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Income Tax-Free Structured Settlements

Internal Revenue Code Section 104(a)(2) provides an exclusion from gross income for damages received on account of personal physical injuries or physical sickness. The damages can be received as the result of a suit or by agreement between the parties. The exclusion applies to up-front cash and periodic payments.

Internal Revenue Code Section 104(a)(1) provides an exclusion from gross income for compensation a person/plaintiff receives for injury or sickness under workers’ compensation acts.

The Internal Revenue Service has ruled that a properly designed structured settlement will flow income tax-free to the recipient if certain guidelines are met. Any remaining unpaid guaranteed periodic payments made to an estate after the death of a payee are also income tax-free (Rev. Rul. 79-220). President Ronald Reagan signed “The Periodic Payment Settlement Act of 1982,” turning the administrative ruling of the IRS (79-220) into law. Thus, we now have certainty under law that the payments from a properly arranged structured settlement are entirely income tax-free.

Under the current Internal Revenue Code Section 104(a)(2), damages paid for past and/or future lost wages, medical needs, and pain and suffering are all excludable from gross income. This exclusion is for cases that pass the “origin of the claims test” where the origin of the claim is based on a personal physical injury or physical sickness.

Tax-Deferred Structured Settlements

A “tax-deferred” structured settlement is an innovative option for cases involving taxable damages and where a tort has been committed. Income taxes are deferred on the portion of the settlement proceeds that are structured, and are not due until the year in which payments are received. The annuity payments are taxed as ordinary income to the plaintiff at his or her personal income tax rate.

The following types of cases are ideal for tax-deferred structured settlements:

Trusts

In some settlements, it might make sense to place a portion of the settlement funds into a trust. Claimants receiving Supplemental Security Income (SSI) and Medicaid benefits will lose their benefits if they take a lump sum settlement and a “special needs” trust is not established. A common practice of purchasing a Medicaid Qualified Structured Settlement Annuity to fund the trust reduces the annual fees the trust can charge as well as replenishes the trust with guaranteed income tax-free payments.

Our firm has relationships with trust attorneys to prepare the trust documents as well as corporate trustees to offer the best services with low annual administrative fees.

Single Premium Immediate Annuity

A Single Premium Immediate Annuity (SPIA) can provide a stream of income for a specified period of time or the life of an individual. Under a life contingent payment option, payments will be received for the rest of the annuitant’s life, regardless of living beyond his or her normal life expectancy.

Under current Internal Revenue Service rules, use of after-tax funds to purchase a SPIA results in payments that are only partially subject to federal income taxes. The non-taxable portion (exclusion ratio) of each payment represents the return of your original investment.

At the other extreme, the purchase of a SPIA with funds from a tax-qualified plan (IRA, TSA, 401(k), etc.), provide payments that are fully taxable as they represent funds that have not yet been taxed.

Attorney Fee Structured Settlement

Attorney fee structured settlements are a creative way for attorneys to defer income taxes on contingent legal fees. In an effort to avoid a higher marginal income tax bracket, fees can be structured to be paid over a specified number of years or for the life of the attorney.

Similar to structured settlements for plaintiffs, attorneys also have the ability to design and plan his or her own payment schedule to meet individual financial objectives such as retirement, overhead expenses, college tuition, etc.

The U. S. Court of Appeals for the 11th Circuit affirmed in Richard A. Childs, et al. v Commissioner of Internal Revenue, that attorneys may structure their fees, holding that taxes are payable on structured attorney fees in the year payments are received.

Please consult your tax attorney or CPA when considering structuring your legal fees.

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