641 / Is a defendant entitled to deduct amounts paid under a structured settlement if the underlying liability is contested?

(1)     the liability has been asserted and the defendant contests it,

(2)     the defendant transfers money or property to satisfy the asserted liability,

(3)     the contest with respect to the asserted liability exists after the money or property is transferred, and

(4)     but for the fact that the asserted liability is contested, the defendant would be allowed a deduction in the year when the transfer took place (or an earlier year).²

The money or property does not have to be transferred directly to the plaintiff in order for the defendant to claim the deduction. The transfer requirement can be met if the defendant transfers the money or property to an escrow agent or trustee that is later required to deliver the money or property pursuant to the settlement, or to the court that has jurisdiction over the case.³ However, if the transfer is not made directly to the plaintiff and is instead made to an escrow account, trust or court, the transfer must discharge the defendant’s liability to the plaintiff in order for the economic performance requirement to be met.⁴ The transfer must take the funds out of the defendant’s control in order for the deduction to be allowed.⁵

If a defendant deducts amounts paid to satisfy a contested liability and these amounts are later refunded (for example, because the defendant is found not to be liable for the plaintiff’s injuries), the defendant must include those amounts in gross income in the year they are refunded.⁶

1.     Treas. Reg. § 1.461-1(a)(2).