Tax Reform and Taxation

History

Traditionally, law suits for personal injury or death were settled by the payment of a single, immediate lump sum of cash. The tax treatment accorded such a payment was simple: Under Section 104(a)(2) of the IRS Code, an amount received "on account of personal injuries or sickness" is not part of the claimant’s gross income [Section 104(a)(2) stipulates that gross income does not include "the amount of any damages received {whether by suit or agreement and whether as lump sums or as periodic payments} on account of personal injuries or sickness"}. However, if a lump sum settlement amount is invested, the income derived from it is taxable.

The theory underlying the tax treatment of Structured Settlements is that the claimant is receiving a series of lump sum payments, and as such, each one should be accorded the same tax treatment as a single, immediate lump sum payment. While the theory seemed legally sound, and this type of settlement flourished, no formal position was enunciated by the IRS until the late 1970’s. At that time, requests for rulings caused the IRS to issue Revenue Ruling 79-220, which provided the basic guideline on which the favorable tax treatment would depend.

Similarly, in the Private Letter Ruling 8029128, where a Trust was established for the benefit of a minor claimant to provide him with "health care services, a suitable home environment, special educational services related to the claimant’s medical condition, and any other reasonable, customary or proper expense incurred primarily for his health, welfare or well-being," the payment received by the plaintiff was excludable from gross income under Section 104(a)(2) of the Code.

In order to receive the favorable tax treatment, the claimant must avoid "constructive receipt" of the funds. In effect, each future payment must be fixed and determinable and the claimant must not evidence any elements of ownership of the funding device. For example, the claimant must not have the right to accelerate, defer, increase or decrease any future payment, change the beneficiary or rely on anything more than the general credit of the owner of the funding device.

Detailed in code regulation Section 1.451-2, Constructive receipt amounts to:

• power over the funds;
• artificially manipulating time of taxation;
• funds availability upon demand;
• authority to require the sum paid in full;
• ability to change beneficiary.

The President’s tax reform proposal originally included taxation to an assignee on annuity income present in a structured settlement. The House later adopted a proposal which limits structured settlements to actions originating in a physical injury. Section 130(c) reads as follows for assignments entered into after December 31, 1986:

(c) QUALIFIED ASSIGNMENT For the purposes of this section, the term “qualified assignment” means any assignment of a liability to make periodic payments as damages (whether by suit or agreement) on account of personal injury or sickness in a case involving physical injury or physical sickness [new language in bold].

Non-physical personal injury actions can still be structured; the annuity must be owned by the self-insured or casualty insurer.

Miscellaneous Revenue Act of 1988

Federal legislation in 1988 now permits a plaintiff to become a secured creditor of an assignee. Section 130(c)(2)(c) was removed from the code - the section requiring that a plaintiff be no more than a general creditor of the assignee.

"Under the bill, a liability assignment is treated as a qualified assignment notwithstanding that the recipient is provided creditor’s rights against the assignee greater than those of a general creditor. The bill also provides that no amount is currently includible in the recipient’s income solely because the recipient is provided creditor’s rights that are greater than the rights of a general creditor."

The repeal of the general-creditor requirement is effective for assignments entered into after November 11, 1988. The general-creditor requirement was not repealed in non-assigned cases.