What is a structured settlement annuity?

A structured settlement annuity is a tool that helps a claimant ensure that the funds from a settlement will be available in the future. Before the settlement papers are signed, the claimant and the defendant agree to a payment design that includes future payments. This payment design becomes part of the settlement between the parties.

The obligation to make the future payments is generally transferred to a third-party assignment company that purchases an annuity to fund the future payments. The defendant satisfies its obligation to the claimant by sending the premium for the annuity directly to the annuity issuer. This arrangement allows the defendant to immediately recognize a tax deduction for the amount paid out while allowing the tax exclusion that applies to physical injury claims to be extended for the plaintiff to the future payments. This tax exclusion applies to the entire future payment even though a portion of each payment is attributable to the interest credited by the annuity issuer.

Structured settlement annuities provide claimants with guaranteed, tax-exempt future payments. The annuities used to fund these future payments are extremely flexible. They can be designed to meet a variety of needs such as funding future college expenses, living expenses, predictable medical spending or they can be used to provide lifelong income.  Injury victims with severe injuries or poor overall health who are seeking lifetime payments may benefit from a “rated age.” A rated age will serve to increase the payout per dollar used to fund the annuity.

While the mechanics of this transaction may seem fairly complex, in practice it is fairly easy for the attorneys at both ends of the transaction. Annuity brokers generally draft and review the language required to be in the agreements and help to make everything go smoothly.  

For many claimants, structured settlement annuities provide much-needed dissipation protection, guaranteed tax-free income, and financial stability. Structured settlement annuities often offer an excellent alternative to traditional investments. Not only do they offer a favorable net rate of return, they guarantee a fixed rate for the duration of the annuity contract period; a period which in many cases is the life of the annuitant. Annuitants with this guarantee can sleep much better at night secure in the knowledge that their money is guaranteed by a highly rated insurance company. This certainly relieves the burden of stress inherent in investing and can completely eliminate the question of whether one will run out of money prematurely.

Annuity payments are guaranteed by the annuity companies that offer them. Most annuity companies in the structured settlement market are rated A+ or better with AM Best.

When is a Structured Settlement Suitable?

There’s no “one size fits all” for personal injury settlement recipients. Claimants come from all walks of life. Depending on the circumstances, structures may have merit in cases involving minors, incompetent adults, financially sophisticated claimants seeking tax-exempt payments, as well as, claimants with little previous experience in managing money. It’s critical to understand who the claimant really is before mediation. Structured settlement annuities are valuable tools if used properly. Below are five examples.

  1. Minors. Everyone defaults here when they think of structures. It’s true that most probate courts favor structures for minors for obvious reasons. Minors are not allowed to receive funds prior to the age of majority. Structures are the best vehicle for delivering guaranteed payments beginning at the appropriate age. However, there are other reasons structures fit well with many minors.

    529 College Savings Plans are tremendously valuable tools for putting away money for higher education. However, personal injury claimants who are minors may benefit more from a structured settlement annuity. A parent may have done a great job accumulating funds for a child through a 529 plan only to find out their student receives a scholarship, in-state tuition, etc. 529 funds not used for higher education may be transferred to a sibling or may face hefty fees if withdrawn. Transfering to a sibling is not very equitable if the child received the settlement funds due to his or her own injuries. Structured settlement annuities carry no penalties if paid out and used for non-education expenses (ie, down payment on a home, starting a business, etc.).

    Bonding of a parent or guardian is typically not required when structured settlements are utilized for minors. The funds are locked away until age of majority which removes the risk of mismanagement of funds by a parent or guardian. In many cases, parents are not bondable anyway.

    Structures provide an efficient low cost alternative to establishing a trust for minors. There are no legal fees for drafting trust documents and paying for ongoing trustee services. Also, the tax exclusion (IRC Section 104) enjoyed by structured settlements can be important for minors. Beginning in 2018, the unearned income of minors is taxed at the trust tax rates which are very high. A structured settlement avoids this taxation issue completely.

