GPSolo Magazine - April/May 2005
Settlement Tools and Tips
This article is a primer for attorneys representing claimants. Each of the four tools described here—aggregate settlement rules, special-needs trusts, structured settlements, and qualified settlement funds—must be mastered to avoid malpractice risks. Indeed, one of them (aggregate settlement rules) could result in forfeiture of your fee if misapplied. Another (special-needs trusts) could result in loss of the entire settlement for the client if not used or misused.
Aggregate Settlement Rules
The first hurdle in settling a multi-client case is being sure that you have complied with the aggregate settlement rules when accepting the defendant’s offer to settle two or more claims. These rules apply to every case in which you have two clients and in which the defendant offers a single sum of money to dispose of all of your cases for those clients.
The rules. Each state has rules prohibiting you from making an aggregate settlement unless you have made certain disclosures to your clients before you agree to the settlement on their behalf. Those state rules are usually identical to the American Bar Association Model Rule 1.8(g), which provides as follows:
(g) A lawyer who represents two or more clients shall not participate in making an aggregate settlement of the claims of or against the clients, or in a criminal case an aggregated agreement as to guilty or nolo contendere pleas, unless each client gives informed consent, in a writing signed by the client. The lawyer’s disclosure shall include the existence and nature of all the claims or pleas involved and of the participation of each person in the settlement.
The commentary. The American Bar Association commentary on Rule 1.8(g) provides the disclosures necessary to comply with the rule, as follows:
Differences in willingness to make or accept an offer of settlement are among the risks of common representation of multiple clients by a single lawyer. . . . The rule stated in this paragraph is a corollary of both these Rules and provides that, before any settlement offer . . . is made or accepted on behalf of multiple clients, the lawyer must inform each of them about all the material terms of the settlement, including what the other clients will receive or pay if the settlement . . . is accepted.
The remedy. If a lawyer facilitates an aggregate settlement and a client later complains, then forfeiture of your fee may be the remedy. The Texas Supreme Court, the only Supreme Court to rule thus far on the remedy question, held in Burrow v. Arce, 997 S.W.2d 229 (1999) that the client does not need to show actual damages from a breach. Moreover, the question of how much of your fee to forfeit for the breach is for the trial court, rather than for a jury. Burrow involved 126 clients injured in a chemical explosion, but the doctrine can also apply to two-client cases. For example, one New Jersey lawyer represented a driver and passenger against a third-party vehicle driver. Because the third-party driver had only limited insurance, the Appellate Division of the New Jersey Superior Court found a violation and also suggested forfeiture of the entire fee. Straubinger v. Schmitt, 792 A.2d 481 (2002). Many other cases invoke disciplinary sanctions, rather than fee forfeiture.
How to comply with the rule. When the defendant offers, “We will pay $1 million for your three cases against us,” your response must be, “I accept, provided that I can first obtain the consent of all of my clients to this aggregate offer.” Then, you must implement the disclosure and consent process.
That process is to describe to each of your multiple clients in correct detail in writing what the aggregate offer is. In this case the offer is money. The attorney must also describe to each client what that client’s share would be of the aggregate settlement offer. If the money is not going to be divided equally among your several clients, you must also describe what shares the other clients you represent are going to receive and why those shares differ in amount or terms. All of this should be documented in writing. In large product-liability cases, this disclosure can be accomplished with a grid of injuries presented in the litigation with assignment of a dollar value to each injury. In most day-to-day cases, however, this disclosure is a more subjective description of each client’s circumstances and how each justifies the amount allocated from the aggregate settlement offer. Ideally, all of this should be done by an independent person, such as a structured settlement consultant, a mediator, or another person not motivated by self-interested contingent compensation to consummate the settlement.
In many cases, the attorney’s assumption of strong client control can lead to trouble. Without written compliance with the rule, your previously well-controlled client could emerge from the next cocktail party with a new lawyer complaining about how inadequate that client’s share of the settlement was. Your attorney fee could become the source of money used by the court to restore to the client the perceived shortfall.
Having complied with these aggregate settlement rules, the next consideration is preservation for the settling client of any governmental benefits to which the client may be entitled.
