Structured settlements are generally income tax-free. The nontaxable nature of qualified structured settlements is one of the biggest advantages of utilizing structured settlements. However, tax law is never so straightforward that knowing the general rule is sufficient. Therefore, this article looks a little deeper.
The Internal Revenue Code (“IRC”) provides a tax exclusion for certain structured settlements. Settlement recoveries arising from compensatory damages for personal physical injuries are income tax-free. IRC Section 104(a)(2) states in part: “…gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal injuries or sickness.”
This income tax-exclusion provides a much-needed break for personal injury claimants who agree to receive their funds over time. Notice in the IRC quoted above that the damages must be compensatory in nature (not punitive) and received for personal injury. To qualify for this exclusion the funds should be paid directly by the defendant or its insurer to fund the annuity and the assignment of the obligation to make the payments must be made in the settlement agreement. If it is clear that the damages are compensatory, the origin of the claim being settled is personal injury, the qualifying language was inserted into the settlement agreement, and the funding was handled properly, then all of the benefits received will be tax-free to the injured party.
Settlements for punitive damages or non-physical injuries do not qualify for this tax exclusion. That does not mean that these claims cannot or should not be structured, just that the benefits won’t be excluded from income tax. Non-qualified structured settlements (structures of taxable damages or attorney fees) are fairly common and they can defer taxes on the benefit payments until those payments are actually received while still allowing an immediate deduction to the defendant or its insurer for the payment of the claim.
Settling parties need to be aware that amounts received in a settlement in exchange for confidentiality are taxable. Therefore, if confidentiality is important to both parties, they should make certain that the settlement agreement specifies that none of the structure payments are for confidentiality. Any consideration for confidentiality should be clearly and separately defined.