Have you been injured and expect a settlement from your company or the company at fault? Consider a structured settlement as a viable way to receive income over time.

Just what is a Structured settlement, you may ask? Well, structured settlements are settlements of tort claims involving physical injuries or physical sickness. These claims may arise out of motor vehicle accidents, sporting accidents, medical negligence, public liability, product liability and similar situations where negligence has resulted in personal injury. Structured settlements are not possible for workers’ compensation type claims (see below), cases where the injured person has died or cases that have been finalized. A structured settlement is the result of an agreement mutually reached between the parties to a case (whether or not this agreement is later used as the basis of a court order). It is good for the injured person because it offers tax savings, flexibility and financial security.

The availability of structured settlements increases the range of options available to defendants to help resolve claims. That is why they use them. Structured settlements mean that a defendant can still finalize claims on a once-and-for-all basis. Defendants generally do not pay out the periodic payments in a structured settlement, but rather purchase a financial product that will provide periodic payments to the injured person.

Settlement proceeds take the form of periodic payments, including scheduled lump sum payments. Instead of a defendant (or their insurer) paying the entire final settlement sum to the claimant in the form of a single lump sum, the settlement money will be paid in the form of two components.

The first component will involve the defendant paying the claimant an immediate lump sum. This immediate lump sum may comprise, for example, half or one-third of the total settlement money.

The second component will involve the defendant using the rest of the settlement money to purchase for the injured person a personal injury annuity or annuities, and possibly also financial products called personal injury lump sums. These products will provide the injured person with an income stream for life.

A structured order will have the same outcome as a structured settlement (at least part of the compensation being paid in the form of periodic payments), but is the result of an order that has been imposed by a court without the prior agreement of both parties. Structured orders will only be possible where a court has power to impose a judgment involving periodic payments of the type satisfying the tax rules for structured orders.

Structured settlements generally are funded by single-premium annuity contracts held by the party that is contractually obligated to make the future settlement payments. Federal tax rules were designed to encourage the use of structured settlements. The full amount of each periodic payment, including the amount attributable to earnings under the annuity contract, is excludable from the settlement recipient’s income under IRC section 104(a)(1) or (2). Better yet, Congress has endorsed the use of structured settlements as a means of assuring continuing income to injury victims to minimize the risk that lump sum recoveries will be dissipated, leaving victims of disabling injuries without income at which time they may then look to public assistance for support. The IRS has specific rules about structured settlements and also many states have enacted their own state structured protection acts (SSPAs) requiring that transfers of structured settlement payment rights receive advance court (or, in some cases, administrative authority) approval. (Since July 1, 2002, every transfer of payment rights has required such approval in order to avoid the federal excise tax.)

IRC section 5891(a) imposes a tax equal to 40% of the factoring discount on any person who acquires directly or indirectly structured settlement payment rights in a structured settlement factoring transaction that does not qualify for exemption under conditions that are specified in section 5891(b).

The purpose of IRC section 5891, is to deter the purchasers of payment rights under structured settlements from taking advantage of recipients who are entitled to receive tax free settlement payments, including payments under settlements received by victims of the 9/11 terrorist attack.

The tax is basically a penalty tax imposed on purchasers of payment rights under structured settlements. The practical effect of section 5891 is to compel such purchasers to comply with State structured protection acts (“SSPAs”), which require that transfers of structured settlement payment rights receive advance court (or administrative authority) approval. Absent an appropriate court or administrative authority order, a party acquiring structured settlement payment rights must pay, up front, a tax equal to 40% of its expected gross profit on the transaction (i.e., the difference between the total undiscounted amount of the future payments it acquires and the amount that it pays to acquire them).

In conjunction with the SSPAs, section 5891 should make structured settlement recipients much less vulnerable to predatory factoring transactions. This new law not only benefits the individual that sells payment rights under his or her structured settlement but also makes clear that insurers involved in structured settlements will suffer no adverse tax consequences as a result of structured settlement factoring transactions. Prior to enactment of section 5891, the tax consequences of these transactions for insurers were uncertain.

IRC section 5891 applies only to transfers of payment rights under settlements providing for payments that are tax-free to the settlement recipient.

