WHAT IS A STRUCTURED SETTLEMENT?
Most personal injury cases now involve a Structured Settlement. The industry is now providing $5 billion annually in Structured Settlement annuities.1
A Structured Settlement is an annuity that pays the injured plaintiff a series of periodic payments over time, rather than in a single lump sum. The annuity is purchased by the defendant from a highly rated life insurance company. The issuer of the annuity agrees to make future payments to the injured party or directly to a Special Needs Trust or Settlement Protection Trust. Most states have Insurance Guarantee Funds offering protection if an insurance company fails. These Funds cover Structured Settlement annuities. However, there are relatively low limits on the amount of coverage. If the settlement is large, there may be more than one annuity in order to spread the risk over more than one insurance company. Payments are typically made for the life of the injured party with a guarantee of payment for a minimum term of years, usually closely correlated with the actual life expectancy of the injured party. If the injured party dies prematurely, the guaranteed portion of the settlement may be payable to his estate, to a trust, to a spouse, or to a child. If there is a Special Needs Trust, generally there must be a 100% commutation rider and the beneficiary on death must be the Special Needs Trust.
One of the principal advantages to a Structured Settlement is that it makes it more difficult for the plaintiff to squander the settlement. The payments made by the insurance company cannot be spent until received, absent a factoring transaction or commutation.
If the structure payments are made to a trust, the trustee would have to agree to a factoring transaction so there is additional protection. The income stream paid by the insurance company is known as a “Periodic Payment,” which is defined as “a commitment to make future payments to a claimant according to an agreed schedule on specified terms.”2
WHO ARE THE PARTIES TO A STRUCTURED SETTLEMENT?
There are four parties to a Structured Settlement:
♦ Annuitant. The annuitant is the “measuring life” for the annuity lifetime benefits. Generally, the injured plaintiff is the annuitant. If the annuity is for a fixed term of years without reference to the plaintiff’s lifetime, then technically there is no annuitant, although the term is still used for identification purposes.
♦ Owner. The owner is the person who owns the annuity and has the normal incidents of ownership. These include:
- the right to designate and change the payee;
- the right to designate and change the beneficiary;
- the right to assign the annuity;
- the right to borrow against the annuity and assign it as collateral; and
- the right to commute the annuity.
It is important to understand that the claimant of the annuity is not the owner of the annuity. Ownership is either retained with the defendant property and casualty insurance carrier or, in the event of an assignment, ownership is retained by the assignment company, and the claimant has a right to receive the future periodic payments as they become due.
♦ Payee. The payee is the person who receives the periodic payment.
♦ Beneficiary. The beneficiary is the person who receives the payments upon the death of the annuitant. The use of the term “beneficiary” can be confusing in cases involving a Special Needs Trust because the beneficiary of the Special Needs Trust is normally the injured plaintiff, while the beneficiary of the Structured Settlement is the person who would receive benefits upon the death of the injured plaintiff. In cases involving Special Needs Trusts, many states require that the trust or the state be named as beneficiary of the Structured Settlement on death of the annuitant.
CAN PART OF A PERSONAL INJURY SETTLEMENT BE STRUCTURED AND PART LUMP SUM?
A settlement can be part lump sum and part Structured Settlement. It is almost always wise to take some lump sum as a part of the settlement to cover unanticipated emergencies. It is useful to try to anticipate immediate cash needs of the injured party and take a lump sum sufficient to pay those needs in the beginning. For example, if there is to be a purchase of a home, a vehicle, a vacation, or repayment of debt, better practice is to increase the lump sum portion of the settlement to include those items. A lump sum should also be set aside for unforeseen emergencies.
In larger cases, the plaintiff should have an investment portfolio. The Structured Settlement could serve as the income portion of the portfolio, but a lump sum should be set aside to invest in the equity component. An appropriate allocation must be made between the income and equity portions based on an investment policy statement.
IS THE INCOME COMPONENT OF A STRUCTURED SETTLEMENT PAYMENT TAXED?
Revenue Ruling 79-220 addressed the issue of whether the income component of a payment under a Structured Settlement annuity made to compensate for physical injuries or physical sickness is taxable.3 The ruling involved the following facts. An insurance company purchased and retained exclusive ownership in a single premium annuity contract to fund monthly payment stipulated in settlement of a damage suit. An additional issue was whether payments made to the estate after the recipient’s death were fully excludable from income.
The ruling held that generally, under § 104(a)(2) of the Code, gross income does not include the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness. The ruling also stated that if the plaintiff died before the end of the guarantee period, the payments made to his estate also would be excludable from income under § 104. The ruling went on to say that if a lump sum damage payment was invested for the benefit of a claimant who has actual or constructive receipt or the economic benefit of the lump-sum payment, only the lump-sum payment would be excludable from income within the meaning of § 104(a)(2) of the Code, and all of the income from the investment of such payment would be taxable.
