Using the Loan Method of Split Dollar as an Alternative to Attorney Fee Deferrals
One of my favorite movies that inspired me to go to law school was The Paper Chase. The movie follows the trials and tribulations of a first-year law student at Harvard Law School. During the same period that I was an Army officer stationed at Fort Hood, the ShowTime series of the story was mandatory watching. Nevertheless, it never occurred to me to apply to Harvard. Coincidentally, my friend and tutor in all the math and science classes, Jim Bowen, did graduate from Harvard Law School. I have always joked that he has his name on two West Point diplomas, his own and mine.
I took the LSAT at Baylor University on the way to my next duty station, Fort Eustis. I did not apply to law school until three years later while living in South Florida. At that time, the University of Miami (UM) had the only evening law program. Since that time, UM dropped its program apparently because prestigious programs don’t have evening programs.
I have written previously about the deferral of attorney contingency fees and have been on a several week rant about the planning power of the Loan Regime Method of Split Dollar.
Attorney Fee Deferrals
Attorneys can defer contingency fees in either qualified assignment or non-qualified assignment cases. The seminal case recognizing an attorney ability to defer contingency fees before there is constructive receipt is Childs v. Commissioner, 103 T.C. 634 (1994), aff’d without opinion, 89 F.3d 856 (11th Cir. 1996). Fee deferrals in qualified assignments are usually structured in structured settlement annuities or in qualified settlement funds. Non-qualified assignments are usually structured through foreign assignment companies in jurisdictions that have favorable tax treaties with the United States.
In my view, trial attorneys have under-utilized fee deferrals of any sort. Deferred compensation ultimately has several problems. First, the deferred fee compensation is subject to federal and state income taxation. Second, the deferred fee income is included in the attorney’s taxable estate. Third, some attorneys are so wealthy that they enough income for one hundred lifetimes and don’t need anymore. The combination of taxes can result in a 70-80 percent erosion in the amount of the deferred fee income. The situation is “Pay now, or pay letter but in all cases, the taxpayer pays.
The Use of Loan Regime Split Dollar as an Alternative to Fee Deferrals
QSFs are trusts that are designed to resolve litigation and satisfy claims of the litigation even if they are not the subject of litigation. The QSF is authorized and governed by the provisions of IRC Sec 468B. A QSF has no statutory time limit within IRC Sec 468B or the treasury regulations regarding how long a QSF may be kept in place.
The QSF has benefits for both plaintiffs and defendants. From a defendant’s perspective, the ability to transfer assets to a QSF can resolve the claim and release the defendant from further liability while achieving an immediate tax deduction regardless of when claimants receive distributions. This is a significant tax planning point for the defendant particularly for non-physical injury tort cases.
The plaintiff can achieve numerous benefits. Claimants can use the QSF to time the receipt of their income. Plaintiffs are not taxed until they receive distributions from the QSF. The QSF provides the plaintiff and their attorney with the ability to work out the details of their distribution.
Structured Settlement Life Insurance
The thrust of the Structured Settlement Life Insurance strategy is use of the QSF as a source of funds to invest in a PPLI or equity indexed life insurance. The policy can be personally owned or alternatively owned by the trial lawyer’s (taxpayer) family trust using the Loan Regime Method of Split Dollar life insurance arrangement. The objective is to provide the taxpayer with tax-free insurance benefits, tax-free income along with deferred compensation payments. Not a bad combination, right!
The taxpayer’s family trust is the applicant, owner and beneficiary of a life insurance contract insuring the taxpayer life. The policy is funded over several years so that the policy is treated as a non-modified endowment contract (Non-MEC). Non-MEC status is a technical acronym to label the policy as one that is eligible for tax-free distributions during lifetime.
The trustee of the family trust enters a Split Dollar Arrangement with the trustee of the QSF using the Loan Regime. Using the Loan Regime Method of Split Dollar, the trustee of the QSF makes a one-time loan to the trustee of the Family Trust. The loan rate is the long-term applicable federal rate which is 1.0 percent in September 2020. The trustee of the QSF receives a collateral assignment interest in the policy cash value and death benefit equal to the amount of the loan plus accrued interest. The agreement provides for repayment at the earlier of the death of the insured, termination of the Split Dollar Agreement or surrender of the policy.
The excess cash value and death benefit accrues for the benefit of the Trust. The trustee of the Family Trust may access this excess through policy loans and withdrawals on a tax-free basis. The policy is also beyond the reach of the taxpayer’s personal and business creditors. The arrangement also provides for the payment of the collateral interest amount payable to the QSF upon the death of the policy’s insured. However, these QSF payments would be taxable to the beneficiary. The death benefit payable to the Family Trust would receive income and estate tax treatment.
In the future, the trustee of the QSF and Family Trust mutually agree to terminate the Split Dollar Arrangement. The collateral assignment interest provides for repayment based upon the life expectancy of the insured at the time of the Split Dollar termination. Depending upon several actuarial factors, these factors may create a substantial discount (65-85%) to the amount necessary to redeem the QSF’s collateral assignment interest. This method is called the Leveraged Split Dollar Rollout™. Following the rollout, the policy is owned entirely within the Family Trust without any encumbrances. The trustee may tax-free distributions to make tax-free loans and withdrawals to provide tax-free income to the taxpayer and family members. The policy benefits receive income and estate-tax treatment.
The proposed Structured Settlement Life Insurance technique provided enhanced personal planning and tax benefits for trial attorneys. Beyond adding additional deferred income when you already have enough future income for ten lifetimes, the Structured Settlement Life Insurance technique converts tax-deferred dollars into tax free dollars for income and estate tax purposes during lifetime and at death.