Section 104(a) of the Internal Revenue Code excludes from gross income the amount of any damages, other than punitive damages, received as a result of personal physical injuries. The government does not tax a physical injury recovery because it is designed to make you whole again after the injury. The same holds true for amounts received on account of physical injuries suffered on the job (workers’ compensation claims).
Section 104(a) provides in relevant part:
(a) In general Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include –
amounts received under workmen’s compensation acts as compensation for personal injuries or sickness;
- the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;
- amounts received through accident or health insurance (or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts (A) are attributable to contributions by the employer which were not includible in the gross income of the employee, or (B) are paid by the employer) . . . .
Defer Taxation on Taxable Damage Awards or Sale of Appreciated Assets
Receiving a lump sum settlement after settling a taxable damages suit (employment discrimination, sexual harassment, age discrimination) can lead to quick dissipation of the settlement. First, the government gets its taxes since the entire amount of the settlement is taxable in the year of receipt. Any investment of the settlement proceeds has to be done on an after tax basis. Second, poor management of the funds can lead to having nothing left very quickly. A cash settlement may not result in a positive outcome for you.
A structured settlement or periodic payment plan via an annuity can result in a substantial tax savings and effective financial management of the settlement proceeds. Comparing a professionally managed periodic payment arrangement that is a pre-tax investment with a lump sum settlement illustrates the power of this solution. Having the ability to earn interest on the principal investment, accumulating interest on deferred payments and interest on the deferred taxes produces an attractive result for you. You may wish to review the revenue ruling (hyperlink) to learn more about the power of deferral of taxation of your damages.
Likewise, if you are selling highly appreciated assets you can invest the proceeds pre-tax and on a tax deferred basis. This is called a Structured Sale. A structured sale is a special type of installment sale pursuant to Internal Revenue Code Section 453. Installment sales permit sellers to defer gains on the sale of a business or real estate to the tax year in which the related sale proceeds are received. Structured sales allow the seller of an asset to pay taxes over time while having the payments guaranteed by a high credit quality alternate obligor, who accepts assignment of the buyer’s periodic payment obligation. Transactions can currently be done as small as $100,000.
In a structured sale, rather than the buyer paying the installments, the buyer pays cash, some of which is used as consideration for a third party assignment company to accept the payment obligation. The assignment company then purchases an annuity from a life insurance company with high financial ratings from A. M. Best. Case law and tax precedents have long supported substitution of obligors include Rev. Rul. 82-122 amplifying 75-457 and Wynne v. Commissioner 47 B.T.A. 731 and Cunningham v. Commissioner 44 T.C. 103. In addition, a properly handled transaction will avoid issues with constructive receipt and economic benefit.
Estate Taxes and Estate Planning Commutation Riders
Structured settlement annuities while income tax free are not free from estate taxes. The present value of the remaining guaranteed payments are includable in the estate for estate tax purposes. The estate taxes are due within nine months of death. How will the estate tax be paid if a structured settlement is established which provides only monthly income even after the plaintiff dies? Life insurance could be used except for the fact that most catastrophically injured victims are uninsurable due to their medical problems.
There is a solution to this problem and it is called an Estate Planning Commutation Rider. This rider provides that at death a certain percentage (up to 100%) of the remaining guaranteed structured settlement payments are commuted to a lump sum of cash. The rider can be added to any structured settlement annuity and is offered by all of the life insurance companies that provide structured settlements. There is no cost for this rider but it must be done at the time of settlement. The only thing that is required is that the settlement paperwork reflects that this rider is to be implemented at death.
The key issue is determining the commutation percentage. Your settlement planner should hire an accounting firm to determine the potential estate tax. The accountant should always be asked to determine the largest potential estate tax, which would occur if the plaintiff died in the first year of the annuity. That way you can commute enough of the annuity to cash to cover a worse case scenario. It certainly does no harm to commute too much. However, if too little is commuted that could cause an immense liquidity problem. Once you know the worse case scenario estate tax liability, you can then determine the commutation percentage.