The significance of the ruling is that it clarified that the income component of a payment under a Structured Settlement is not taxable to the recipient. However, it would be unwise for an injured plaintiff to take a lump sum and buy his own annuity, because the income on the Structured Settlement purchased under a § 130 Qualified Assignment is income-tax free to the plaintiff. Conversely, if the plaintiff buys his own annuity, the income component would be taxable.
NOTE: While this Ruling used the language “personal injury,” the Code has since been amended to limit the exclusion from income tax to compensation for “physical injuries and physical sickness.”
An issue arises as to whether a Structured Settlement can be issued with the income excluded from tax where the payee of the structure is not injured but suffered damages from an incident involving physical injury or physical sickness or death of a related person. These claims often arise in wrongful death cases. According to Patrick Hindert,4 “Derivative claims concern the receipt of funds by persons who are not themselves injured, but are harmed from an incident that involves the physical injury, sickness or death of a related person. Claims for loss of consortium or companionship, for example, are made by persons who cannot themselves demonstrate any physical injury or sickness of their own, but stem from a physical harm to their relative. These claims are treated as arising on account of the underlying physical injury or sickness, and so are tax-exempt. Likewise, damages from wrongful death claims are excludable from the recipient’s gross income, even though the recipient did not die and may have suffered no physical ailment…the recipients do not have to show that they themselves were physically injured or sickened, as long as the underlying reason for receiving funds was ‘on account of’ the related party’s physical injury or sickness.”
The authority is Conference Report 104-737 (August 1, 1996), which states in part, “(D)amages (other than punitive damages) received on account of a claim of wrongful death continue to be excludable from taxable income as under present law.”
WHEN SHOULD A STRUCTURED SETTLEMENT BE CONSIDERED?
Structured Settlements offer several benefits to all of the parties. A Structured Settlement might be considered in all of the following situations:
- Protection. To prevent premature exhaustion of funds through poor investments and/or mismanagement.
- Medical Needs. To guarantee funds for long-term medical needs.
- Future Use. Injured persons attempting to retain some portion of their settlement for future use.
- Disability. Injured parties who are temporarily or permanently disabled.
- Wage Loss. Total or partial wage loss for any period of time.
- Mental Incompetence. Severely injured or mentally incapacitated persons.
- Guardianship. Guardianship cases, including minors or incapacitated persons.
- Future Support. When a settlement is a large portion of all of the injured party’s future support.
- Alternative Investment. As an alternative to investing part of settlement proceeds.
- Fixed Income. As a part of an overall investment portfolio, providing for the fixed income portion.
- Severe Injury. Severe injury, especially involving shortened life expectancy resulting in a Rated Age.
- Mentally Disabled. For the mentally disabled, Structured Settlements make sense because of their inability to manage money.
- Death Cases. Death cases with surviving spouse and/or children needing monthly/annual income.
- Special Uses. Deferred payments for college funds, retirement, attorneys’ fees, or worker’s compensation cases.
- Tax-Free. Any case where a secure tax-free income makes sense.
- Minors. A Structured Settlement might also be considered in cases involving minors.
- Plaintiffs Lacking Money Management Skills. If the plaintiffs lack money management skills and a trust is not being utilized, a Structured Settlement might make good sense.
- Special Needs. In cases involving individuals with long-term special needs, the settlement can be structured in such a way as to pay for the rehabilitation or permanent care facility expenses later in life, and provide for disbursements to purchase medical equipment or modified vehicles. The settlement can also include a cost-of-living adjustment to help cover future increases in these expenses.5
WHAT ARE THE ADVANTAGES TO A STRUCTURED SETTLEMENT?
Structured Settlements offer advantages to several parties involved, as discussed below.
♦ The Plaintiff. There are a number of potential benefits to the injured plaintiff.
- Lifetime Payment. The Structured Settlement can guarantee the plaintiff a lifetime income. The amount of the income can be flexible. This insures that the plaintiff will not outlive his or her money.
- Tax Free. The income from the Structured Settlement is completely tax-free if it is for a physical illness or sickness or for a worker’s compensation claim and can be guaranteed for life. It should be noted that making the individual eligible for Medicaid would be a more cost-effective solution.
- Estate Taxes. The structure can provide funds to pay estate taxes.
- Public Benefits. The structure can be used in combination with a special needs trust to maintain public benefits.
- Mortgage Payments. A structure can be used to make mortgage payments, although it is usually better practice to buy a home with a lump sum from the settlement or to pay off an existing mortgage with a lump sum from the settlement.
- Creditor Protection. A structure also guarantees an income that is free from the claims of the injured person’s creditors until receipt. The structure offers protection to minors and can guarantee benefits for a spouse, children, and beneficiaries.
