by John Darer CLU ChFC MSSC CeFT RSP CLTC
Structured settlement payments received on account of physical injury, physical sickness, workers compensation, and/or wrongful death, are income tax free to extent the payments represent damages within the meaning of IRC 140(a)(1) or 104(a)(2). How valuable is the tax exclusion? Perhaps more than you think points out a well-intentioned industry colleague who writes that the value is even higher when one takes into account the state and local taxes.
He says "Local income taxes appear under a variety of designations: wage taxes, income taxes, payroll taxes, local services taxes, and occupational privilege taxes. Some are imposed as a percentage of salaries or wages, while others are stated as a percentage of federal or state tax, and still others are flat amounts charged to all. For example, residents of Yonkers, New York pay 15% of their state tax as a “piggyback” local tax. In Maryland and New York City, residents pay their local income tax when they file their state income tax". (Emphasis ours)
John McCulloch writes that "there are a total of 4,943 local jurisdictions that impose taxes. The states that have local taxes are as follows: Alabama (4); California (1); Colorado (3); Delaware (1); Indiana (91); Iowa (297); Kansas (535); Kentucky (218); Maryland (24); Michigan (22); Missouri (2); New Jersey (1); New York (4); Ohio (774); Oregon (2); Pennsylvania (2961); and West Virginia (3) Most local income tax rates are low (1% to 3%), they generally have been ignored when computing the taxable equivalent yield of a structured settlement and as such the structured settlement may be undervalued. Taxable equivalent yields are the return that is required on a taxable investment to make it equal to the return on a tax-exempt investment, such as a municipal bond. "
McCulloch's analysis is notable however, it should be supplemented by noting that it would not be accurate to assume that state and local taxes are a straight add on. Consider that some taxpayers who pay state and local taxes, take itemized deductions (Schedule A), The value of the "add on tax" (in an effort to determine the highest possible taxable equivalent yield when comparing to a taxable investment) would have to take into account the effect of the deductions. This will vary state by state. Then of course you have variables such as some smaller structures involving people in low tax brackets who don't itemize and people who in very high tax brackets who lose many itemized deductions. If you have someone with exceptionally high un-reimbursed medical expenses, the nominal value of the tax benefit may be offset by the tax deductions for medical expenses (again "the itemized deduction thing"). Are you comparing payments to an individual, or to a trust? It's not a simple add on.