Volume 1, Number 1
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Structuring Taxable Claims
In many cases, periodic payments from structured settlements are tax-free because their origin is in physical injury; however, in cases involving punitive damages, wrongful termination and discrimination, the proceeds are fully taxable. By implementing a structured settlement, a victim can defer taxesand achieve a longer term benefit.What is a Structured Settlement?
Formally recognized by the federal government since 1983, a structured settlement is a voluntary agreement between the claimant and defendant(s) under which the victim receives a series of periodic payments instead of a lump sum.
A structured settlement may be agreed to privately (for example, in a pre-trial settlement) or required by a court order (usually involving minors and persons deemed mentally unfit to maintain a lump-sum settlement).
The amount of the payments and the payment timetable is strictly up to the negotiating parties. Payments may be in equal amounts at regular intervals. Or the parties are free to agree to intermittent larger payments that take into account future needs (e.g., to fund a college education in 10 years or a new mechanized wheelchair every four years).
Importantly, once the parties have agreed to the payment amounts and timetable, the plaintiff cannot make changes.
How Can a Structured Settlement affect a Taxable Settlement?
A structured settlement is a powerful tool when receiving monies from a taxable settlement. A structured settlement will not allow the victim to avoid paying tax, but will allow for taxes to be paid on benefits as they are received.
By implementing a structured settlement, the victim will receive guaranteed income, and, protection that structured settlements uniquely provide (i.e., protection from creditors).
Let’s assume that a victim will be receiving $500,000 “net” in settlement money that is fully taxable as income at federal and state levels. Presently in Kentucky, this individual, assuming he or she has no other source of income, no deductions and no alternative minimum tax (AMT), will pay 35% federal and 6% state tax, which would total $205,000. The victim’s total “net in pocket” then is $295,000.
By implementing a structured settlement, significant benefits can be achieved. Assume that the claimant chooses to structure his or her $500,000 settlement to receive guaranteed monthly payments over a 30 year period. At current structured settlement rates, this victim would receive approximately $2,585 per month ($31,020 annually) and $930,600 over the 30 year period. Using today’s tax brackets, the total tax paid annually over the 30 years would total $232,650 ($7,755 annually). The claimant’s “net in pocket” over 30 years then is $697,950 ($23,265 annually).
Why Utilize a Structured Settlement?
There are a myriad of reasons to structure money over a period of time, but it seems that many claimants, very simply, want their money to provide for them on a regular basis, with very little hassle, and with less risk.
Its popular now to invest in 401Ks, IRAs and other qualified plans with the hope that sometime in the future, they will provide money with which to retire. However, that money is of no use until age 59.5. The structured settlement can not only guarantee benefits today but can guarantee them over a long period of time (even over a lifetime) with no rate of return or management risk.How Is a Structured Settlement Funded?
When a payment schedule is agreed to, the defendant and/or the defendant’s insurance company will typically purchase an annuity to fund the schedule. Typically, these are then assigned to an experienced financial institution (e.g., a life insurance company) that manages the payment schedule.
Structured Settlements: Legislative Background
The specific origin of structured settlements is murky. The concept of an extended payment schedule for claimants facing long-term injury costs seems to have emerged in general when punitive damages for physical injuries began rising, and specifically, during settlement of thalidomide cases. But the process was held back due to a lack of federal law and IRS guidance.
That changed in 1983, when President Reagan signed legislation (P.L. 97-473) to formalize structured settlements in federal law. According to The National Structured Settlements Trade Association, under the 1983 law, Congress approved specific tax rules to encourage the use of structured settlements to resolve physical injury actions. First, Section 104(a)(2) of the Internal Revenue Code was amended to clarify that the full amount of a structured settlement’s periodic payments constitutes damages which are received by the victim free of any federal tax liability. (By contrast, the investment earnings on a lump sum are generally taxable.)
Second, Congress adopted IRC Section 130 to facilitate secure, long-term funding arrangements, funded by annuity contracts or Treasury securities, for tort victims needing long-term care and support.
What allows for any claim to be “structured” is the theory of constructive receipt. Constructive receipt is the test by which the IRS determines whether an individual has received income. The theory concludes that if an individual has perceptible control of money to be received then that money is considered to be income and tax is due.
By utilizing a structured settlement the victim in a lawsuit is conceding control of the principal lump sum (not future benefits) and, therefore, can not be in constructive receipt.