Are Structured Settlements Really TAX-FREE?

by John Darer CLU ChFC MSSC CeFT RSP CLTC

The websites of a number of structured settlement and settlement planning firms advertise that structured settlements are "tax free".   Is the statement "structured settlements are tax free" a true statement?

It depends on the type of tax. Read below for reasons why the statement "structured settlements are tax free" could be false and MISLEADING.

Let's first look at the different types of taxes and their relevance to structured settlements:

1. Value Added Tax- Tax on the value of a good, service or property Current relevance to structured settlements: None
2. Environment Affecting Tax Current relevance to structured settlements: None
3. Capital Gains Tax- the tax levied on the profit released from the sale of an asset Current relevance to structured settlements: None to fixed structured settlements for personal injury settlements, but may have relevance when structured settlement annuities are used for structured installment sale or settlement of construction defect cases
4. Consumption Tax- A tax on non-investment spending (e.g. sales tax) Current relevance to structured settlements: None.
5. Corporation Tax: a direct tax on the profits of companies or associations including capital gains.
6. Estate Tax or Inheritance Tax: a tax arising on the death of an individual Current relevance to structured settlements: If a structured settlement annuitant dies with remaining unpaid guaranteed or certain structured settlement payments the present value of such payments is included in the decedent's gross estate. If the estate is suffiently large there may be estate taxes due.
7. Excise Tax: Tax based on the quantity of the product purchased. Current relevance to Structured Settlements: A 40% excise tax is levied on transferee of structured settlement payment rights if a "qualified order" is not obtained per IRC 5891(b)(1).
8. Income Tax: a tax levied on the financial income of of individuals, corporations, or other legal entities including trusts. Current relevance to structured settlements: IRC sections 104(a)(1), 104(a)(2)and IRC 130 provide the exclusions to otherwise taxable income that make most structured settlements work.
9. Poll Tax: A per capita tax that levies a set amount per individual. Current relevance to structured settlements: None
10. Property Tax: A tax imposed on property by reason of ownership Current relevance to structured settlements: None.
11. Retirement Tax: Example FICA   Current relevance to structured settlements: None.
12. Sales Tax: a tax applied when a good or service is sold to its final consumer. Current relevance to structured settlements: None.

and the list goes on.

What are some instances where the blanket statement "structured settlements are tax free" is false?

1.  Structured attorney fees are not income tax free or estate tax free and a retired attorney may have self employment tax to pay on such payments.
2. Structured settlements where there is no "qualified assignment" represent taxable income to the owner of the qualified funding asset, if that owner is a taxable entity, such as a product manufacturer. Further, while the payments ultimately made to the structured settlement recipient  (plaintiff) are income tax free, the cost of the "qualified funding asset" cannot be written off by the entity in year 1. The entity must wait to write off each payment as made to the recipient.
3. There is an estate tax exposure on some settlements involving long periods certain and large guaranteed lump sum payments. While this certainly does not impact every case it is sufficient to render the statement "structured settlements are tax free" FALSE!

Under the Federal Trade Commission Act:

• Advertising must be truthful and not deceptive. According to the FTC, an ad is deceptive if it contains a statement-or omits information-that is "material" and is likely to mislead consumers acting reasonably under the circumstances. What claims are express or implied by the statement "structured settlements are tax free"? Can they be made in good faith as a blanket statement?
• Advertisers must have evidence to back up their claims
• Advertisements cannot be unfair

Given the potential for the statement "structured settlements are tax free" to be misleading a best practice would be to qualify the tax benefit.

Let's sample some live structured settlement industry websites

For examples of accurate

"A properly designed structured settlement is "income tax-free"

" periodic payments are completely free of federal and state income taxes"

"The annuity payments received under such a structured settlement are not subject to federal income taxation"

"Under current law, structured settlement payments are completely free from federal and state income taxes"

For examples of somewhat accurate/somewhat misleading

"When you want the benefit of guaranteed tax-free income

"Can rest assured that the injured party will receive a steady stream of tax-free income

"the principal and interest generated from structured settlement annuties written in the resolution of a legal claim involving personal physical injuries are completely exempt from federal, state, and local taxation."

For an examples of misleading

"The tax-free nature of this instrument delivers a significantly higher after-tax benefit than a lump sum settlement"

"The Internal Revenue Code (IRC) section 104(a)(2) allows plaintiffs involved in a personal injury lawsuit to receive their settlements in future periodic payments excluded fromtaxation"

"Our brokers focus on achieving the best possible results for all parties using tax-free structured settlement annuities"

"If a structured settlement is used to fund a personal physical injury claim, it provides the payments tax-free"

"Structure your financial future tax-free"

"The Internal Revenue Service determined that since the money you receive through a structured settlement is compensation for an injury, you will never pay taxes on any of the payments (principal or interest)".

"Structured payments received by your estate or by your heirs are also received tax free"

"A structured settlement is an agreement between parties, pursuant to existing Internal Revenue Regulations, which provides tax-free payments for an agreed upon period of time or for the life of the claimant"

"Tax free- guaranteed-secure"

"A method of settling a personal injury claim in which the injured party receives tax-free payments in the future"

THESE ARE ALL STRUCTURED SETTLEMENT INDUSTRY WEB SITES. IT'S SHOCKING!

Further misinformation that ties in with the above

One settlement planning firm is using the term "structured settlements" in ways that conflict with the definition of "structured settlement" under the Internal Revenue Code at IRC 5891 (c)(1). The settlement planner advertises that "structured settlements" are effective in wrongful termination cases. Wrongful termination case neither involve damages of the character excluded from income under the Internal Revenue Code, nor do the financial instruments the broker advertised constitute structured settlements in the legal sense defined under the Internal Revenue Code. Such financial instruments are called non qualified assignments. They are however, commonly referred to as "non qualified structured settlements". The use of the qualifier "non qualified" is critical if one is to use the latter.

In the immediate above example about wrongful termination "structured settlements" there is hyperlink for the word "structured settlements" that discusses tax exemption while at the same time the text bleow teh hyperlink discusses tax deferral. Isn't this potential confusion for the layperson?

Best Practices and Professional Responsibility

1. This type of impact statement would be correct "Structured Settlements are Income Tax-free-Secure and Guaranteed!"
2. The word "income" should precede the words "tax free" in any discussion of structured settlements where the payments are for damages arising out of personal physical injury or physical sickness or out of workers compensation.
3. Periodic payment solutions for non qualified cases (i.e where damages do not fall within the exclusions from income under IRC 104(a)(1), 104(a)(2) and/or 130) are called non qualified assignments, non qualified periodic payment settlements or even non qualified structured settlements
4. State insurance regulations governing professionals in the structured settlement and settlement planning industry are clear in the expectation that the advertised benefits of recommendations and  product solutions are articulated clearly and accurately