Article Reprinted with permission of TRIAL (June 2011). Copyright American Association for Justice, formerly Association of Trial Lawyers of America (ATLA®). By: Amy Fisch Solomon & Patrick C. Farber
For 30 years, structured settlements have provided injured people with long-term financial security and special tax benefits. How these settlements are used and funded is constantly evolving. Make sure you know all the options so you can build the best structure for your client.
Structured settlements and the laws governing them are ever-changing. Issues like how they are taxed, when they can be used, and whether they can be sold seem to be in a near constant state of flux. For plaintiff trial lawyers who are charged with properly advising their clients regarding settlement of their cases, this instability can be disconcerting, to say the least.
If it looks like a structured settlement (or periodic payment plan for tax-deferred structures) would benefit your client, you’ll need to consult with qualified financial and tax advisers. But before you make that call, you should understand the latest developments regarding structured settlements and how they might affect your case.
The Periodic Payment Settlement Act of 1982 launched the structured settlement movement by enabling parties involved in personal injury and workers’ compensation cases to receive structured settlements for their injuries instead of lump-sum payouts.1 Typically, the defendant in a lawsuit buys a single-premium annuity on behalf of the plaintiff from a life insurance company, which is contractually obligated to make the future settlement payments.
The income received through structured settlements is exempt from state and federal income taxes and excludable from gross income under the federal tax code. Internal Revenue Code §104(a) determined that damages for specific injuries (that is, personal injury or sickness, medical malpractice, products liability, workers’ compensation) could be excluded from gross income and thus tax-free. Interest earned on the annuity payments is also tax-free.2 Qualified structured settlements provide guaranteed long-term, tax-free income.
But what if the plajntiff is not a person or has not suffered physical injury or illness? Does that mean settlement funds aren’t tax-free? Not necessarily. For example, in one confidential case, a homeowners association (HOA) sued its building contractor because of damage from leaking windows in the association’s newly built rec room. The HOA claimed that because of poor construction, the building’s windows would always leak.
The parties agreed to a periodic payment settlement that provided payments every 10 years for 40 years so the HOA could replace the windows when necessary. Even though the plaintiff is not a person and suffered no physical injury or illness, the settlement payments are tax free as long as they are paid directly to the HOA.
The settlement called for the annuity issuing life insurance company to pay the HOA directly. The HOA is a tax-free entity, so it enjoys the same tax benefits as a person who settles a personal injury claim involving a physical injury or illness.
Even when cases do not qualify for tax-exempt status, the tax-deferred and financial-planning aspects of periodic payment settlements may make them worthwhile. According to industry figures, in 2010, life insurance companies issued $5.8 billion in annuities to fund future settlement payments; that was up from $5.6 billion in 2009.3
Periodic payments are becoming common in non-personal-injury cases, like those involving construction defects, employment discrimination, and punitive damages, because they offer the security of lifetime payments and tax deferral advantages.
For example, in another confidential case, after a 30-year-old man was killed in an auto accident, his wife and child filed suit. At trial, the jury’s award to the plaintiffs included $11 million in punitive damages.
A tax-deferred structure for this portion of the award provided that the plaintiffs would receive $2.5 million in cash up front. The widow would then receive $150,000 annually for 20 years, and the child would receive $50,000 annually for five years after turning age 18, $150,000 at age 25, and another $300,000 lump sum at age 30.
Periodic payments also have slowly become part of mass tort physical injury litigation. Plaintiff lawyers, their clients, and special masters have recognized that certain individuals in mass tort actions have a need for lifetime income because of ongoing medical needs.
Recent class action settlements including those involving medical device manufacturers, large pharmaceutical companies, and toxic waste cleanup sites-have allowed present-value settlements to be extended by the use of annuities to provide guaranteed long-term payments to meet long-term needs.
In a large class action involving toxic drinking water in California, the defendants and class members agreed to a confidential settlement of more than $300 million. The 1,400 adult and minor plaintiffs either had developed cancer because of the contamination or believed the chances were good that they would.
