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Using Structured Settlements

If you are not familiar with the term “structured settlement,” you are already lucky; that probably means you have not been involved in a serious accident where you were injured due to someone else’s negligence.

For those who are not so lucky, structured settlements offer an alternative to lump-sum settlement payments in personal injury litigation. Instead of receiving the reward all at once, the plaintiff will receive it in periodic payments over time. The main reason that structured settlements exist in their current form is that they offer some significant tax benefits to plaintiffs.

The tax code dictates that damages paid to redress a physical injury are free from federal income tax, whether paid all at once or over time. This is true of damages awarded by a court or offered in an out-of-court settlement. Note that many lawsuits result in both taxable and tax-free damages; plaintiffs owe tax on damages due to “emotional distress,” for example, and punitive damages are also often taxable. Plaintiffs may need to allocate the damages in order to keep the tax component unambiguous.

Since both lump-sum and periodic damages for physical injury are tax-free, you may wonder why one is better than the other. The truth is, neither is better in every situation. But structured settlements offer two distinct advantages.

The first advantage is beneficial tax treatment for investment returns. If you take the lump sum and invest that money, the earnings are taxable, the same way any other interest, dividends, or short- and long-term capital gains would be. If you opt for a structured settlement instead, however, each payment is entirely tax-free, even though part of the payment could represent asset growth.

In addition, structured settlements offer security for plaintiffs who anticipate needing long-term or lifetime care as a result of their injury or disability. Congress took action to ensure qualified structured settlements’ favorable tax treatment, largely in an effort to keep plaintiffs from losing a lump-sum award to poor markets or other financial misfortune and thus falling back on the social safety net.

In contrast, lump sum awards, when managed properly, may yield superior long-term returns, even when allowing for capital gains tax. To understand why, it is important to consider how a structured settlement functions.

How Do Structured Settlements Work?

Most structured settlements involve a fixed annuity – a product that will pay out regularly over a set period of time. In exchange for the guarantee that the agreed payments will arrive as scheduled, the annuity company takes a cut of the investment returns. In other words, the recipient is effectively paying for the certainty of future payments.

During the process of settling the lawsuit, the parties’ attorneys typically involve a special type of insurance agent called a structured settlement broker. These professionals are regulated by state insurance commissions, and create projections assuming different time horizons and payment periods, which the attorneys can use in their negotiations.

Structured settlements are quite flexible upfront. Terms may be a set number of years, the plaintiff’s lifetime, or the plaintiff’s lifetime plus that of his or her spouse. Plaintiffs can opt for different payment periods, such as monthly or annual payouts. Depending on circumstances, the plaintiff may want to build in a gap before payments start – for example, if the plaintiff’s spouse plans to retire in 10 years, the settlement can be set up to start payments then. Plaintiffs can also request unequal payments; depending on the injury, it may make sense to take a larger portion upfront to make a home more accessible or to pay off overdue bills. Payments can increase or decrease over time.

All of this flexibility is useful, but it is important to bear in mind that it is only available during the negotiation process. Once a structured settlement is set up, it generally cannot be changed later. It is also essential that the settlement be structured properly; you should never try to go it alone in the negotiation process.

Once the parties’ attorneys and the broker are satisfied with the terms, the defendant – or potentially the defendant’s insurer – will send the payment to an “assignment company,” a subsidiary of a life insurance company. The assignment company uses the payment to purchase an annuity from their parent insurer, and then pays the plaintiff each month per the terms of the contract. Even though the plaintiff is guaranteed to receive the full amount, the tax code does not treat him or her as owning anything except an expectation of each payment.

The current rules for structured settlements were largely shaped by the Periodic Payment Settlement Act of 1982. Congress made explicit that 100 percent of every structured settlement payment was exempt from federal income tax. The law followed Internal Revenue Service rulings to similar effect in the 1970s. The first recorded structured settlements in the U.S. related to the birth defects arising from use of the drug thalidomide. Although the drug affected only a handful of American infants, plaintiffs in the cases hoped to secure benefits for the children’s lifetime care without sacrificing the existing tax benefits related to lump sum awards for physical injury or sickness. Since then, structured settlements have become common, and Congress extended the existing rules to cover workers’ compensation claims in 1997.