  2. Incompetent adults. As with minors, many default to incompetent adults as they think of structured settlements suitability. When an adult is found to be incompetent, some combination of a trust and/or structured settlement is utilized. Probate courts favor structures in these cases as they do for minors. Having a predetermined, guaranteed, tax-free income is often what is needed for the incompetent adult or their trustee.

  3. Financially sophisticated adults. Many claims managers and plaintiff attorneys overlook this claimant. That’s unfortunate. The tax-free, guaranteed, payments from a structure are often very well received by the financial savvy claimant. For financial and emotional reasons, many of these claimants consider their personal injury settlement proceeds to be money that should be protected. Quite often, this thought process leads them to municipal bonds or similarly conservative investments. When presented with an appropriately designed structure, they and their financial/tax advisors quite often opt for the structure. Unlike a bond, structures can be medically underwritten to obtain more favorable returns should the claimant be injured or have any unrelated health issues. Also, unlike many bonds, structures are not callable and can be designed for longer payouts. If they are the surviving spouse of a primary income earner, structures become even more attractive for income replacement utilizing a cost-of-living adjustment. As an additional benefit, money placed into a structured settlement may be protected under most States’ laws from creditors.

    Financially sophisticated adults are often involved in aviation, medical malpractice and sometimes trucking/auto cases. However, accidents have no prejudice and may include these type claimants in any cases.

  4. Claimants with little previous experience in managing money. This category of claimants is often thought of when mentioning structures. Many personal injury claimants are competent adults with little or no expertise in handling large sums of money. Whether they have proven to be a spendthrift or not, most people with no real financial experience are not well suited for cash settlements. Human nature is such that our lifestyles typically adjust to match our finances. We’ve all seen this statement to be true with athletes, beneficiaries, and lottery winners. Many studies have been conducted on the matter. Unfortunately, it's just the way most of us are wired.

    Even if a claimant doesn’t become a spendthrift, they still may succumb to unwise investment decisions. The average person learns about investments as they go. Should they lose money in a bad investment, they may learn from that loss and not repeat it with the next investment. Settlement recipients may not have another investment. Their settlement proceeds may be the one and only sizable check they ever receive. Structures help protect that sum.

In addition to the above examples, structures may be suitable in several other situations. For example, structures should always play a key role in funding Medicare set aside accounts in workers compensation settlements. For older claimants facing longevity risk (the risk of outliving one’s income), a structure may be designed to provide guaranteed payments for life. As well, structures are increasingly popular as a deferred compensation technique for plaintiff attorneys.

In conclusion, every personal injury case should be looked at closely to determine the suitability of a structured settlement. The claimant, plaintiff attorney, and defendant may benefit from a well planned strategy. Structured settlements have proven to be suitable for many types of settlements for over 35 years.

How are Structured Settlements Taxed?

Structured settlements are generally 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.

Estate Tax

Recipients of very large settlements or those who are otherwise wealthy should consider the impact of estate taxes on their structured settlement if some payments are scheduled to continue after death. In 2018, this tax issue is only a problem if the decedent’s gross estate exceeds $11,200,000. The present value of any payments remaining after the death of the measuring life will be included in his or her gross estate. IRC Section 2039 states in part: “The gross estate shall include the value of an annuity … receivable by any beneficiary by reason of surviving the decedent under any form of contract … , if … an annuity or other payment was payable to the decedent … for his life or for any period not ascertainable without reference to his death or for any period which does not in fact end before his death.”  Inclusion in the estate can cause a liquidity problem. Commutation riders arranged at the time of settlement allow for the conversion of guaranteed future payments, providing immediate funds to pay any applicable estate taxes.

What is a Qualified Assignment?