Each plaintiff was offered a lifetime annuity as part of the settlement. For those with cancer, the lifetime annuity would pay for medical bills and, since most could no longer work, would help maintain their lifestyle. Those without cancer established annuities for future medical bills and lifestyle expenses. Minors, who had lost parents due to illnesses caused by the water contamination, received annuities that would pay for living and college expenses.
While the settlement was for the class, each lifetime annuity was tailored to the needs of each individual plaintiff. The tax-free annuities took present-value settlement dollars and increased their value four fold by extending the payments over the lifetime of the plaintiffs.
In another development, elderly injured parties are combining pooled special needs trusts (SNTs) with life annuities to preserve government benefits while receiving income for non-medical needs. Pooled SNTs are established and managed by a charity for individuals primarily over age 64. Because they are created through a nonprofit entity, support a “pool” of individuals rather than a single individual, and the settlement money remains in the trust and is not owned by the plaintiff until distributed, the income from these trusts is not counted against needs-based public benefits such as Social Security and Medicare.In one confidential case, family members sued an assisted living home for the mistreatment of their 73-year old mother. A pooled SNT was created. The woman received $135,000 with a $2,150 monthly payment guaranteed for five years. Her public benefits were not affected.
Pooled SNTs can be used for an individual of any age, but this is the only type of special needs trust available to people age 65 or 0lder.4 Some restrictions apply. For example, pooled SNTs must be for the “sole benefit” of the trust beneficiary.
In states that have accepted the Deficit Reduction Act of2005, a transfer penalty will apply for funds placed in a pooled SNT.5 The penalty can create up to five years of ineligibility. Other states allow only one transfer of funds into a pooled SNT. Check with your state for specific Rules. In most states, direct disbursements (or gifts) to children or spouses are not permitted, as the disbursement must be for the elderly plaintiff only.
Choosing a Structure
Life annuities provide lifetime guaranteed income to maintain the injured party’s standard of living. These payments can be paid at intervals determined by the annuity carrier and the plaintiff’s needs.
Over the years, annuity options available to the injured party have become more creative. In another confidential case, the plaintiff sued a church for clergy abuse he recalled suffering as a child. He did not remember physical abuse, just emotional abuse. Because the man claimed he could not work, the settlement included a lifetime annuity, and the periodic payments were tax-deferred because his injuries were emotional, not physical. The $2.7 million settlement provided a taxable $285,000 lump-sum payment, plus monthly guaranteed payments of $1,250 for 20 years.
Until recently, these types of payment arrangements were used only in traditional cases of physical injury or sickness. Although they do not meet the criteria of a typical structured settlement, guaranteed, tax-deferred annuities are making up more of the annuity market.
Stepped annuities involve increases of the annuity payments for a fixed period or over the lifetime of the structure. In a case involving a 35-year-old computer programmer who lost both hands in an accident, a stepped benefits plan was created to compensate for loss of earnings. The confidential plan called for monthly payments guaranteed for 20 years, with payments increasing by $1,000 per month every five years until the plaintiff reached age 55. At 55, a life only annuity would begin, paying him $10,000 a month for the rest of his life.
Stepped annuities help hedge against inflation. Instead of buying one annuity that will pay one rate over its lifetime, stepped annuities that adjust or inflation can guarantee payments to the injured party to cover cost-of-living increases.
Joint and survivor periodic payments are created for joint settlement recipients. These annuities involve one contract for two annuitants. When one of the annuitants dies, the survivor continues to receive annuity payments at a prearranged percentage of the original annuity. For example, say the settlement calls for monthly guaranteed payments. for 20 years, payable jointly to a man and his wife. If either spouse dies before the 20-year contract expires, the surviving spouse would continue to receive full monthly payments, tax-free.
U.S. Treasury bond structures involve the purchase of U.S. Treasury strips or bonds. These can be laddered so that every few years the interest rate increases. Laddering bonds is similar to using stepped annuities. Treasury securities can be purchased with 1-, 5-, and lO-year maturities, with the longer-term securities providing larger yields. The bonds continually mature so the injured party can take advantage of rising rates. If interest rates drop, the injured party will still hold longer-term bonds with higher yields.
