General Practice, Solo & Small Firm DivisionMagazine
Volume 15, Number 3
Negotiating a Structured Settlement
BY WAYNE WAGNER
Let’s say you are negotiating a personal injury claim and the defendant/insurer has proposed a structured settlement that was developed by the defendant/insurer’s structured settlement broker.
The claimant is a 35-year-old male with a 35-year-old wife and a seven-year-old daughter. He was injured in an automobile accident but liability is questionable. Allegedly, the claimant cannot perform the duties of his previous employment and is expected to be a minimum wage performer for his work life expectancy. No future medical care is indicated.
The structured settlement proposed will yield $2,000 per month for his life or 30 years (guaranteed for 30 years to protect his family against his early demise). A college fund of $10,000 will be paid in August of each year in which his daughter will be the ages 18, 19, 20, and 21. Finally, a series of guaranteed lump-sum payments will be paid every five years through the next 30 years. The total payments through the claimant’s 40-year life expectancy is $1.2 million. The annuity needed to generate these benefits would cost a premium of $482,965.
In addition to the structured portion, the defendant/insurer is offering $500,000 up front in cash for all immediate family needs, attorney fees, and past expenses of any nature.
The cover letter accompanying the proposal states that all of the payments of the settlement are tax-free. That would mean that the $717,035 growth in the structured settlement would pass to the claimant without income taxation, which is a significant benefit.
As a lawyer, you have always been intrigued by structured settlements (also known as settlement annuities or periodic payments) but have never consummated one. This one is particularly attractive because it takes care of all of the claimant family’s needs, and the total cost of $982,965 ($500,000 up- front cash plus the annuity premium of $482,965 is within the broad settlement range for this claim. It is extremely important for you to verify that the benefits will be tax-free and to negotiate and document the settlement in a manner that does not jeopardize its tax-free status. It does not matter whether you are the claimant’s lawyer or the defendant/insurer’s lawyer. It is in both parties’ interest to verify and preserve the tax-free status of the structured settlement proposal. Tax-free status enhances the value of the offer and helps to bridge the gap between the litigants.
Evolution of Structures
The first recorded structured settlements were used in the Thalidomide claims in the 1960s. Expectant mothers took Thalidomide to ease the symptoms of morning sickness. Unfortunately, Thalidomide often deformed the fetus. Consequently, various suits begged for a financial product that would provide benefits for the lifetime of these children (70 to 80 years), who were expected to outlive their parents.
An annuity contract was introduced to the process. An annuity is merely a contract issued by a life insurance company that guarantees a certain future payout in exchange for an immediate premium. It is also one of the few mechanisms that can guarantee a payment stream for a lifetime.
The structured settlements set up in the Thalidomide claims established the obligation to make the future periodic payments in the settlement agreement. The defendant/insurer then purchased and continued to own an annuity that guaranteed the same payments required by the settlement agreement. For convenience, the defendant/insurer instructed the annuity provider to make the payments directly to the claimant, thus providing instant and direct payment administration of the obligation.
There were no guidelines for structured settlements in those days. The closest arrangement to structured settlements were deferred compensation agreements, where the benefits were tax-deferred as long as the recipient had neither actual nor constructive receipt of the funding asset (if any). Consequently, the Thalidomide claims were set up in a manner analogous to deferred compensation arrangements. For this reason, everything was established by the defendant/insurer. The claimant had no hand in setting up the arrangement except to accept the benefits.
The parties to the Thalidomide settlements were hoping that these settlements would be treated as tax-free and not tax-deferred, since at that time the Internal Revenue Code (I.R.C.) § 104 (a)(2) excluded from income "the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness." However, the I.R.C. was silent as to "payments over time," which would later be called "structured settlements" or "periodic payments." The Thalidomide litigants felt that their best chance of receiving tax-free status would be to avoid constructive or actual receipt of the annuity by the claimant.
Related Tax Authorities
They were right! In 1979 the IRS issued two Revenue Rulings: 79-220 and 79-313. These Rulings put forward the following requirements for a structured settlement to be tax-free under § 104:
• The claimant is a mere recipient of the benefits.
• The annuity is purchased at the convenience of the obligor/defendant.
• The claimant has neither actual nor constructive receipt of the annuity or the economic benefit of the lump-sum amount that was invested to yield the future payments (i.e., the premium).
• The claimant does not have the right to accelerate any payment or increase or decrease the amount of the payments.
