What is a structured settlement?
Structured settlements are a tax-advantaged method of compensating injury victims. Encouraged by the U.S. Congress since 1982, a structured settlement is a voluntary agreement between the injury victim and the defendant for future periodic payments.
With a structured settlement annuity, the injured claimant doesn’t receive compensation for his or her injuries in one lump sum. Rather, the claimant receives a stream of tax-free payments tailored to meet future medical expenses and basic living needs.
A structured settlement may be agreed to privately (for example, in a pre-trial settlement) or it may be required by a court order, which often happens in judgments involving minors.
What kind of flexibility is associated with a structured settlement annuity?
Structured settlement annuities are exceptionally flexible and can be designed to meet virtually any set of needs. A relatively simple payment schedule can be set up that provides for equal payments at set intervals – for example, every month for 20 years.
However, payments need not be made in equal amounts. A claimant who will need a new wheelchair every three years might elect to receive a larger payment every 36 months to help defray the cost. (This would presumably be in addition to the regular payments.)
The inherent flexibility of structured settlement annuities means that they are well-suited to compensate claimants for a wide variety of injuries.
Who determines the amount of payments and the payment schedule?
In any physical injury case, the claimant and defendant negotiate matters such as the cost of the injured party’s medical care, basic living, and family needs. Oftentimes, one side (or both) engages an expert, such as a settlement consultant, who provides calculations on the long-term cost of these needs.
Once there is agreement on the total damages, the injured claimant can select a periodic payment plan that meets his or her needs. The defendant must then agree to make the future payments via a structured settlement annuity. The defendant assigns the payment obligation to a third-party assignment company, who funds the obligation to make periodic payments through a life insurance company annuity.
As these issues involve complex calculations, specific language for the settlement agreement, and the completion of the appropriate paperwork, the claimant should always consult with his/her attorney and settlement consultant.
Are structured settlements annuities more likely to be used in certain types of cases?
Structured settlement annuities can be ideally suited for many types of cases, including:
- Persons with temporary or permanent disabilities;
- Guardianship cases involving minors or legally incompetent adults;
- Workers’ compensation cases;
- Wrongful death cases with surviving spouses and/or children; and
- Severe injury cases, particularly those that involve long-term needs for medical care, living expenses, and familial financial support.
I’m involved in a lawsuit now. Why should I consider a structured settlement annuity?
The tax-free payments from a structured settlement annuity can:
- Relieve the financial pressures of medical expenses and living needs;
- Meet long-term rehabilitation or permanent care facility expenses;
- Provide for the future costs, such as college tuition, a down payment on a home or mortgage payments, or retirement;
- Provide enhanced protection of the recovery from creditors; and
- Provide long-term, tax-advantaged financial security.
What are the advantages of a structured settlement annuity over a lump-sum payment?
A structured settlement annuity has several advantages. First, there is security. A structured settlement annuity provides guaranteed* long-term income, giving the injured claimant the ability to recover without spending time and resources determining investment strategies. Regular payments can be tailored to fit the claimant’s specific needs.
A second advantage is financial: when Congress amended the federal tax code to encourage structured settlement annuities, it explicitly provided that 100% of every structured settlement payment received on account of physical injury or sickness within the meaning of IRC 104(a)(2) would be exempt from federal and state income taxes. While the proceeds from a lump sum injury settlement are income-tax free, if the proceeds are placed in a traditional investment, any interest earned may be taxable.
There are many other benefits as well. For instance, the claimant avoids the risk of mismanaging his or her settlement proceeds. Insurance industry statistics show that nearly 25-30% of all injured parties completely dissipate their judgments or settlements within two months of recovery, and 90% of them spend it all within five years. (Source: The Rutter Group, Ltd. from Flahavan, Rea, Kelly & Tener, “California Practice Guide: Personal Injury” (TRG 1992) Ch. 4.)
Finally, using a structured settlement annuity, an injured party can avoid the risk of outliving his or her recovery by transferring the risk to a reliable, experienced financial institution.
*Guarantees are subject to the claims-paying abilities of the issuing insurance company.
What are the disadvantages of a structured annuity?
There are two main disadvantages:
- The periodic payments cannot be borrowed against, deferred, accelerated or modified once they’ve been set up. That’s why it is vitally important for claimants to work with an experienced settlement consultant to determine the best individual strategy.
- Default risk, meaning the life insurance company that is selected becomes unable to make the payments. However, this risk is small due to the well-capitalized life insurance companies that are used for structured settlement annuities. Settlement proceeds can also be spread among several different life insurance companies to lessen default risk.
What are some of the federal tax rules that make structured settlement annuities beneficial?
In the Periodic Payment Settlement Act of 1982 (P.L. No. 97-473), Congress adopted tax rules to encourage the use of structured settlement annuities for resolving physical injury cases.
Section 104(a)(2) of the Internal Revenue Code clarifies that the full amount of the structured settlement annuity payments is tax-free to the injured party. By contrast, the investment earnings on a lump sum payment are usually fully taxable.
What is a “qualified assignment”?
The defendant or its insurer may transfer the obligation to make future payments through a “qualified assignment” to a financially secure and experienced institution – a life insurance company, for example.
This process relieves the defendant of further responsibility for the payments and transfers the administration and record-keeping responsibilities. The assignment company specializes in these activities and may offer additional financial security to the claimant.
What other federal tax rules govern the use of structured settlement annuities and qualified assignments?
Internal Revenue CodeSection 130 specifies the requirements to establish a qualified assignment, which include:
- The assignee assumes the liability from the defendant;
- Both the injured party (and his/her attorney) and the defendant agree that the payment schedule cannot be “accelerated, deferred, increased or decreased”;
- The payment stream may be excluded from the recipient’s gross income for tax purposes;
- The injury must be a physical sickness or injury; and
- A highly secure funding asset (such as an annuity or U.S. Government obligation) must be used to fund the payments.