Because Treasury bonds can be called by the government, these periodic payments cannot include payments for a lifetime; they must be for a fixed number of years. Because of tliis, the injured party may also need a separate annuity to cover ongoing lifetime care costs. Deferred periodic payments are also ideally suited for structuring attorney fees when an attorney or firm wishes to generate a steady, long-term stream of income or create income at retirement. Anyone who accepts a periodic payment annuity has a large amount of flexibility when it comes to how to receive payments.
In most cases, it is in the plaintiff’s interest to receive settlement payments over time, but many plaintiffs have been lured into selling their structures to “factoring” companies in return for a lump-sum payment. These companies, with their aggressive commercials and promises of fast cash, have made factoring a booming business.
While there may be circumstances where plaintiffs may find themselves suddenly in need of a significant amount of money, the cost of converting a structured settlement to a lump-sum payment can be high, with factoring company fees and taxes taking a large piece of the payout.
Concerned about the potential problems with factoring transactions, the federal government and many states have passed laws requiring prior court approval of structured settlement buyouts. Under federal law, if court approval is not received, a 40 percent excise tax is levied against the factoring company on its discount (the difference between the actual amount that would have been paid to the injured party and the amount
paid for the structured settlement by the factoring company).6
While most state statutes on factoring are similar, in 2009, California passed a law that created even greater judicial oversight of these transactions? The law states that the lawyer who handled the initial settlement must be notified before a buyout takes place. This ensures that plaintiffs are adequately protected, fully informed, and acting in their own best interests. The law also provides explicit guidelines for courts to consider when deciding whether a buyout is appropriate. The guidelines require courts to review the injured party’s current and future financial needs, determine whether the party has received independent legal and financial advice concerning the buyout, and assess whether the “discount rate” proposed by the factoring company reflects current market rates. The guidelines ensure that injured parties are aware of the value of the structured settlement versus the value of the lump sum buyout.
Pending legislation in Oregon8 is designed to amend the state’s Structured Settlement Protection Act9 and contains many of the same features of the California law. A New York law that became effective this year requires factoring companies petitioning the court to include “a statement setting forth whether there have been any previous transfers or applications for transfer of the structured settlement payment rights and giving details of all such transfers or applications for transfer.”10 Another new provision of the New York law states that “the payee shall attend” the hearing on the proposed transfer unless the court excuses such attendance “for good cause.”11
Structured settlements have created financial security for millions of plaintiffs. As applications continue to grow and attorneys become more creative with the options available, structures will find their way into more and more settlement discussions.
MORE ON SETTLEMENTS:
- AAJ SECTION | Sole Practitioner and Small Firm | www.justice.org/sections
- AAJ LITIGATION GROUP | Attorney Information Exchange Group | www.justice.org/litgroups
- LITIGATION PACKET | “Medicare and Medicaid Reimbursement Claims Survival Guide” | www.justice.org/exchange
- AAJ EDUCATION PROGRAM | “Advocacy Track-Negotiation and Settlement and Damages” (# OO-t05) | www.playbackaaj.com
About The Authors
Patrick C. Farber is a structured settlements broker in California. He can be reached at email@example.com.
Amy Fisch Solomon is an attorney with the Los Angeles law firm of Girardi & Keese. She can be reached at a firstname.lastname@example.org.
1. Pub. L. 97-473, 96 Stat. 2803 (1982).
2. 26 U.S.C. §104(a)(2) (2006).
3. LIMRA IntI., Inc., Variable Annuity Sales Experience Double Digit Increase in the Fourth Quarter of 2010, www.limra.com/
news center / databank/ defau I t.aspx.
4. 42 U.S.C. §1396p(d)( 4)(C) (2006).
5. Pub. L. 109-171, 120 Stat. 4 (2006).
6. 26 U.S.C. §S891 (2006).
7. Cal. Ins. Code Ann. §§10134- 10139.S (West 2009).
8. Or. H. 2922, 2011 Reg. Sess. (Jan. 11, 2011).
9. 2006 Or. Laws Ch. 173.
10. N.Y. Gen. Oblig. Law §S-170S(d) (iv) (McKinney 2002).
11. N.Y. Gen. Oblig. Law §S-170S (McKitmey 2002) .