While fixed annuities are by far the most common way to fund a structured settlement, they are not mandatory. Occasionally, defendants can set up a trust that invests only in U.S. Treasury obligations instead; the trust makes the payments to the plaintiff. On very rare occasions, the settlement may be self-funded by the defendant. For example, if the defendant is a large corporation that does not anticipate liquidity issues, the entity may be in a position to make payments outright. For obvious reasons, however, few plaintiffs want to agree to such an arrangement over long payment terms, such as 20 or 30 years, due to increased risk.

In addition to the tax benefits and long-term security of structured settlements, there are a few other potential advantages. First is asset protection. Assuming the settlement is funded through a fixed annuity, most states protect insurance company obligations by law. Should an insurer become insolvent, the state’s guaranty association will cover claims up to the state’s limits. On a personal level, too, it is more difficult – though not entirely impossible – for creditors to access funds in a structured settlement, meaning that if a plaintiff runs into financial difficulties, these assets may be at least partially shielded.

For further protection, many recipients choose to combine a structured settlement with a settlement preservation trust. If structured correctly, a trust can further shield assets from creditors. A trust may also include spendthrift provisions if desired.

In general, a structured settlement allows plaintiffs to avoid a variety of hazards associated with any large financial windfall, even one that is income tax-free. People may feel they lack the skill to effectively manage a large award all at once. They may be tempted by risky investments or large, luxury purchases. Or they may find that loved ones who know about the award may ask for major loans or gifts, in ways that make it hard to say no. My colleague Shomari Hearn covers a variety of these pitfalls in his article “How To Handle Sudden Wealth.” A structured settlement, however, allows the recipient to avoid many of these challenges outright.

All of this is not to say a lump sum is never the right choice. Award recipients should consider a variety of factors, such as their relationship with an investment adviser, the type of injury sustained and its long-term prognosis, and the potential negative consequences of downturns in the market on cash flow. For plaintiffs who don’t expect to need long-term care or who can integrate a windfall into an existing financial plan, a structured settlement may not be the best choice.

Pitfalls To Avoid

Like any financial or tax planning strategy, structured settlements are not without potential drawbacks. Many of these can be mitigated, however, with some care and planning.

If you are currently on Medicare or Medicaid, or expect to need either program in the future, note that the laws governing these programs interact with structured settlements in sometimes-complex ways. Medicare patients, for instance, may need to set up a Structured Medicare Set Aside (MSA) arrangement in order to preserve benefits after a settlement. For plaintiffs in this situation, it is essential to consult with an experienced attorney at the outset.

As discussed earlier in this article, situations in which damages are taxable or tax-free are not always clear-cut. It is rare, but occasionally the IRS may claim that a qualified structured settlement – that is, one designed to be tax-free – is not, in fact, qualified. This can create major tax headaches, and is part of the reason that experienced attorneys and brokers are essential in creating the settlement initially.

In recent years, there has been an uptick in “nonqualified” structured settlements, in which taxable settlements are also set up to pay out over a term of years. Although this situation does not offer the tax-free growth benefit, when set up properly, it can allow the plaintiff to avoid realizing the entire amount of damages at once, and can offer some of the other benefits discussed in the previous section. Plaintiffs should, however, proceed with caution, as this arrangement is still less common than its tax-free cousin. With the favorable tax component removed, the settlement also loses one more advantage over the lump sum alternative.

Plaintiffs should beware offers to buy out their settlements in exchange for immediate cash from a life insurance company or an investment firm. If you are considering such an offer because of an immediate need for liquidity, you should speak with a trusted attorney – ideally the one who originally negotiated your settlement.

This is because most states (47 as of this writing) have structured settlement protection acts that make it complicated for such transactions to proceed legally. State legislators found that many third-party buyout offers put the former plaintiffs at a disadvantage, especially since, in order for the transaction to be attractive to the buyer, the buyer has to pay less than the annuity is worth over time. Most state laws require the buyer to disclose the value of the transferred payments in contrast to the net amount the seller will receive in the transaction, so it is clear how much of the original settlement the plaintiff would forgo by selling.

In addition to state law, federal law requires court oversight and approval for any instances in which injury victims choose to sell their structured settlement payments to a third party. If court approval is not secured, the tax code imposes a 40 percent excise tax on the expected gross profit on the transaction, which the buyer is responsible for paying upfront.

Structured settlements are, at their core, a mechanism designed to make sure someone who is injured receives compensation in a way that will best assure their long-term quality of life. While they are complex to set up, once they are underway, they can ideally ensure that plaintiffs have the income they need to recover or adjust to their new way of life.