton created the legend of Sidd Finch, his protagonist, as a top major league prospect who grew up in an English orphanage and was adopted by an archaeologist who died in a plane crash in Nepal. After briefly attending Harvard, Finch went to Nepal to study the yoga with a Dali Lama-like guru. Finch who stood at 6 feet 4 inches, had a 168 mile per hour fastball. However, He struggled with the decision between a career in professional sports or playing the French horn.
In my own case, after a lifetime of Perry Mason and other shows about lawyers, my own litigation experience happened accidentally. While pursuing wealthy Latin American investors as tax clients, I ended up in immigration court and the Federal Court of Appeals litigating on behalf of poor and undocumented Latin Americans. Like Plimpton in his stories facing professional athletes, I suffered a “thrashing” from experienced government litigators on a regular basis. Truth be told, I have never beaten my wife (aka Mrs. Nowotny or Long Suffering) in an argument. For that matter, I am certain no man would disagree with that dilemma vis-à-vis a wife!
This article outlines a new tax planning model for trial attorneys who heretofore have financed litigation relying on the firm’s “war chest” accumulated from prior settlements on an after-tax basis. The new business model for litigation law firms proposes a significant change to the traditional model relying on third party litigation finance resources to finance business and litigations expenses while simultaneously deferring a larger portion of contingency fees on a tax-deferred basis. The new business model envisions the law firm accessing these deferred fees on a tax-free basis while using a revolving line of credit against these deferred fees. The investment earnings on the tax deferred contingency fees continue to accrue on a tax-deferred basis. The interest expenses associated with the third-party litigation finance and the revolving line of credit are tax deductible. The most noticeable difference is the 40-50 percent reduction in the “haircut” from federal and state taxation. In the low interest rate environment and absence in taxation on revenue, the trial lawyer can build wealth quickly.
The New Fee Deferral Strategy for Trial Lawyers and Law Firms
The proposed strategy allows a trial attorney or a litigation law firm to defer contingency fees for either qualified or non-qualified assignments. The deferred contingency fees are not currently taxable to the attorney or law firm relying upon the provisions of the U.S.-Swiss Income Tax Treaty which was ratified in 1996 and amended in 2009. The special purpose vehicle (SPV) which hold the deferred fees relies on the provisions of the Treaty.
Under the Treaty, investment income such as interest income is exempt. Short- and long-term capital gain income is exempt. Qualified dividend income is subject to a 5 percent withholding tax. Royalty income is not subject to any withholding tax. Nevertheless, an investment advisor may desire to invest deferred fee income in the SPV into assets classes which are subject to withholding taxes. A private placement variable deferred annuity (PPVA) may be used to convert U.S. source income that is subject to withholding taxation into “annuity” income which is not subject to withholding taxation under the Treaty.
The proposed strategy provides a lending structure which allows the lawyer to borrow up to 75 percent of any deferred fees at an exceptionally low interest rate in the current environment. The lawyer may also continue to defer fees into the structure in future years. In the ensuing years, the lawyer may use litigation financing to meet business and litigation expenses. Any interest expenses associated with borrowing should be tax deductible.
In summary, the lawyer can defer as much revenue as he would like. Otherwise, the lawyer would subject to taxation at ordinary rates. The lawyer may borrow against the deferred fees on a tax-free basis. The firm may also use litigation financing at a low cost to meet current business and litigation expenses. Interest payments are deductible. In the final analysis, the trial lawyer is able to accumulate wealth on an accelerated basis.
Joe Smith, age 50, is a litigator in his own personal injury law firm. He is a resident of California. The firm was formed as a limited liability company. He is married and has three children. He has accumulated $1 million in the firm's qualified retirement plans. His combined marginal tax bracket for federal, state, and municipal purposes is 50 percent. His annual income after bonuses has averaged $1.5 million per year. Joe's lifestyle requires a net income of $500,000 per year. He has a family trust that owns a life insurance policy on his life for $2.5 million. Joe expects to earn $1 million each year from contingency fees on cases for the next twenty years. He plans to defer 50 percent of each contingency fee which he estimates to be at least $500,000. The expected rate of return on deferred assets is 7.5 percent. Joe plans to practice law until he is age 70. Joe and his wife have a number of important charitable causes including their church, respective alma maters as well as a defense fund for indigent members of their community.
Joe agrees to assign 50 percent of each settlement to a special purpose vehicle (SPV) owned and managed by a Swiss Trust Company. The deferral fees are held and managed in separate cell for each participating attorney for legal and asset protection purposes. The structure of the SPV qualifies for tax purposes for the use of the provisions of the U.S.– Swiss Income Tax Treaty.
The law firm will begin to use litigation financing to meet firm expenses and litigation costs so that the firm can defer a higher percentage of contingency fee income. The interest payments associated with the debt are tax deductible to the firm.
The projected accumulation of the deferred contingency fee income over the next twenty years assuming a reinvestment of investment earnings and no borrowing against the deferred account, is $20.5 million. Unlike the limitations and restrictions of qualified retirement plans, Joe may borrow up to 75 percent of the account value on a tax-free basis at a negligible rate of interest which incidentally is tax-deductible. The Plan does not require the participation of firm employees. The Plan does not have any required minimum distribution requirements. Most importantly, the Plan does not limit how much money he can defer into the Plan.
Joe is able to recommend his own investment advisor to manage assets within the SPV. The investment advisor has no investment restrictions. The Plan may incorporate the use of a PPVA within the SPV for investments such as real estate and business holdings that would otherwise be subject to onerous withholding tax treatment under the Treaty.
Nothing in the current landscape – economic or tax – suggests that plaintiff’s attorneys will make less money due to tort reform or that taxes will be lower. Trial lawyers living in high tax jurisdictions have made the transition to using litigation financing rather than maintaining the “Old School” philosophy of building a war chest on an after-tax basis at the highest marginal tax rate. The new tax planning model for trial lawyers proposes “having your cake and eating it too, “ i.e. using borrowed funds to finance litigation expenses while deferring a maximum amount of contingency fee income and borrowing a high percentage of the tax deferred fees on a tax-free basis The process may be repeated year-after-year. Interest payments are tax deductible.
A future article will illustrate a strategy illustrating a tax strategy to migrate tax-deferred funds to a family trust in a very tax efficient manner. The result is tax-deferred is converted into tax-free dollars.
The new tax planning model for trial lawyers provides a new path forward to reduce taxes and build wealth on an accelerated basis. California dreamïn on such a winter’s day!