Reimagining the Tax Planning Paradigm of Trial Attorneys
It never occurred to me before law school to become a litigator. Truth be told, I have never beaten my wife (aka Mrs. Nowotny or Long Suffering) in an argument. For that matter, I am not certain if any man could say that! All of the legal shows - past, present, and future - deal with litigators. The last TV show that I can remember featuring a tax attorney in any sort of meaningful way was LA Law. TV shows and movies always deal with criminal defense attorneys, or prosecutors. On the civil law side, movies and TV shows show trial attorneys taking on large corporations.
The traditional business model of the litigation law firm typically has a law firm representing clients on a contingent fee business. In the early days of the litigation law firm, the firm may also represent clients on a traditional fee basis in order to provide a reasonable flow of revenue until contingency cases settle. This revenue balance provides some financial certainty until there is a significant backlog of contingency cases or "war chest" to meet business expenses, finance litigation expenses.
The business model for business law firms has begun to change in more recent years. In the low interest rate environment, a number of litigation finance funds have begun to emerge to provide law firms with lending capital to finance litigation expense.
In my view, trial attorneys have never taken full advantage of their ability to defer their contingency fees for tax purposes in litigation. Part of the reason has been the need to maintain the "war chest” to finance current and future litigation.
Most law firms are taxed as pass-through entities. As a consequence, trial attorneys are usually taxed at the highest rate for federal and state tax purposes. A California attorney can pay taxes on contingency fee income as high as 50 percent. Even if a lawyer wanted to use current income as a source for future litigation costs, this method is the most expensive way to finance cases.
A combination of litigation financing and tax structuring reverse this inefficient tax planning paradigm. The use of litigation financing for litigation and business expenses at low interest rates should allow a litigation law firm and lawyer to structure or defer a much larger portion of contingency fee income without taxation.
The deferral structure allows for tax deferral on 100 percent of the deferred income. The lawyer may select the investment advisor for the deferred fee structure. The investment income on the deferred fee income is also tax deferred. The range of investment options is unlimited and with proper planning not subject to any U.S. income or withholding taxation.
Additionally, the lawyer may enjoy a revolving line of credit up to 75 percent of the deferred fees. Loans against the deferred fees enjoy tax-free treatment, interest payments on the litigation financing is tax deductible in the year incurred, interest payments to the special purpose vehicle (SPV) in the tax structure are also tax-deductible.
In the new paradigm, litigation law firms and trial lawyers may reduce their tax burden significantly and accumulate wealth personally more rapidly. There is the matter of truth and justice, but there is also the matter of being able to show something for the efforts at the end of a trial.