Nothing worse can happen to your client on Medicaid than to receive a large award for an injury, to be thereby disqualified for further Medicaid, and to be required to spend that award to pay for his or her own medical care before requalifying for Medicaid. Only the government entities that would otherwise be paying for such care can potentially benefit from your settlement efforts. But there is a solution for this potential problem: a special-needs trust (SNT). Settlement amounts held in such SNTs don’t count when your client applies for Medicaid. The statutory authority is in 42 U.S.C. §1496p(d)(4)(A), which is also described in the Social Security Administration’s Program Operations Manual System at §SI 01120.105, as follows:
If the claimant beneficiary’s access to the trust principal is restricted (e.g., only the trustee or court, etc. can invade the principal), the principal does not count as a resource to the claimant. The authority for discretion by the trustee in the use of trust funds, including invasion of the principal for support and maintenance of the beneficiary, does not mean that the principal is available to the claimant/beneficiary and, as such, is not a resource.
The purpose of SNTs. SNTs provide a “legal tool” to preserve and upgrade the care provided by the government. The upgrade is achieved by preserving the client’s eligibility for Medicaid and Supplemental Security Income (SSI) by segregating settlement proceeds into a trust. The trust can pay for a home, home improvements, a van, medical equipment, a limited amount of household goods, and consumables other than food, clothing, or shelter. The SNT can provide significant services such as entertainment, travel, dentistry, and medical service beyond those services provided by the government.
Benefits preserved and protected by SNTs. Two of the most important benefits preserved and protected by SNTs are Medicaid and SSI. Medicaid provides significant medical services (including skilled nursing facility services). SSI provides monthly cash payments based upon family size and income level. Each program continues only so long as your client has poverty-level income and assets. Sometimes, county welfare, Section 8 housing, and other programs may also be preserved.
Being a creature of the Social Security laws and their accompanying regulations, SNTs are unduly complex. There is simply insufficient space here to explore that complexity. Nevertheless, if your client is currently enjoying any form of governmental benefit based on assets or income, you should consult someone who knows about these strategic vehicles before formally finalizing the settlement. If an SNT is appropriate, you should consider funding the trust with structured periodic payments.
Having screened your client for SNT eligibility, the next step is to determine how your client would best receive the money to be paid as a result of the settlement. Should all of the settlement amount be paid immediately, or should all or a portion of the settlement proceeds be paid periodically in future years?
The Internal Revenue Code excludes from income all compensation (other than punitive damages) for physical personal injuries. That exclusion is found in section 104(a)(2) of the Internal Revenue Code, as follows:
(a) In General.—Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include . . . the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. [emphasis added]
A settlement that pays an unsophisti-cated injured claimant a large amount of money in a single lump sum payment carries with it the very real risk that the settlement money will be dissipated all too soon. The client might then reappear in your office as the victim of predatory relatives or poor financial decisions and seek more money—which would, of course, be unavailable. Receiving the compensation over time ensures that additional future money is available to deal with the ongoing financial needs of the claimant.
The settlement agreement. Because section 104(a)(2) excludes from income the compensation received for the injury, the wording of the settlement agreement is important. It should provide that none of the settlement is to compensate the claimant for prior medical expenses that have been deducted. It should provide that none of the amount being paid is for lost income or punitive damages.
The settlement agreement should also provide that, if periodic payments are to be paid, the defendant or its insurer is agreeing to pay them. But defendants often balk at agreeing to a long-term payment obligation. In addition, when seeking future payments, claimants are seldom willing to look to the tort-feasor or to its insurer with whom the claimant has been doing battle. For such reasons, a payment device has been provided in the Internal Revenue Code. That payment device, called a qualified assignment, permits the defendant or its insurer to transfer its obligation to a third-party payor to make future periodic payments and to fund defendants’ settlement obligations with a commercial annuity policy.
The qualified assignment. The qualified assignment is advantageous for the claimant because a new, possibly more credit-worthy obligor is normally substituted for the tort-feasor or its insurer for future periodic payments. The qualified assignment is good for the tort-feasor and for its insurer because it permits the file to be closed on the litigation, instead of retaining a long-term obligation to pay the claimant in the future. The qualified assignment is additionally advantageous because it ensures tax certainty for all of the parties to the qualified assignment.
The qualified assignment provision is in section 130 of the Internal Revenue Code and contains several rules for qualification. Among the most important for the claimant are the rules prohibiting future anticipation or borrowing by the claimant against the settlement annuity benefits. In fact, however, borrowing may be permitted with court approval. Generally such loans against settlement proceeds are made at very high interest rates. Thus, to avoid the need for such loans, claimants should be counseled to plan carefully for the timing and amount of each payment for housing, college, and other personal needs. This, among others, is a task best performed by an experienced structured settlement consultant.
