What Does A Tax Free Structured Settlement Do For You?

If you are considering a structured settlement, you should know what it will do for you. If you agree to a structured settlement, the defendant may pay you some money now and arrange to have a stream of payments paid to you over time. How much and when these payments are made is negotiated between you and the defendant, based on your individual needs. These payments will be tax free to you – that means unlike interest income from a taxable investment made with a cash settlement, you are not required to report this income to the IRS.
Because the use of an annuity or bond trust to fund any periodic payments is a conservative investment,made with only the most secure financial institutions, the Internal Rate of Return (IRR) may not appear to be competitive when compared with more risk based investment products. However, periodic payments are excluded from gross income under Internal Revenue Codes 104(a)(1) and 104(a)(2). Therefore, one must compare the tax free rate of return with an equivalent taxable yield to accurately analyze the investment decision.

IRS Code Section 104

Compensation for injuries or sickness was enacted in 1918 for the purpose of excluding from gross income those monies received in compensation for Personal Injury and Sickness. The intent of the code is that damages received from an injury are a “replacement of a loss” and are not a gain to the taxpayer. The IRS in recent years has looked for ways to enhance revenue. As a result, there have been several changes to this code (i.e. “Personal Injury” has been more narrowly de�ned as “Personal Physical Injury” thus eliminating punitive damages and most emotional distress claims from the tax-free status). However, with the long history of income tax-free payments under this Section, it would appearSection 104 is secure from repeal.Both Workers’ Compensation damages 104(a)(1) and Tort damages 104(a)(2)are excluded from income taxation by this code. Periodic payments from a Structured Settlement have also been coded in Section 104. While sub section(a)(1), (2) and (3) are most relevant to the Structured Settlement industry, the entire section follows:


(a) IN GENERAL – Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include –(1) amounts received under workmen’s compensation acts as compensation for personal injuries or sickness(2) amounts of any damages (other than punitive damages) received (whether by suitor agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;(3) amounts received through accident or health insurance(or through an arrangement having the effect of accident or health insurance) for personal injuries or sickness (other than amounts received by an employee, to the extent such amounts(A) are attributable to contribution by the employer which were not included in the gross income of the employee, or (B) are paid by the employer); (4) amounts received as a pension,annuity, or similar allowance for personal injuries or sickness resulting from active service in the armed forces of any country or in the Coast and Geodetic Survey or the Public Health Services, or as a disability annuity payable under the provisions of section 808 of the Foreign Service Act of 1980 ; and (5) amounts received by an individual as disability income attributable to injuries incurred as a direct result of a violent attack which the Secretary of State determines to be a terrorist attack and which occurred while such individual as an employee of the United States, engaged in the performance of his offical duties outside the United States. For purposes of paragraph (3), in the case of an individual who is, or has been, an employee within the meaning of section 401(e)(1) (relating to self-em-ployed individuals), contributions made on behalf of such individuals while he was such an employee to a trust described in section 401(a) which is exempt from tax under section 501(a), or under a plan described in section 403(a), shall, to the extent allowed as deductions under section 404, be treated as contribution by the employer which were not included in the gross income of the employee. For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. e preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section213(d)(1) attributable to emotional distress(Effective August 20, 1997).


Prior to 1979, periodic payments in settlement of tort cases were assumed to be excluded from gross income of the recipient just as a lump sum settlement had been under Sec. 104. However, as there was no prevailing code, the IRS was asked to rule on a fact situation under a structured settlement agreement to clarify the issue. Revenue Ruling 79-220 issued a holding with very specific legal requirements for such payment to fall under Sec.104. It is these requirements that have been the benchmark for the wording of settlement agreements for structured settlements. For this reason,the settlement advisor and legal professional should carefully read this ruling and fully consider the constructive receipt and economic benefit concepts in any structured settlement negations.ISSUE: Does the exclusion from gross income provided by section 104(a)(2) of the Internal Revenue Code of 1954 apply to the full amount of monthly payments received in settlement of a damage suit or only to the discounted present value of such payment?FACTS: “A”, an individual, sued “B” for damages for personal injuries. “B” is insured by “M”, an insurance company. Before trial, A accepted M’s offer to settle the suit for a lump-sum payment of$8,000 and M’s agreement to provide A with monthly payments of $250 for A’s lifetime or 20years, whichever is the longer, the payment to be made to A’s estate after A’s death if A should die before the end of 20 years. A had no right to the discounted present value of the monthly income(the present value of which, at date of settlement,was less than the total monthly payments to be provided) or to control the investment of that amount.To provide the monthly payments for A, M purchased a single premium annuity contract from”O”, another insurance company. M advised O to make payments directly to A. However, M is the owner of the annuity contract and has all rights of ownership including the right to change the beneficiary. A can rely only on the general credit of M for collection of monthly payments.