When a victim brings a lawsuit for personal injuries or the death of a family member, the claim is for monetary compensation. If the lawsuit is successful at trial, the jury or judge awards a lump sum as damages and the legal system enters a judgment against the at-fault party for payment of the amount awarded all at one time. For this reason, when personal injury or wrongful death claims are settled out-of-court or before trial, they are traditionally settled for a lump sum payment. In the 1970s and 1980s, insurers began proposing (and claimants began accepting in some cases) that personal injury and wrongful death claims be settled through periodic annuity payments to the victim rather than a lump sum payment. This method of settling a claim, using a specific type of annuity, was termed a ‘structured settlement.’
An understanding of the tax treatment of personal injury and wrongful death settlements is essential to understanding the mechanism of structured settlements. The United States Code Title 26 § 104, “Compensation for injuries or sickness”, provides: “…Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include…(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 or physical sickness…” (US Code, Cornell University Law School; http://www.law.cornell.edu/uscode/html/uscode26/usc_sec_26_00000104—-000-.html)
There are exceptions to this rule as when the award is itemized and the itemization includes an amount for lost wages or when pre-or post- judgment interest is added to an award. However, interest, dividends or gains that are earned from investing a personal injury or wrongful death settlement are taxable income. Thus, if a lump sum settlement is invested to provide living or care expenses for someone who has been injured or the family of a deceased victim, the amount that the settlement earns will be taxed as income. A special form of settlement was devised and blessed by the IRS to meet this concern. This special form came to be referred to as a ‘structured settlement’.
In this form, the liability insurer buys a structured settlement annuity from another insurer to provide periodic payments to the injured victim or family of the deceased. The annuity’s payments are not taxable because they are periodic payments under § 104. However, because there is the purchase of an annuity, the injured victim or family of the deceased gets some of the benefit of the investment gain on the amount paid by the liability insurer without having to pay income tax on this benefit. There are specific requirements for this type of annuity to be non-taxable under§ 104, such as that the ‘owner’ of the annuity cannot be the victim and that the annuity cannot be transferrable or contain a right to change the amount or frequency of payments.
It is now commonplace for an insurer to propose that all or part of a personal injury or wrongful death settlement be a ‘structured settlement.’ Such a proposal should also contain a lump sum cash alternative for settlement. The decision about whether to accept a ‘structured settlement’ should be entirely the victim’s or family’s, not the insurer’s.
A number of factors should be considered in making this decision. Structured settlements lack the flexibility of a lump sum settlement. If future financial needs change, it is difficult if not impossible to change the amount or frequency of payments of a structured settlement. Certain firms advertise that they will pay cash for structured settlements. These firms ‘buy’ the annuity payments at a huge discount which results in a huge loss for the injured victim and should be avoided. Therefore, if there’s a chance that a lump sum will be needed in the future, a structured settlement should be avoided.
Structured settlements were originally devised when both tax rates and interest rates were considerably higher than now. Therefore, the monetary benefit in not being taxed on the ‘gain’ from the annuity was much greater. At present, that benefit is often not worth the loss of flexibility. That said, there are circumstances when a structured settlement is useful, such as when the victim or family are unable or uncomfortable investing a lump sum settlement or when there is a concern that a lump sum might be subject to inappropriate spending or invaded by family or friends.
One feature of a structured settlement that can be useful is the flexibility (available only at the time of settlement) to customize the amount and payment timing of the benefits. The insurer buying the annuity commits to paying an agreed upon amount in settlement and then the victim or family can use that amount to customize a structure. For example, a settlement for a minor can be structured to provide ‘tuition’ payments during each of the college-age years or the amount of payments can be matched to present expenses with an inflation adjustment feature.
One feature that is common to most structured settlements is a provision about the continuation of payments in the event of the death of the victim or family members receiving the payments. This is called the ‘guaranteed’ period. For example, a structured settlement might provide payments of a certain amount every month for the remainder of the life of an injured victim with a guaranteed payment for 10 years. This means that even if the victim dies before the end of the 10 year period, the annuity will pay for the full 10 years. Payments scheduled to be made after the death go to a designated beneficiary.
The frequency with which liability insurers propose a settlement using a ‘structured settlement’ demands that a personal injury victim or the family in a wrongful death case be represented by a personal injury law firm familiar with this type of settlement. Because changing a ‘structured settlement’ or converting to cash later can be difficult, costly and sometimes impossible, the advice of an experienced personal injury attorney and firm is essential before deciding to accept this type of settlement.
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