Usually when compensation is paid to an injured person in the form of a single lump sum, that money is tax-free in the hands of the injured person. But if that money is invested and earns interest, then the interest earnings are taxable as income.

Up until now, if compensation was paid over time and each payment included interest and indexation amounts, then at least part of each periodic payment would be taxable in the hands of the injured person as income. The change to the tax rules mean that periodic payments of compensation that are paid in the form of a structured settlement or structured order are entirely tax-free in the hands of the injured person, including any interest and indexation component that may make up part of each periodic payment.

This means that large personal injury cases that would ordinarily be settled for a lump sum can be settled in such as way as to deliver tax-free periodic payments to an injured person.

Only particular types of cases can be structured. Importantly:

• the claim must have been made by the person who has been injured or their legal personal representative, and
• the claim must not be made against the defendant in their capacity as an employer of the injured person, or be a workers’ compensation claim.

Only cases of certain settlement sizes can be structured because the legislation specifies a minimum level of monthly payments. The formula to be applied is complex, but essentially requires enough compensation money to fund the purchase of an annuity that will provide the injured person with lifetime monthly payments that start at an amount equal to or greater than the level of the current age pension and that increase in line with the Consumer Price Index (CPI).

The cost of such an annuity will depend mainly on how long the injured person is expected to live. Less money will be required to provide the minimum amount to an older person with a shorter life expectancy than a young person with a long life expectancy. For example, the cost of providing the minimum monthly amount to an 18 year old is likely to be more than the cost of providing the minimum amount to a 60 year old. These figures will vary depending on age, sex, life expectancy and other factors that affect the cost of annuities, such as interest rates.

Only future and currently open cases can be structured. Structured settlements and structured orders are not possible in cases that have already been finally resolved for a lump sum.

The Department of Justice compiles a list of annuity brokers who meet minimum qualifications for providing annuity brokerage services in connection with structured settlements in the US. For a link to this list, click here.

It is advisable to check out any broker or settlement factoring company who approaches you for your business.

Many structured settlement factoring companies advertise for customers through web sites that can be located by searching for references to structured settlements, structured settlement purchasing or the National Association of Settlement Purchasers, a trade organization to which most of the largest structured settlement factoring companies belong. (They do not generally call themselves “factoring companies.”) Some companies also advertise extensively on cable television and in magazines and newspapers. Reported court decisions involving factoring transactions, including decisions approving or disapproving transactions under SSPAs, can be useful sources of information. Those decisions are readily located by searching Westlaw and Lexis databases for cases referring to “structured settlements.”

In two states, Maine and West Virginia, the SSPAs require that structured settlement factoring companies obtain special licenses. See Me. Rev. Stat. Ann. Tit. 24-A § 2242 (requiring that factoring companies register with the Superintendent of Insurance); W. Va. Code § 46A-6H-8 (requiring that factoring companies register with the Secretary of State). Information about factoring companies that have done business in those states should be available from their registrations. However, these appear to be sites maintained by factoring brokers, not factoring companies per se, and they may not be very helpful.

A final source of information may be the National Structured Settlements Trade Association (NSSTA). The NSSTA is headquartered in Washington D.C. This Association lobbied hard for the law which created section 5891 imposing the Excise Tax on the structured settlement factoring transactions, and has a direct interest in the enforcement of the new excise tax. In this regard, the Trade Association may be in a position to provide technical support and information.

Most workers’ compensation acts prohibit or sharply restrict assignment of workers’ compensation, including compensation payable under workers’ compensation settlements. In conditioning exemption from the federal excise tax, in the case of factoring transactions involving workers’ compensation settlements, on approval of such transactions by the “responsible administrative authorities,” IRC section 5891 does not imply that such transactions can or should be approved. In most cases they presumably should not be approved, because they contravene applicable statutes (i.e., workers’ compensation laws) and/or orders of responsible administrative authorities (i.e., the workers’ compensation commission orders approving the settlements). IRC section 5891 simply establishes the standards that must be met in those cases in which payment rights under workers’ compensation settlements can be transferred, consistent with applicable workers’ compensation law restrictions.

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