IRC 5891 (Commutation) Section 5891 of the Internal Revenue Code regulates factoring transactions (selling annuity payments) or commutation (turning annuity payments into a lump sum immediate payment). Any company that does not comply with 5891 gets hit with a 40% excise tax on the transaction. A court must make a finding that it is in the best interest of the annuitant to sell/commute the annuity payments. If the factoring transaction or commutation is allowed there are no adverse tax consequences for any of the parties. Because of the way 5891 was written, if a life insurance company is provided with a qualifying order under 5891 they themselves can commute the annuity to a single lump sum payment. The life insurance companies do this at the rate they normally charge when an estate planning commutation rider is used which is 6 – 7%.
5891 is an important addition to the law because it gives structured settlement recipients some flexibility. If there is a large future medical need that arises suddenly they can request a commutation under IRC Section 5891. If unforeseen financial circumstances arise, they can pursue the 5891 option. Finally, on structured settlements that were done without an estate planning rider, they can use 5891 to provide sufficient liquidity to take care of estate taxes.
IRC 5891 (Commutation)
IRC 5891 governs the commutation or factoring of structured settlement annuities. The full text of this provision is below.
STRUCTURED SETTLEMENT FACTORING TRANSACTIONS
`Sec. 5891. Structured settlement factoring transactions.
`SEC. 5891. STRUCTURED SETTLEMENT FACTORING TRANSACTIONS.
`(a) IMPOSITION OF TAX- There is hereby imposed on any person who acquires directly or indirectly structured settlement payment rights in a structured settlement factoring transaction a tax equal to 40 percent of the factoring discount as determined under subsection (c)(4) with respect to such factoring transaction.
`(b) EXCEPTION FOR CERTAIN APPROVED TRANSACTIONS-
`(1) IN GENERAL- The tax under subsection (a) shall not apply in the case of a structured settlement factoring transaction in which the transfer of structured settlement payment rights is approved in advance in a qualified order.
`(2) QUALIFIED ORDER- For purposes of this section, the term `qualified order` means a final order, judgment, or decree which–
`(A) finds that the transfer described in paragraph (1)–
`(i) does not contravene any Federal or State statute or the order of any court or responsible administrative authority, and
`(ii) is in the best interest of the payee, taking into account the welfare and support of the payee`s dependents, and
`(B) is issued–
`(i) under the authority of an applicable State statute by an applicable State court, or
`(ii) by the responsible administrative authority (if any) which has exclusive jurisdiction over the underlying action or proceeding which was resolved by means of the structured settlement.
`(3) APPLICABLE STATE STATUTE- For purposes of this section, the term `applicable State statute` means a statute providing for the entry of an order, judgment, or decree described in paragraph (2)(A) which is enacted by–
`(A) the State in which the payee of the structured settlement is domiciled, or
`(B) if there is no statute described in subparagraph (A), the State in which either the party to the structured settlement (including an assignee under a qualified assignment under section 130) or the person issuing the funding asset for the structured settlement is domiciled or has its principal place of business.
`(4) APPLICABLE STATE COURT- For purposes of this section–
`(A) IN GENERAL- The term `applicable State court` means, with respect to any applicable State statute, a court of the State which enacted such statute.
`(B) SPECIAL RULE- In the case of an applicable State statute described in paragraph (3)(B), such term also includes a court of the State in which the payee of the structured settlement is domiciled.
`(5) QUALIFIED ORDER DISPOSITIVE- A qualified order shall be treated as dispositive for purposes of the exception under this subsection.
`(c) DEFINITIONS- For purposes of this section–
`(1) STRUCTURED SETTLEMENT- The term `structured settlement` means an arrangement–
`(A) which is established by–
`(i) suit or agreement for the periodic payment of damages excludable from the gross income of the recipient under section 104(a)(2), or
`(ii) agreement for the periodic payment of compensation under any workers` compensation law excludable from the gross income of the recipient under section 104(a)(1), and
`(B) under which the periodic payments are–
`(i) of the character described in subparagraphs (A) and (B) of section 130(c)(2), and
`(ii) payable by a person who is a party to the suit or agreement or to the workers` compensation claim or by a person who has assumed the liability for such periodic payments under a qualified assignment in accordance with section 130.
