Structured Settlements

<div class="Section1">A structured settlement is a settlement of a lawsuit that calls for periodic payments to be made over time, rather than as a lump sum. Structured settlements are common in tort actions (usually personal injury lawsuits) where the amount of the judgment can be particularly large.</div><br /> <div class="Section1"><br /> <br /> Structured settlements are typically employed where either the financial position of the defendant requires that payments be spread over time or the plaintiff prefers to receive steady income over time, rather than a lump sum. The defendant may also prefer a structured settlement because the present dollar value needed to fund a stream of settlement payments into the future will be smaller than that which would be required with a lump sum payment.<br /> <br /> </div>

<div class="Section1">If a structured settlement of a personal physical injury or sickness claim is properly planned, each payment will be tax-free to the recipient.</div><br /> <div class="Section1"><br /> <br /> Usually, when the plaintiff in a personal injury lawsuit receives a settlement, the proceeds of that settlement are taken tax-free.<a href="#_ftn1" name="_ftnref1">¹</a> 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.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> 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.<br /> <br /> 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).<a href="#_ftn3" name="_ftnref3">³</a> 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.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 104(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 104(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Kovacs v. Commissioner</em>, 100 TC 124 (1993).<br /> <br /> </div>

<div class="Section1">A designated settlement fund (DSF) is a fund that is established pursuant to a court order to completely extinguish a defendant’s liability with respect to a claim for personal injury, death or property damage.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> A DSF must also meet the following requirements: (1) no amounts may be transferred to it except in the form of “qualified payments,” (2) it must be administered by persons, a majority of whom are independent from the defendant transferring the claim, (3) it must be established for the purpose of resolving and satisfying claims against the defendant (or related persons) for claims arising out of personal injury, death or property damage, (4) the defendant (and related persons) may not hold any beneficial interest in the income or corpus of the fund, and (5) the defendant must make an election to treat the fund as a DSF.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A “qualified payment” is a payment made to a DSF pursuant to a court order other than payments that (1) may be transferred back to the defendant (or a related person) or (2) are transfers of stock or indebtedness of the defendant (or any related person).<a href="#_ftn3" name="_ftnref3">³</a> Once a defendant has made the election to treat a fund as a DSF, it is revocable only with the consent of the Secretary of the Treasury.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 468B.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 468B(d)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 468B(d)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 468B(d)(2).<br /> <br /> </div>

<div class="Section1">A payor who uses the cash receipts and disbursement method of accounting can deduct qualified payments made pursuant to a structured settlement in the year they are paid.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> If the payor uses the accrual method of accounting, he or she can deduct any allowable expenses in the year in which: (1) all events that prove liability have occurred, (2) the amount of the liability can be determined with reasonable accuracy and (3) the economic performance requirement has been met with respect to the liability.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> In the context of a structured settlement, economic performance by the defendant will typically occur as the defendant actually makes the required payments to the plaintiff.<a href="#_ftn3" name="_ftnref3">³</a><br /> <br /> For example, assume that the parties to a lawsuit enter into a structured settlement that requires the defendant to pay $150,000 per year to the plaintiff for 10 years, and the defendant immediately purchases an annuity to provide for the entire $1.5 million obligation. Economic performance occurs when each $150,000 payment is made to the plaintiff—<em>not</em> when the defendant purchases the annuity. Therefore, assuming all other requirements are met, the defendant is entitled to deduct $150,000 for each of the 10 years in which payment to the plaintiff is properly made under the structured settlement.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.461-1(a)(1).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.461-1(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 461(h).<br /> <br /> </div>

<div class="Section1">The parties to a lawsuit have substantial flexibility in composing the terms of a structured settlement. In some cases, a structured settlement may be paid in equal installments over a set period of time, while in other cases a larger up-front payment is made, followed by smaller payments over time. The parties can structure a settlement so that it includes a guaranteed number of payments (which may be preferable to ensure that the plaintiff’s heirs are entitled to continue to receive payments should the plaintiff die) or so that it includes payments for the life of the plaintiff.</div>

