From time to time, a life agent encounters a person who received, or is about to receive, a large settlement of a personal injury lawsuit. The agent has heard of structured settlements and wonders if there is an opportunity for an annuity sale.
A structured settlement is a arrangement in which the injured party (plaintiff) agrees to accept a series of periodic payments either over a lifetime or for a fixed number of years, rather than pursue a lump-sum settlement. The desirability of the arrangement is obvious where the injured party is a child or otherwise incompetent to manage a large lump sum, but many competent adults also accept a structured settlement because of income tax considerations.
Let’s look at an example to illustrate the tax advantages of a structured settlement. Assume Mary receives $1 million as a lump sum settlement for personal injuries. The $1 million itself is tax-free under the Code, but Mary wants to invest in order to provide an income to live on. Suppose she buys an investment that produces an 8% return, or $80,000 per year. Depending on where Mary lives, the combined local, state, and federal income tax on her annual income could be in the 30-40% range. On the other hand, if Mary had agreed to accept a properly arranged structured settlement of, say, $100,000 per year for life, the entire amount received is income tax-free under Code section 104(a)(2), according to Revenue Ruling 79-220, 1979-2 C.B. 74.
A Negotiated Settlement
A structured settlement is arranged through negotiations between the injured party and the defendant, or more likely, the defendant’s casualty insurer. It’s important to note the desired tax effects aren’t available if the plaintiff has either actual receipt or constructive receipt of a lump sum. If the plaintiff has the settle-merit check in hand, there is no doubt actual receipt has occurred.
Constructive receipt occurs when a plaintiff has the money available or when it is set-aside for her. Thus, if the plaintiff is offered the choice of a lump-sum settlement or a structured settlement, the IRS may take the position the plaintiff had constructive receipt of the money. If the defendant’s casualty insurer agrees to make periodic payments to the plaintiff, it could buy an annuity to fund the payments, but it would have to be the owner of the annuity. Under no circumstances can the plaintiff be the owner of the annuity without triggering the constructive receipt rule.
As a practical matter, casualty insurers won’t buy an annuity and make periodic payments themselves. First, the casualty insurer desires to "close the books" on claims and doesn’t want to keep a file open for years to come. Secondly, the casualty company can’t deduct the premium cost of the annuity in the year of purchase; instead, the company must amortize the cost of the structured settlement over the term of the annuity, and deduct the payments when made to the plaintiff.
In practice, structured settlements are carried out through the use of a "qualified assignment." An assignee, typically an affiliate or subsidiary of a life insurance company, assumes the obligation of the casualty company to make periodic payments to the plaintiff, and in consideration, receives a single premium payment from the casualty company. The plaintiff agrees to release the casualty company from liability and look solely to the assignee for periodic payments. The casualty company then deducts the entire premium payment in the year made as a business expense and clears its books. This arrangement is what’s meant when the term structured settlement contract or structured settlement annuity is used.
An agent can’t expect to sell an ordinary deferred annuity to either the plaintiff or casualty company as part of a structured settlement. In order to make a commission, an agent must be licensed with a structured settlement company and sell that company’s contract to the casualty company to cover a settlement previously negotiated with the plaintiff.
Of course, if the plaintiff has a lump-sum settlement check in hand, the agent may sell a deferred annuity to her, but she must be made aware distributions will be subject to the usual annuity taxation rules, including a 10% penalty for withdrawals prior to age 591/2.
Last Updated: 9/23/2012 10:05:00 PM