For nearly fifty years, traditional structured settlements have been extensively employed in physical injury and workers compensation claims. These specialized annuity plans: offer guaranteed future payments, pay benefits free of federal, state and local income taxes and can be tailored in nearly infinite ways to dovetail with the claimant’s future medical and life care needs. Likewise, contingency fee attorneys can employ non-qualified structured settlement plans for significant savings using tax-deferred future payment plans, while providing for their and their family’s own future financial needs.
TAX CONSIDERATIONS
While the guarantees of a traditional structured settlement plan provide valuable security for the claimant, some claimants and their attorneys are savvy enough to allocate their assets from a settlement and fee agreement with slightly more risk/reward. By taking their funds in a cash lump sum at settlement, they can incur significant tax obligations, especially for the attorney.
Likewise, a claimant in an employment case has immediate tax consequences when taking a lump sum at settlement. Like the attorney, the aggrieved employee’s receipt of nonphysical injury settlement funds incurs a present year, income tax obligation. And it is significant in larger settlements!
Until recently, structured settlements were solely backed by US Treasury bonds and high-grade corporate bonds. A frequent criticism over the past ten years in such a low yield bond environment is that the rates of return building up in the structured settlement annuity were too low. Sophisticated claimants and most attorneys desire higher returns in the equity markets – and they want to employ their own financial advisors. Yet, they do not want the added tax hit of taking cash at settlement. Thus, the dilemma. Until now!
Claimants and attorneys can now use the tax benefits of structured settlements and obtain market-based returns. Importantly, they may also continue to employ their own personal financial advisors for managing their investment portfolio within the structured settlement framework.
THE CLAIMANT’S MARKET-BASED ALTERNATIVE
By offering market-based solutions, claimants can obtain tax-free (or, in some cases, tax-deferred) future periodic payments with the potential for higher rates of return. However, the importance of guaranteed payments when developing a sound settlement plan cannot be overstated.
Guaranteed payments are critical in securing the future needs of an injured claimant, especially when planning for future medical and non-discretionary essential life care needs. A traditional fixed annuity-based component should always be the foundation of a comprehensive settlement plan.
But, what about the plaintiff who can afford to take some market risk, has discretionary settlement dollars or turns down the traditional structured settlement in favor of an all-cash settlement? We can keep that conversation going on otherwise all cash settlements. That conversation at mediation can often bridge the gap between the claimant’s best settlement demand and the defendant’s best settlement offer.
Employing an open architecture platform allows the claimant to choose between passive or active investment strategies including model portfolio options through the program’s master custodian or a customized portfolio managed by the claimant’s own personal financial advisor. The claimant can realize tax-free gains utilizing market-based investments inside a tax-advantaged structured settlement. The best of both worlds!
Like a traditional structure, the future periodic payments must be “fixed and determinable” to receive tax-exempt or, in the case of non-physical injury claims, tax-deferred status. Settlement dollars are therefore allocated as $10 units, and the unit value at the time payments are due is determined by the underlying investment performance chosen by the claimant. At the time of the settlement, the claimant must decide how many units are to be paid and when.
Future payments can be made quarterly, semi-annually, annually, in future lump sums or some combination of these options. Although lifetime payments are not available, future payments can be scheduled through a claimant’s normal life expectancy.
As with traditional structured settlements, the defendant and/or its insurer must agree to fund the structure at settlement closing in a separate check to the assignment company, as well as execute a proper settlement agreement and release employing required structure language and an assignment agreement and release freeing the defendant from future payment obligations.
THE ATTORNEY’S MARKET-BASED SOLUTION
In 1996, the 11th Circuit Court of Appeals upheld a US Tax Court decision allowing attorneys to use structured settlements to defer income and recognize future payments in the tax year in which they are received. Attorneys are permitted to take advantage of the tax-deferred savings compared to the likely higher and immediate tax hit when taking their contingency fees in an immediate lump sum at settlement.
Therefore, structured attorney fees have become commonplace. Like claimants’ structured settlements, attorney fee structures have been traditionally funded with fixed annuities from highly-rated life insurers. Benefits of structuring contingent attorney fees include: tax-deferral of lump sum attorney fees, the opportunity for tax-deferred gains (future payments are taxed as ordinary income in the years paid), leveling out income streams for the “up and down” income years, and future payments made before age 59 ½ are not subject to early withdrawal penalties (as can be the case with qualified retirement plans). But, again, the rates of return from these annuity-based attorney structures have been generally conservative. Until now!
Attorneys uninterested in conservative returns from a fixed annuity product now have the option to invest their fees with the potential of market-based rates of return. And, the attorney can avoid an immediate, present year tax consequence – often at the highest tax brackets – by taking advantage of tax-deferred, future periodic payments. As with a traditional structured attorney fee, the future payments must be both “fixed and determinable.” The IRS recently refined the definition of fixed and determinable in a series of private letter rulings. According to two recent decisions by the Service, payment obligations are, fixed when set forth in the terms and provisions of a settlement agreement and determinable when they can be calculated based on an objective formula. Like the claimant’s market-based product, contingent fee dollars are allocated in $10 units, and the unit value at the time payments are due is determined by the underlying investment. At or before the time settlement documents are executed, the attorney determines how many units are to be paid, and when they are to be paid.
Again, payment options include quarterly, semi-annually, annually and lump sums – or a combination thereof. As with traditional structured settlements, the defendant/insurer must agree to fund the upfront (or present value) cost of the structure, then execute a proper release and assignment agreement.
Fees can be invested with the exact risk and return profile desired by the attorney or his/her law firm. In addition to low-cost model portfolios offered thru our program administrator, the attorney has the option to use their own financial advisor allowing their investment to work in conjunction with specific needs and overall wealth management strategy.
SEPARATE RISK CATEGORIES
Allocating a claimant’s settlement funds among separate risk categories is a fundamental principle of wise investment. And doing so represents the evolution of structured settlements. These are invaluable settlement planning tools in resolving the thorniest and largest litigated cases. Moreover, these tools augment the traditional, fixed annuity-based structured settlements when discretionary settlement dollars are available to the claimant.
Each case is different, and a market-based solution is not always appropriate for every claimant. However, when used in combination with a fixed annuity-based and guaranteed future payment plans, a comprehensive settlement plan often makes sense in order to address future medical and life care needs while providing a market-based upside for discretionary settlement dollars. Like a traditional structured settlement, the defendant and/or insurer can resolve difficult cases; obtain a full and final release of future contingent liability; release often-significant reserves, and take advantage of all available immediate tax deductions. Tacker LeCarpentier