The Revenue Rulings settled the tax issue for the claimant, but left the defendant/insurer on the hook for the duration of the obligation as owner of the annuity. Defendant/insurers are accustomed to a complete release once they pay their money, but this result was unattainable in the 1970s.
The defendant/insurer’s problem was solved with the passage of the Periodic Payment Settlement Act of 1982. First, Congress added to I.R.C. § 104 (a)(2) the following italicized words "whether by suit or agreement and whether as lump sums or as periodic payments." The Conference Committee reports made it clear that Congress intended to codify the Revenue Rulings, rather than change them, and reaffirmed the prohibition against actual or constructive receipt.
Additionally, this legislation enacted new I.R.C. § 130, which paved the way for the assignment of the periodic payment obligation to a third-party assignee, thus allowing the original defendant/insurer to be completely released. The assignee would take over the obligation and own the annuity instead of the original defendant/insurer. An assignment under § 130 is referred to as a qualified assignment. Some of the requirements of § 130 are as follows:
1. Originally, only liability claims that qualified under § 104 (a)(2) could be assigned. This was amended in 1997 to include workers’ compensation claims under § 104 (a)(1) filed after August 5, 1997.
2. The only assets that qualify to fund a qualified assignment are (a) annuity contracts, or (b) any obligation of the United States.
3. The periodic payments must be fixed and determinable as to the amount and time of payment.
4. Although not in the original act, § 130 was amended in 1988 to allow the recipient to be a secured creditor of the funding asset.
I.R.C. § 130 paved the way for third-party assignments because it clarified the tax consequences to the third-party assignee of ownership of the funding asset (annuity or U.S. government obligation). Other arrangements were developed later to accomplish the same objectives in claims that do not qualify under
§ 130. Among these are non-qualified assignments, which are used in limited circumstances, and reinsurance agreements, which can be used only when the original obligation is insured. Both are valid alternatives; but the vast majority of structured settlement activity today occurs via the qualified assignment.
After the particulars of the settlement are negotiated, the settlement agreement and release must be drafted. Normally, the structured settlement broker will supply the forms necessary, and for the most part, they are fairly standard. These agreements differ from cash settlement documents in the following ways:
1. The consideration paragraph is split between the cash and the periodic payments portion. There is usually a reference to the I.R.C. § 104 (a)(2), which governs the damages being settled, and any allocation to other elements of damages that may be taxable. (This will be discussed below.)
2. The settlement agreement and release contains a statement that the claimant cannot alter the amounts or timing of the payments, nor can the claimant sell, mortgage, encumber, anticipate, or assign the benefits.
3. The settlement agreement and release contains a beneficiary paragraph governing the succession of guaranteed payments.
4. The settlement agreement and release contains a provision that the claimant specifically consents to the qualified assignment to the assignee, which the defendant/insurer may execute; and that upon such assignment, the claimant will look only to the assignee for performance since the original defendant/insurer will be released.
5. The settlement agreement and release contains a provision that the defendant/insurer or assignee may purchase an annuity from the annuity provider and shall maintain all rights of ownership.
6. The settlement agreement and release contains a statement as to how the obligation to make each payment shall be discharged.
All of the above are necessary to define the obligation to make the future periodic payments.
At the same time that the settlement agreement is executed, the qualified assignment is signed by the defendant/insurer and sent to the assignee for its signature. Normally, this is a two-party document between the defendant/insurer and the assignee. Occasionally, the claimant also will be required to sign the qualified assignment, as some of the forms have additional release language requiring the claimant’s consent.
What types of damages can be structured to yield a tax-free return? Aside from workers’ compensation claims under § 104 (a)(1), the answer was clarified by the 1996 italicized additions to § 104 (a)(2): "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 and physical sickness." Obviously, Congress was trying to weed out some elements of damages by disqualifying them from § 104.
For years the courts had flip-flopped and different jurisdictions had disagreed about the nature of punitive "damages." Are they "damages" or "penalties"? If penalties, they are taxable. Congress weighed in on the "penalty" side. The only exception in which punitive damages are tax-free occurs when such damages are received in a wrongful death action if the applicable state law allows only punitive damages to be awarded in a wrongful death action.
By adding the word "physical" twice, Congress disqualified damages that did not have their origin in a physical injury or physical sickness, such as employment discrimination or injury to reputation claims. The act redefined "emotional distress" as a non-physical injury or sickness for the purpose of determining the origin of the claim. It is the origin of the claim that governs whether it qualifies.
But, if the origin of the claim test is satisfied, all damages, except punitive damages, that flow from the claim are excluded from income whether or not the recipient of the damages is the injured party.
