Understanding constructive receipt can make the difference in one’s tax burden and long-term financial stability as either a plaintiff receiving a financial settlement or an attorney about to receive their fees. Constructive receipt is an accounting principle used to determine when money is recognized as income by the IRS and is subject to income taxes. According to Treasury Regulation 1.451-2(a):
“Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. “
How constructive receipt affects plaintiffs
As the plaintiff, you are not seen as having received the settlement money until it is disbursed to you. To give you time to make a financial plan, a qualified settlement fund (QSF), also called a 468(b) Trust, can be established. This way, the settlement money goes directly from the defendant into the trust, bypassing you. This prevents you from being seen as constructively receiving the money and provides you with the necessary time to decide how and when you want to receive it. There is no clear guidance on how long you can keep the money in the trust, but we recommend working with a settlement planning company within one year from funding to create a plan that best suits your current and future needs.
Once the funds are in a QSF, you may choose to structure your settlement money so that it is distributed to you in predetermined amounts over a set period of time, instead of receiving it in one lump sum. This can be done to prevent you from becoming disqualified from means-tested government assistance like Medicaid. Another benefit of most structured settlements is that the growth on the funds are tax-free. For the tax-free benefit to remain, you must not have been in constructive receipt of the settlement funds. Fortunately, if you use a QSF, or if you structure the settlement prior to the end of litigation in a way that cannot later be modified, then you meet that requirement.
Essentially, when your settlement is directed to a QSF, since it is not credited to or made available to you immediately, then the IRS does not consider it as income. This prevents the settlement funds from affecting any benefits you may currently receive and gives you the time necessary to determine the best financial plan for your specific needs.
We recommend that plaintiffs consult with a skilled financial planning team to determine what is best for them. There are a host of tools and options for how those funds can be invested and structured, which can be tailored to any plaintiff’s specific goals.
How constructive receipt affects attorneys
Similar to plaintiffs, as a litigation attorney you can avoid constructive receipt of your contingency fees through the creation of a QSF. While the money remains in the QSF, you are not recognized as having received the funds and can create a customized plan for how and when you receive your fees. Milestone’s feeMaster program helps attorneys control their financial futures by creating the best fee deferral plan for you.
While your fees are deposited in a QSF you have the ability to choose how you receive your fees, while reducing your overall tax burden. You may choose to take a lump sum at a future date, receive smaller, periodic payments, place the funds into an investment account, defer the entire fee, or a combination of those options. A benefit of deferring your fees is investing your funds at a higher starting point, as they will be invested pre-tax. Another benefit of choosing to receive periodic payments is spreading your income tax burden over multiple years and yielding a larger payout in the long run. This is most clearly seen when you directly compare feeMaster to receiving your fee as a lump sum.
If you choose to invest your fee while it’s sitting in a QSF, you can see much larger financial returns. This is because the IRS will take a portion of your constructively received fees – fees paid out in a lump sum – thus lessening the initial amount that you privately invest. When you start with the full value of your fee, your investment can grow at a much faster rate than if you received it directly.
Here’s an example where two attorneys both received fees totaling $1 million each. Attorney #1 chose to use feeMaster for fee deferral and Attorney #2 chose to take a lump sum:
- Attorney #1 – the entire $1 million is deferred and invested at an annual growth rate of 6%, and the attorney withdraws $100,000 every year. The funds would be depleted after 14 years with a total of $1,833,306 dispersed to them during that time.
- Attorney #2 – after paying their initial tax burden, they would have to grow their money at an annual growth rate of 6% for eight years without removing any money before reaching $1 million again. However, if they chose to withdraw $100,000 per year from the initial investment amount at the same annual growth rate of 6%, then the funds would be depleted in 7 years with a total of $827,540 dispersed to them.
The starting point of investment makes all the difference for the total amount yielded. Choosing to defer your fees can yield more than three times the total growth compared to taking a lump sum. This is why avoiding constructive receipt matters. The taxes that you pay on your fees – and when you pay them – changes your lifelong wealth. Aside from the tax implications, deferring your fees can be the better long-term financial plan because the payout may last twice as long. Structuring your fees with our feeMaster program can give you and your firm the financial flexibility to pursue the cases that matter most to you.
Whether you are a plaintiff or an attorney trying to figure out what the best financial option is for you and your family, Milestone can help. Contact our team to discuss your lingering questions about constructive receipt, qualified settlement funds, and how your money can work for you.
This content should not be viewed as an offer to buy or sell any of the securities mentioned or as legal or tax advice. You should always consult an attorney or tax professional regarding your specific legal or tax situation. Milestone Consulting, LLC, is not engaged in the practice of law or accounting. Different types of investments involve higher and lower levels of risk. There is no guarantee that a specific investment or strategy will be suitable or profitable for an investor’s portfolio. There are no assurances that a portfolio will match or exceed any particular benchmark. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.