Funding the future payments. Assuming that the claimant has not agreed to permit the defendant or its insurer to make the future payments, the third-party assignee (typically a highly rated insurance company) will provide an annuity from which the claimant will receive payments as agreed upon in the written settlement agreement. This annuity is not owned or controlled by the claimant. Instead, this annuity is owned by the assignee, which is usually an affiliate of the insurance company that issues the annuity to fund the structured settlement. The reasoning for this somewhat contorted arrangement is simply that the issuing company cannot own its own annuity and neither can the claimant own the annuity. In some cases, this arrangement also avoids the payment of a premium tax. Presenting the choices of the appropriate annuity issuer is also a task for the structured settlement consultant. There are some underwriting advantages to this process, too. For claimants whose life expectancy is shortened by their injuries, annuity issuers often compete by promising larger benefits owing to the shortened life expectancy. That underwriting process is referred to as “age rating.” Comparing and negotiating the age ratings among the various life insurers is imperative to achieve the largest stream of benefits in the structured settlement.
What about you as the claimant’s attorney? Can you participate in these structured, future financial benefits by deferring and spreading out your fees? Yes, you can.
Structuring attorney fees. Recent federal tax legislation potentially threatened the future periodic payment of attorney fees, the arrangement by which attorneys elect to defer receipt of contingent fees. The structured fees are taxable only when received. Such arrangements achieve several valuable objectives for attorneys. Income may be deferred until retirement. Cash flow over future years can be structured to make a contingent-fee practice more predictable or to fund litigation expenses for future cases. Moreover, taxes may be deferred into future years.
Late in 2004, Congress passed a sweeping revision of the tax rules for deferred compensation: the American Jobs Creation Act of 2004, Pub. Law No. 108-357, 118 Stat. 1418. The revised tax rules would have put a stop to structured attorney fees until further guidance was published by the Treasury Department. That guidance could have made the rules difficult for attorneys to utilize, effectively ending the use of structured attorney fees.
However, in response to requests from several groups concerned about taxpayers who earn fees and commissions from several, rather than single, sources of income, the Treasury Department specifically removed contingent-fee attorneys from the group of taxpayers to be affected by the American Jobs Creation Act of 2004. The Treasury guidance, published December 20, 2004, removes attorneys from the new rules with the following interim guidance:
[The new law] does not apply to arrangements between a service provider [the attorney] and a service recipient [the client] if (a) the service provider is actively engaged in the trade of business of providing substantial services, other than (i) as an employee or (ii) as a director of a corporation; and (b) the service provider provides such services to two or more service recipients to which the service provider is not related and that are not related to one another. [Treasury Notice 2005-1, A-8, (Guidance Under
§ 409A of the Internal Revenue Code, Dec. 20, 2004)]
Thus, the “old rules” continue to apply to the deferred, structured payment of contingent attorney fees.
What are the “old rules?” First, the attorney must elect to defer his or her attorney fees prior to the date on which those fees are earned. In a contingent-fee case, fees are normally earned at the time that the client receives money in settlement.
Second, that election must be reflected in a writing. The writing can be an amendment to the original contingent-fee agreement, if that agreement does not already deal with structured attorney fees. The writing can also be included in the settlement agreement or release between the client and the defendant or its insurer.
Third, the writing should specify the timing and amount of each future payment to be received by the attorney. Thus, the attorney should make early contact with a structured-settlement professional to determine the stream of payments available and the insurance company providing that stream.
For those interested in reading about the technical tax issues related to structuring attorney fees, see Childs v. Commissioner, 103 T.C. 634 (1994), aff’d per curiam, 89 F.3d 856 (11th Cir. 1996). In that case, the Tax Court, which is a court of national jurisdiction in tax cases, agreed with the attorney-taxpayers, and the 11th Circuit af- firmed without an opinion. Since that time, no other cases have been published dealing with structured attorney fees, nor are we aware of any audits on the issue since that decision. The recent guidance by the Treasury Department under the American Jobs Creation Act offers more support for the deferral of contingent attorney fees.
As is true for clients, structured attorney fees are funded with an annuity purchased from one of the dozen-or-so life insurance companies that sell structured-settlement annuities. As a trade-off for all of the tax and financial benefits of the deferred-compensation arrangement for attorneys, the payments from those annuities cannot be accelerated, deferred, or pledged as security for loans. So planning from the outset for the timing and amount of each payment is important . . . just another reason for early contact with an experienced structured-settlement consultant.