`(2) STRUCTURED SETTLEMENT PAYMENT RIGHTS- The term `structured settlement payment rights` means rights to receive payments under a structured settlement.
`(3) STRUCTURED SETTLEMENT FACTORING TRANSACTION-
`(A) IN GENERAL- The term `structured settlement factoring transaction` means a transfer of structured settlement payment rights (including portions of structured settlement payments) made for consideration by means of sale, assignment, pledge, or other form of encumbrance or alienation for consideration.
`(B) EXCEPTION- Such term shall not include–
`(i) the creation or perfection of a security interest in structured settlement payment rights under a blanket security agreement entered into with an insured depository institution in the absence of any action to redirect the structured settlement payments to such institution (or agent or successor thereof) or otherwise to enforce such blanket security interest as against the structured settlement payment rights, or
`(ii) a subsequent transfer of structured settlement payment rights acquired in a structured settlement factoring transaction.
`(4) FACTORING DISCOUNT- The term `factoring discount` means an amount equal to the excess of–
`(A) the aggregate undiscounted amount of structured settlement payments being acquired in the structured settlement factoring transaction, over
`(B) the total amount actually paid by the acquirer to the person from whom such structured settlement payments are acquired.
`(5) RESPONSIBLE ADMINISTRATIVE AUTHORITY- The term `responsible administrative authority` means the administrative authority which had jurisdiction over the underlying action or proceeding which was resolved by means of the structured settlement.
`(6) STATE- The term `State` includes the Commonwealth of Puerto Rico and any possession of the United States.
`(d) COORDINATION WITH OTHER PROVISIONS-
`(1) IN GENERAL- If the applicable requirements of sections 72, 104(a)(1), 104(a)(2), 130, and 461(h) were satisfied at the time the structured settlement involving structured settlement payment rights was entered into, the subsequent occurrence of a structured settlement factoring transaction shall not affect the application of the provisions of such sections to the parties to the structured settlement (including an assignee under a qualified assignment under section 130) in any taxable year.
`(2) NO WITHHOLDING OF TAX- The provisions of section 3405 regarding withholding of tax shall not apply to the person making the payments in the event of a structured settlement factoring transaction.`.
(b) CLERICAL AMENDMENT- The table of chapters for subtitle E is amended by adding at the end the following new item
`Chapter 55. Structured settlement factoring transactions.`.
(c) EFFECTIVE DATES-
(1) IN GENERAL- The amendments made by this section (other than the provisions of section 5891(d) of the Internal Revenue Code of 1986, as added by this section) shall apply to structured settlement factoring transactions (as defined in section 5891(c) of such Code (as so added)) entered into on or after the 30th day following the date of the enactment of this Act.
(2) CLARIFICATION OF EXISTING LAW- Section 5891(d) of such Code (as so added) shall apply to structured settlement factoring transactions (as defined in section 5891(c) of such Code (as so added)) entered into before, on, or after such 30th day.
(3) TRANSITION RULE- In the case of a structured settlement factoring transaction entered into during the period beginning on the 30th day following the date of the enactment of this Act and ending on July 1, 2002, no tax shall be imposed under section 5891(a) of such Code if–
(A) the structured settlement payee is domiciled in a State (or possession of the United States) which has not enacted a statute providing that the structured settlement factoring transaction is ineffective unless the transaction has been approved by an order, judgment, or decree of a court (or where applicable, a responsible administrative authority) which finds that such transaction–
(i) does not contravene any Federal or State statute or the order of any court (or responsible administrative authority); and
(ii) is in the best interest of the structured settlement payee or is appropriate in light of a hardship faced by the payee; and
(B) the person acquiring the structured settlement payment rights discloses to the structured settlement payee in advance of the structured settlement factoring transaction the amounts and due dates of the payments to be transferred, the aggregate amount to be transferred, the consideration to be received by the structured settlement payee for the transferred payments, the discounted present value of the transferred payments (including the present value as determined in the manner described in section 7520 of such Code), and the expenses required under the terms of the structured settlement factoring transaction to be paid by the structured settlement payee or deducted from the proceeds of such transaction.