"All damages" include economic damages (loss of income) and noneconomic damages (pain and suffering and even emotional distress). Derivative claims—such as loss of consortium, wrongful death actions, or bystander claims—are also embraced despite the fact that the claimant may not be the person physically injured. Since all of these damages qualify under § 104, they are tax-free and assignable under § 130. Another element common to personal injury claims that needs to be classified is prejudgment interest. This element is taxable. It is interest on the damages and not an element of damage itself.
In many claims, it is common to have all of these elements: loss of income, loss of consortium, pain and suffering, punitive damages, bystander claims, and prejudgment interest. If all of these elements are pled, the settlement agreement must allocate the various segments of the consideration to the various elements of "damages." The tax treatment of "loss of income" falls under § 104 (a)(2), whereas "prejudgment interest" is taxable. Even though an allocation between the litigants is not binding on the IRS, it is advisable to make a reasonable allocation in order to establish a defensible position as to which amounts are taxable and which are not—and the rationale used. Otherwise, the IRS would be free to allocate as it deems appropriate subject to rebuttal by the claimant.
Some elements of personal injury claims still can be structured, even though they do not qualify under § 104. Non-qualification just means that it will not be tax-free and cannot be assigned under § 130. It might still be desirable to structure a large punitive element to make it tax-deferred.
Suppose you have a claim with a potential for $1 million in punitive damages. If you are successful, can you imagine the tax bite on $1 million taken in one year? It might be better to receive $75,000 per year for the next 20 years. Its $1.5 million future payout would cost the defendant/insurer only $900,000. But the cumulative tax on $75,000 each year is considerably lower than that on $1 million in one year because the tax rate is so much lower for $75,000.
A "cash basis" taxpayer can acquire tax-deferred treatment on amounts to be received in the future as long as he or she does not have actual or constructive receipt of the asset (if any) purchased to fund those payments or the premium paid. It must be an arm’s-length transaction that creates the obligation to pay the future payments. It should be negotiated on the same manner as a tax-free settlement, with the defendant/insurer handling the premium and asset purchase.
Negotiating a structured settlement in this situation can obviously be advantageous to both sides. One problem: If it does not qualify under § 104, it does not qualify for a § 130 qualified assignment. How will it be orchestrated?
This is the function of the non-qualified assignment programs and the reinsurance agreements mentioned earlier. A non-qualified assignment is established in a similar manner as a qualified assignment without the references to §§ 104 and 130. A reinsurance agreement is set up similar to a non-qualified assignment except that there is no mention of either an assignment or an annuity. Through a reinsurance agreement, the reinsurer merely assumes the obligation and retains the entire premium.
New variations and new products evolve periodically. Each product has its own function and restrictions. If you introduce the right product to the appropriate situation, the result can be extremely gratifying. Since these products are being developed for an emerging non-qualified market, expert tax advice should be sought for each specific use.
Structures and Trusts
Sometimes it is advantageous to combine the tax efficiency of a structured settlement with the flexibility of a trust. Quite often it is desirable to use a trust to accomplish specific objectives, such as additional spendthrift protection, or in order to manage the life-style of a severely impaired claimant. A trust can use the talents of the trustee and, if authorized, can hire other disciplines, such as medical care managers, to accomplish the trust objectives. However, if all of the settlement proceeds are initially dumped into the trust, any retained earnings each year will be taxed in the trust at fairly higher rates, a considerable drain on the trust’s resources.
A better way to maximize resources is to seed the trust with a small amount initially and to set up a structured settlement to periodically re-seed the trust every one or two years; or at specific times, such as the college years. The structured settlement grows tax-free outside of the trust, sheltering the resource from excessive taxation. Once the funds are paid into the trust, they can be used to forward the purposes of the trust. A considerable amount of unnecessary taxes can be saved with this arrangement.
The Structure Expert
In most situations, a structured settlement broker is involved. He is a considerable resource of information who will be able to clarify unclear or uncertain points. Use this resource since it is available to you at no charge.
Since the late 1970s the federal government has consistently lent support and encouragement to the formation of structured settlements. It has verified the basic tax-free status that qualifies under § 104. It has paved the way to release the original defendant/insurer via a qualified assignment and expanded the assignment process to workers’ compensation claims. Armed with the above information, the practitioner should be able to successfully negotiate a structured settlement with the desired tax treatment.
Wayne Wagner is a lawyer who operates the New Orleans office of Ringler Associates, Inc., a nationwide firm that specializes in assisting litigants in negotiating and funding structured settlements.