Note that the above discussion and the Childs case apply to contingent fees earned in physical injury only as to that part of the settlement proceeds on which the claimant is not taxed. If you are settling discrimination or employment or other cases in which damages are taxable, other rules apply, and an experienced structured settlement professional can explain those rules to you.
Qualified Settlement Funds
What if the defendant insists on paying only a lump sum? What if you reached an agreement to settle, but your clients don’t know how best to receive the settlement money and don’t know yet whether they want a special-needs trust? What if the defendant is on shaky financial ground? The answer to all such issues may be the qualified settlement fund (QSF).
Why a QSF? The QSF concept was enacted in 1986 as section 468B of the Internal Revenue Code to enable large product-liability defendants to get a tax deduction for amounts paid to settle lawsuits before the claimants had agreed on how the amounts would be allocated among them, notwithstanding the violation in such cases of the aggregate settlement rules. In those cases, the defendants and claimants had agreed how much the defendants or their insurers would pay to settle the cases collectively so that a trial on liability was unnecessary. The defendants, however, under law at the time, could not get a tax deduction for amounts paid to a fund to settle in such cases because the amounts were not paid directly to claimants. QSFs now provide the defendants with a deduction in those circumstances.
The claimant benefit. The claimant obtains the defendant’s money early and thereby avoids an insolvency risk. Claimant can make his or her own settlement agreement with the fund, which can include a structured settlement of the claimant’s own design, and can enjoy financial counseling while the fund holds the money. Once the QSF is established, the defendant can pay its money to the QSF and be dismissed and released as if the cash settlement had been paid directly to the claimant without a fund. The claimant can then complete plans for use of the money.
How to establish a QSF. Treasury regulations require that the establishment of a fund be approved by a court or arbitrator or governmental entity (but not a mediator). Thus, a petition must be filed with a fund document and an Order for Signature by the court. The fund need not be a formal trust. In fact, the Treasury regulations permit something as minimal as segregation of the settlement money by the defendant into a separate checking account. In practice, however, trusts are normally used because the actions of a trustee are well regulated by the fiduciary rules of each state.
The regulations also require that the court retain jurisdiction over the fund. The extent to which such retained jurisdiction will be exercised will vary with each court. Some courts want to approve every disbursement. Others rely on the adverse interests of the claimants against the fund and require that complete agreement is reached by all claimants of the QSF before any disbursements are made.
Most, but not all, types of claims are eligible for a fund. Tort and contract claims are the most common, but workers’ compensation, warranty, and certain other types of claims do not qualify.
Who should administer the QSF? If a trust form is used, a bank or other trust institution can administer the fund. Fees are always an issue with large institutional trustees, however. Thus, an individual may in some circumstances be a better choice to administer the fund. Such individuals should not include, however, the claimant’s attorney or anyone else who could be characterized as an agent of the claimant because “constructive receipt” of the fund by such an imputed agent could be deemed to be effective receipt by the claimant.
Taxation and operation of the fund. The fund is taxed as a corporation and at the highest rate in the Internal Revenue Code, with no use of the lower brackets. Thus, investment of QSF funds in tax-free instruments is often financially advantageous. Funds should not be invested in a way that exposes QSF assets to unreasonable risk of loss and in a way that permits full liquidity at all times. Those factors usually result in a low yield in fund income. Thus, claimants have an incentive to complete their financial planning as early as possible to put the funds to work financially. Like other taxpayers, the QSF, through its administrator, will file state and federal income tax returns annually (Form 1120-SF federally) and will file information reports (Forms 1099) for any payments to attorneys. The Internal Revenue Service has issued guidance permitting the fund to enter into structured settlements in the same way that the defendant could do so, preserving all of the same tax benefits for the claimant (Rev. Proc. 93-34, 1993-2 Cum Bull. 470).
Termination of the fund. The funds normally terminate by their terms when the fund is depleted. Alternatively, for those courts taking an active role in QSF administration under their retained jurisdiction, final accountings can be filed with the court with an order discharging the fund and its administrator.
Some aspects of the QSF rules are currently under review and reconsideration by Treasury for further determination in 2005. If you have a contingent fee case that potentially merits a QSF, you should talk with an experienced structured settlement consultant about the new rules and about the various techniques and strategies discussed above.
William Taylor “Tay” Robinson IV is president of Strategic Settlements, a structured settlement firm based in northern Kentucky. He can be reached at firstname.lastname@example.org.