<div class="Section1">If a plaintiff who is receiving payments under a structured settlement enters into an agreement to sell the rights to the future payment stream, a 40&nbsp;percent excise tax may be imposed upon the purchaser.<a href="#_ftn1" name="_ftnref1">¹</a> This type of sale is known as a structured settlement factoring transaction.<div class="Section1"><br /> <br /> The 40&nbsp;percent tax applies only to the &ldquo;factoring discount.&rdquo; The factoring discount is defined as the amount in excess of a fraction, the numerator of which is the aggregate undiscounted amount of structured settlement payments being acquired and the denominator of which is the total amount actually paid by the purchaser to the plaintiff who is selling the payment rights.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The 40&nbsp;percent tax does not apply if the sale of the structured settlement payment rights is approved in advance by a court order, which can result if the court finds that the sale is in the best interest of the plaintiff (as, for example, if the plaintiff needs the purchase price to pay medical expenses or support dependents).<a href="#_ftn3" name="_ftnref3">³</a> See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="635">635</a> for more details.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 5891.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 5891(a), 5891(c)(4).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 5891(b).<br /> <br /> </div></div><br />

<div class="Section1">A qualified settlement fund (QSF) is a type of designated settlement fund (DSF) that was developed in order to expand the use of DSFs in satisfying payment obligations under structured settlements. Unlike DSFs, QSFs can be used to facilitate the settlement of claims that do not involve personal injury or sickness. In order to qualify as a QSF, the following requirements apply:</div><br /> <div class="Section1"><br /> <blockquote>(1)     the QSF must be established pursuant to a governmental order (such as a court order or order of a state or the federal government) and must be subject to the continuing jurisdiction of that government entity,<br /> <br /> (2)     it must be established to resolve a claim (whether contested or uncontested) arising under (a) the Comprehensive Environmental Response, Compensation and Liability Act of 1980, (b) arising out of a tort, breach of contract, or violation of law or (c) designated by the Commissioner in a revenue ruling or revenue procedure, and<br /> <br /> (3)     the fund must be a trust under state law, or the assets must otherwise be segregated from other assets of the defendant-transferor (and related persons).<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> QSFs are also subject to certain limitations on the types of litigation claims they can be used to satisfy. For example, if the liability arises under the workers’ compensation act or a self-insured health plan, it may not be settled through a QSF.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.468B-1.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.468B-1(g).<br /> <br /> </div>

<div class="Section1">Because of the economic performance requirement of IRC Section 461, payments made to a designated settlement fund (DSF) arguably may not be deductible by the defendant because the plaintiff has not actually received the funds transferred into the account. Despite this, IRC Section 468B provides an exception and allows a defendant to deduct “qualified payments” made to a DSF.<a href="#_ftn1" name="_ftnref1">¹</a> Qualified settlement funds (QSFs) receive the same tax treatment as DSFs pursuant to the regulations under Section 468B.</div><br /> <div class="Section1"><br /> <br /> A “qualified payment” is a payment made to a DSF or QSF pursuant to a court order other than payments that (1) may be transferred back to the defendant (or a related person), meaning that the transfer must be irrevocable, or (2) are transfers of stock or indebtedness of the defendant (or any related person).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the fund is a DSF or QSF that meets the requirements of Section 468B, the economic performance requirement will be considered met upon transfer to the DSF or QSF so that the defendant will be entitled to a deduction as payments are transferred into the fund regardless of when they are eventually paid to the plaintiff.<br /> <br /> The gross income of DSFs and QSFs is taxed at the maximum tax rate applicable to trusts.<a href="#_ftn3" name="_ftnref3">³</a> Qualified payments (see above) made to the fund are not considered income to the fund.<a href="#_ftn4" name="_ftnref4">⁴</a> DSFs and QSFs are not subject to additional taxes, such as the alternative minimum tax, the accumulated earnings tax, the personal holding company tax or the capital gains tax.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC 468B(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 468B(d)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 468B(b)(1), Treas. Reg. § 1.468B-2.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 468B(b)(3).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Treas. Reg. § 1.468B-2(g).<br /> <br /> </div>

