Tax Exclusion for Structured Settlements | When Are Structured Settlements Tax Free?

by John Darer® CLU ChFC MSSC RSP CLTC

What Type of Damages Do the Structured Settlement Payments Represent?

Generally the determination of whether a structured settlement payments are income tax free, is based on the reason for settlement and the damages that the structured settlement payments represent. Not all structured settlements are income tax free.

While other tax principles may also come into play,  it is critical that constructive receipt, or actual receipt, of the structured settlement funding amount has not occurred. 

Ignore The Slick and Inaccurate

A slick presentation about structured settlements by one of my industry brethren includes the following inaccurate information:

• The misleading title "Annuity: Always Tax Free"
  
• The inaccurate statement that the governing US code and tax law is The Internal Revenue Code of 1954 which the individual represents is a "mandate that settlement proceeds from personal physical injury claim are always tax free"

Comments

1. An annuity is not always tax free.
2. A structured settlement annuity is not always tax free
3. There is nowhere in the Internal Revenue Code that says that structured settlement annuities are tax free.
4. IRC 104(a)(2) provides for an exclusion from taxable income, of "the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness".
5. The word "physical" does not appear in IRC 104(a)(2). The author of the critiqued presentation has muddled things with its inclusion in IRC 130. IRC 130 came into being with the Periodic Payment Settlement Act of 1982.
6. The governing law is the Internal Revenue Code of 1986, as amended, not the Internal Revenue Code of 1954.
7. One must distinguish between taxes on income and taxes upon an estate in the event of death
8. Since 1918, the tax exclusion includes the terms "whether by suit or agreement".

 

References

• Revenue Act of 1918  Section 213(b)(6) The exclusion for personal injury damages appears in the Internal Revenue Code-see p22

"Amounts

received, through accident or health insurance or under workmen's compensation acts, as compensation for personal injuries or sickness plus the amount of any damages received whether by suit or agreement on account of such injuries or sickness"

Internal Revenue Code of 1954

"Section 104(a)(2) excludes from gross income the amount of any damages received (whether by suit or agreement) on account of personal injuries or sickness. The term damages received (whether by suit or agreement) means an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution".

Read more: http://cfr.vlex.com/vid/104-compensation-injuries-sickness-19700889#ixzz0nPMxz98x

Knuckles v. Commissioner (1965)
The determination of whether a settlement amount is excludable must be based on the reason for settlement, which is determined by the wording of settlement agreement.