When a settlement is reached that involves future payments to the claimant, the defendant and its insurers typically anticipate meeting the obligation to make the future payments with a structured settlement annuity. Structured settlement annuities require qualified assignments. A qualified assignment is a formal arrangement wherein a defendant or its insurance company or other representative agrees to transfer their obligation to make future periodic payments to a third party (“an assignment company”).  This is generally done using a uniform qualified assignment (“UQA”) document. The UQA is designed to meet the requirements of IRC Section 130, which is the section that determines what cases qualify for an immediate tax deduction for the payor after making a third party assignment. Among these requirements are:

  • The assignee assumes the liability from a party to the suit or agreement;
  • The payments are fixed and determinable;
  • The payments cannot be accelerated, deferred, increased or decreased, or otherwise changed after the agreement is reached;
  • The assignee's obligation is no greater than that of the assignor;
  • The periodic payments are excludable from the recipient's gross income under Section 104(a)(2), and, for settlement of filed workers compensation claims on or after 8/5/97, Section 104(a)(1);
  • The injury must be a physical sickness or injury;
  • A qualified funding asset must be purchased.

The UQA identifies the parties involved and makes clear the schedule of future payments required by the claimant in the form of an addendum. Once the UQA is signed by both parties the claimant agrees to release the original defendant from further liability. After paying the agreed premium to the assignment company, the defendant is released from the claim and it can take a tax deduction for the payment and go about its business without the burden of the liability for future payments.  

In order to implement qualified assignments, insurance companies participating in the structured settlement market set up assignment companies that will accept the assignment and subsequently purchase the annuity. Usually these companies do nothing but assume the obligations of defendants and hold qualified funding assets. The assignment company is typically associated with the issuing life insurance company. A structured settlement annuity is purchased from the related life insurance company as a qualified funding asset.  The assignment company, not the payee, then owns the contract for the duration of the contractual period.

Qualified assignments are an integral part of a structured settlement and thus should always be reviewed by experts to ensure proper execution.

Structured Settlements and Special Needs Trusts

It is not uncommon for settlement recipients to have lost their primary source of income due to their injuries and be facing a horizon full of future medical expenses. Settlement proceeds are rarely enough to meet these future needs, especially after reducing the settlement for attorney fees, costs, and liens. As a result, many injured clients must rely on government assistance in the form of Medicaid, Supplemental Security Income (SSI), or other federal/state/community assistance programs to pay for medical and other basic living costs.

Many of these government benefits, such as Medicaid and SSI, are considered “needs-based,” meaning eligibility is based in part on the recipient’s financial need. Each state has specific eligibility requirements, but as a general rule an individual cannot have more than a minimal amount of “countable assets” and cannot receive income in excess of a designated amount. These asset and income limits are usually shockingly low and most personal injury settlements, if disbursed directly to the client, will render the client ineligible for these government benefits. Even avoiding a lump-sum amount by electing to have structured settlement annuity payments can still surpass the income limits.

One of the best ways to allow for a settlement recipient to receive their settlement while still maintaining their needs-based public benefits is to use a special needs trust sometimes also called a supplemental needs trust..

What is a special needs trust?

Special needs trusts, codified under 42 U.S.C. § 1396p(d)(4)(A) and (C), can be established to allow an individual to qualify for federal needs-based public benefits while still receiving the settlement. The net settlement recovery that otherwise would disqualify the injury victim for needs-based public benefits can instead be paid  directly to a special needs trust. The assets in special needs trusts are not considered “countable assets” and the investment income is not counted unless disbursed for anything other than a “supplemental need.” In general, disbursements cannot be made for food and shelter, but can be made for a wide range of goods and services that enhance the injury victim’s quality of life and provide for needs that are not covered by Medicaid. Although Medicaid is paid by the Federal government, it is administered by the states, and each state’s rules are a little different.  

There are two main types of special needs trusts that are generally used by settling injury victims and each has unique requirements and characteristics. The first is typically referred to as a “self-settled” or (d)(4)(A) trust. The second is referred to as a “Pooled Trust” or (d)(4)(C) trust. A self-settled trust requires the client to be under age 65, and the trust must contain a payback provision upon the death of the beneficiary for benefits paid by Medicaid. A pooled trust can be established for clients of any age and does not contain a mandatory payback provision, but must be established and managed by a nonprofit institution. Special needs trust planning is becoming increasingly complex, and deciding which type of special needs trust is best for each client is a decision best left to a qualified special needs or elder law attorney.