<div class="Section1">Yes. If the DSF or QSF meets certain requirements, it can make a qualified assignment (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="645">645</a>) of its obligations under a structured settlement. In order for an assignment of a defendant&rsquo;s obligations under a structured settlement to constitute a &ldquo;qualified assignment&rdquo; for tax purposes, the IRC requires that the assignee assume the liability from an original party to the lawsuit or agreement.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS has provided the following guidance for determining when a DSF or QSF can be treated as an original party for purposes of Section&nbsp;130(c):<div class="Section1"><br /> <blockquote>(1)&nbsp;&nbsp;&nbsp;&nbsp; the plaintiff receiving periodic payments under the structured settlement must agree to the assignment by the DSF or QSF in writing,<br /> <br /> (2)&nbsp;&nbsp;&nbsp;&nbsp; the assignment must relate to a claim for personal physical injury or sickness and either (a) the claim is being satisfied under a DSF established pursuant to a court order that completely extinguishes the defendant&rsquo;s tort liability with respect to the claim or (b) the claim is being satisfied under a QSF established to resolve or satisfy liability (whether contested or uncontested) that resulted from an event that has already occurred and given rise to at least one claim asserting liability,<br /> <br /> (3)&nbsp;&nbsp;&nbsp;&nbsp; each qualified funding asset (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="645">645</a>) purchased by the assignee in connection with the assignment by the DSF or QSF relates to a liability to a single plaintiff to make periodic payments for damages,<br /> <br /> (4)&nbsp;&nbsp;&nbsp;&nbsp; the assignee is not related to the defendant who transferred the claim to the DSF or QSF, and<br /> <br /> (5)&nbsp;&nbsp;&nbsp;&nbsp; the assignee does not control the DSF or QSF.<a href="#_ftn2" name="_ftnref2">²</a></blockquote><br /> In addition to these requirements, the DSF or QSF must continue to satisfy all other requirements of IRC Section&nbsp;130 in order for the assignment to be qualified.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 130(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Proc. 93-34, 1993-28 IRB 49.<br /> <br /> </div></div><br />

<div class="Section1">Most secondary market annuities (also known as “factored” structured settlements) are annuities that were originally issued pursuant to structured settlements, meaning that the defendant in a lawsuit (often a personal injury suit) is found liable and, rather than pay damages to the plaintiff up front, reaches an agreement with the court so that the plaintiff receives the right to receive guaranteed annuity payments over time. In many cases, however, the plaintiff needs the funds immediately and, through a court-approved process, transfers the right to guaranteed payments under the annuity to a third-party buyer for a lump sum.</div><br /> <div class="Section1"><br /> <br /> The court approval process is necessary because, while the plaintiff has received the right to income under the annuity, the defendant technically owns the annuity contract. Through this process, the parties enter into an assignment agreement that is presented to the court, which will approve or deny the transfer based upon whether it is in the transferring plaintiff’s best interests.<br /> <br /> It is important to note that failure to comply with this court approval process can result in imposition of a tax equal to 40 percent of the discount at which the product is sold.<a href="#_ftn1" name="_ftnref1">¹</a> In recent years, however, nearly all states have developed a standardized process that has made obtaining court approval much more simple.<br /> <br /> A secondary market annuity is often able to provide the taxpayer with a higher than average interest rate because the selling plaintiff typically must sell his income rights at a discount. The interest paid out under the contract, however, is governed by the original contract terms, which may provide for a rate that is much higher than today’s market averages.<br /> <br /> Because interest rates on guaranteed financial products have remained relatively low despite recent market success, these products, which are typically issued by large and well-known insurance companies, are often attractive to taxpayers who are otherwise wary of locking themselves into a low interest rate.<br /> <br /> Further, secondary market annuities have only recently become widely available to individual taxpayers—prior to the financial crisis of 2008 and 2009, these products were most commonly purchased by large, institutional investors. New economic conditions, coupled with the newly streamlined court approval process, have opened the door for everyday individuals to invest in the secondary market for annuities.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 5891.<br /> <br /> </div>