638 / What are the tax consequences to the plaintiff who receives structured settlement funds?

Usually, when the plaintiff in a personal injury lawsuit receives a settlement, the proceeds of that settlement are taken tax-free.¹ Despite this, if the payments are structured so that the plaintiff receives the settlement funds over time, the earnings on the settlement will be taxable to the plaintiff unless a “structured” settlement is created.²

The plaintiff may prefer to receive settlement payments over time. For example, although the plaintiff can invest a lump sum payment, earnings on that investment would be fully taxable. In contrast, if a structured settlement is used, any earnings on the settlement are not taxed.

Whether or not the earnings on the settlement amount will be taxed depends largely on how the parties to the lawsuit characterize the payments. For example, the Tax Court has concluded that portions of a settlement that were labeled by the parties as “interest” were taxable as ordinary income (the case did not specifically deal with structured settlements).³ However, in the usual case, a structured settlement will avoid this result because it will not distinguish between amounts paid to satisfy the claim and amounts paid as interest (e.g., the settlement will require the defendant to pay $150,000 per year for 10 years). As such, the entire amount of each payment will be treated as proceeds of the settlement and can be taken tax-free.

1. IRC § 104(a).