- Fiscal Restraint. It makes it more difficult, although not impossible, for the injured plaintiff to squander the money prior to it being received.
- Investment Risk. The structure eliminates investment risk, because the insurance company is responsible for management of the funds.
- Guarantee. The periodic payment is guaranteed.
- Fixed Immediate Annuity. Essentially, there is a fixed immediate annuity.
- Rate of Return. Whether the rate of return on the capital invested to purchase the annuity is more or less than what could be achieved by investing the lump sum is an issue that should be carefully analyzed.
- Settling the Case. Often, a Structured Settlement may be useful in settling a case where the defendant is unwilling to pay a large enough lump sum to meet the plaintiff’s needs, but is willing to arrange a Structured Settlement that will give the plaintiff enough income over time to meet those needs.
- Rated Age. If a plaintiff has medical conditions warranting the establishment of a rated age, the periodic payout from the Structured Settlement can be considerably higher. This maximizes the settlement for the lifetime of the plaintiff.
♦ The Plaintiff’s Attorney. Personal injury attorneys often feel more comfortable in having arranged a Structured Settlement for their clients, because they feel it is more difficult for them to squander the settlement. Many personal injury attorneys are unaware that Structured Settlements can be factored and do not so advise their clients.
♦ The Defendant. A Structured Settlement benefits the defendant-insurer in that it enables it to remove the claim from its books, take the tax deduction, and move on. The settlement may also save expenses involved in the defendant-insurer processing and paying claims.
♦ The Defense Attorney. Using a Structured Settlement gives the defense attorney another alternative when negotiating a settlement. By taking advantage of the defendant’s rated age, it may be possible to achieve fairly high monthly annuity payments for the injured plaintiff. In determining a rated age, the insurance company looks at the injured person’s medical records. Because of the medical condition, the injured person often does not have a normal life expectancy. The insurance company determines how long they expect that person to live given the medical condition and assigns an age to the injured person. The age often is much higher than the injured person’s actual age. This means the insurance company can afford higher periodic payments, because payments are being made over a shorter period of time.
WHAT ARE THE DISADVANTAGES TO A STRUCTURED SETTLEMENT?
There are three disadvantages to Structured Settlements:
1. Rate of Return. If a Structured Settlement is purchased at a time where there is a low interest environment, the payments under the structure will be based on interest rates in effect at the time the structure is purchased and are locked in indefinitely based on that low rate. The annuity is a fixed annuity rather than a variable annuity, so the payee does not benefit from a rise in the stock market over time.
2. Lack of Liquidity. With respect to lack of liquidity, if the payments are fixed and an emergency arises, additional funds cannot be obtained short of commuting or factoring the annuity contract.
3. Insurer’s Solvency. The solvency of the insurance company providing the structure must be carefully examined. It is wise to purchase a structure only from top-rated companies and, where the sum is large enough, to purchase structures from more than one company to spread the risk. One way to protect the plaintiff is to be sure that the plaintiff is a secured creditor. The plaintiff receives a security interest in funding assets when a qualified assignment is used in settlement. Plaintiff’s counsel should always insist that a qualified assignment be used. Typically, a qualified assignment will be used, but occasionally the defense will draft a settlement agreement stating that the defendant “may” make a qualified assignment. A class action lawsuit6 was filed against Ringler Associates, a national Structured Settlement company, for its role in setting up Structured Settlements funded with annuities issued by Executive Life of New York (ELNY). ELNY went into liquidation and nearly 1,500 beneficiaries lost nearly $1 billion in future Structured Settlement payments. For many annuitants this meant losing nearly 60% of their future payments. Many of these beneficiaries lived in states where ELNY was not licensed. The Structured Settlement consultants who sold these annuities pocketed huge undisclosed cash commissions while concealing what they knew about ELNY and its parent First Executive Corp. This raises the question in the Ringler lawsuit as to, if the Structures were not set up correctly, what is the responsibility of the property and casualty companies? Will they be dragged into cases that were closed twenty years ago?7
1 nssta.com (Aug. 22, 2015).
2 Daniel W. Hindert, Joseph Julnesdehner, & Patrick J. Hindert, Structured Settlements and Periodic Payment Judgments, Law Journal Press (2011).
3 Rev. Rul. 79-220.
4 Daniel W. Hindert, Joseph Julnesdehner, & Patrick J. Hindert, Structured Settlements and Periodic Payment Judgments, Law Journal Press (2011).
5 Structured Settlements: An Effective Solution for Meeting the Ongoing Financial Needs of Physical Injury Victims, Prudential (2014), www.prudential.com.
6 Westrope and Kelly v. Ringler, United State District Court, District of Oregon, Portland Division, Case No. 3:14-cv-00604-SD.
7 Tough Times for Structured Settlements, Edward Stone, www.lifehealthpro.com (Oct. 27, 2014).