How can structured settlements help?

One of the issues with using trusts in general is that the principal amount placed inside the trust is not guaranteed and could lose value. Special needs trusts are likely to be invested more conservatively than most, but some risk still remains. In addition, any interest earned inside the trust is fully taxable. These drawbacks (investment risk and tax liability) can be mitigated by funding them in part with structured settlement annuities established to pay into the special needs trust. Structuring future payments into a special needs trust allows the client the peace offered by a guaranteed, fixed, tax-free annuity, while the trust allows the client to keep their needs-based government benefits and offers the flexibility and liquidity to meet the client’s ever-changing life situation. However, the structured settlement cannot be designed in such a way to thwart Medicaid’s right of recovery following the death of the beneficiary of the special needs trust.

MSA’s and Structured Settlements

Medicare’s interest need to be considered any time that future medical benefits from Worker’s Compensation are being settled. The same now holds true for settlement of third-party liability claims. If Medicare’s interest is not considered, stiff penalties can follow to the liability insurer, plaintiff attorney and the client could jeopardize future access to Medicare.

The Centers for Medicare and Medicaid Services (CMS), the federal agency that administers Medicare, has the responsibility to recover monies from past overpayments and to ensure that future medical benefits are paid by the primary payer (liability insurers, Worker’s Comp, self-insureds, judgments, settlements, compromises, etc,) and not shifted to Medicare.

If Medicare erroneously pays a claim that should have been paid by the primary payer in a liability or WC case and finds that their interest was not properly considered, the penalty can be double the damages incurred by Medicare, and the injured party could lose their future Medicare benefits (42 C.F.R. 411.24(c)(2)).  CMS is also authorized to recover not only from the claimant, but from the claimant’s attorney, the fees paid, as well as payments made to medical providers, private insurers, or any other party receiving a payment from the case, including experts who may have paid (42 C.F.R. 411.24(g)).

Therefore, if the primary payer is settling claims that involve future medical benefits for a “qualified” injured party, an allocation to a Medicare Set Aside (MSA) account is worth serious consideration by all involved parties. For Worker’s Compensation cases, an injured party is considered “qualified” if he/she is currently on Medicare (through Social Security Disability or retirement), or if there is reasonable expectation that the injured party is going to be on Medicare within 30 months of settlement and the amount of settlement is $250,000 or more. While as of the date of this article, At present, there has been little guidance with regard to the specific circumstances that require an MSA with regard to third-party liability claims and some regional offices of CMS are not yet requiring an MSA allocation in third party liability cases, the statute referenced above gives CMS the authority to do so. Therefore, we suggest that attorneys retain qualified experts that are up to date on the latest developments on this issue. The plaintiff attorney and the claimant each have duties to protect Medicare’s interest with regard to settlements involving future injury-related medical payments and MSAs are often used when meeting that duty.

The components and requirements for creating and funding an MSA are, unsurprisingly, very detailed, and require expertise and medical proficiencies that attorneys rarely possess, and generally don’t have the time to develop. If an MSA is to be established as part of a settlement, the parties should all be aware that it is highly unlikely that any funds used to fund that MSA will not directly benefit the injured party since they only pay for future care that Medicare would have otherwise paid. Therefore, it is in all parties best interest that the amount of funding be the lowest amount that would reasonably meet the legal obligation.

One way to reduce the funds that are placed into an MSA is by using a qualified structured settlement. Structured settlement annuities allow the future expenses to be discounted to the cost of buying a structured settlement that will pay the projected future injury-related costs. This often yields a very substantial discount from the amount that must be allocated to the MSA.  Make certain that their MSA professionals are taking advantage of this opportunity.

Structured Settlement Annuity Providers