Income Tax

Settlement recoveries arising from compensatory damages for personal physical injuries are income tax free. IRC Section 104(a)(2) states in part:

This income tax-exemption is a much needed break for personal injury victims - most of whom have endured severe injuries followed by years of grueling litigation. Additionally, if the injured party decides to utilize a qualified structured settlement annuity with all or a portion of their settlement recovery, the interest earned on that qualified structured settlement annuity is income tax-exempt as well.

Taxable Damages

In cases in which a settlement or judgment is reached and the origin of the claim is not 100% personal physical injury (punitive damages, bad faith, construction defect, etc), that portion not derived from the injury claim does not qualify under IRC Section 104(a)(2) and is taxable to the claimant in the year received.

This presents a unique opportunity in which settlement planners can offer solutions potentially yielding claimants considerable amounts of tax savings. By spreading payments over a number of years in lieu of receiving a lump sum payment in year one, a claimant may face lower marginal tax rates when the money is received.

Likewise, if the claimants attorney decides to spread his/her fee over a number of years, it may reduce the claimants tax liability in year one and prevent triggering the alternative minimum tax.

Estate Tax

Many structured settlement annuities include payments streams that may outlast the life of an injury victim. This can occur if a period certain is used or where payments are made over the lifetime of an injury victim with a guaranteed minimum number of payments. The guaranteed portion of these future payments, while income tax exempt, is not estate tax exempt. Upon an injury victim's death, the present value of any remaining payments in a structured settlement annuity is included in the gross estate of the decedent. IRC Section 2039 states in part:

This can cause a liquidity problem for the claimant's family and a potential malpractice trap for plaintiff attorneys if the structured settlement does not include a commutation provision. Commutation riders allow the family of an injury victim to receive a cash settlement from the annuity provider instead of awaiting future payments, providing funds to pay the estate taxes.

While this particular scenario applies only to large cases with significant annuity guarantee periods, a much more common scenario exists when the decedent's estate simply needs liquidity to fund funeral expenses, pay executors, etc. Claimants and their attorneys need to utilize a settlement planner who understands the estate tax and liquidity issues these annuities may present.

Special Needs Trusts (SNT)

Many of the government programs that provide financial assistance with medical services or monthly income are means tested - such as Medicaid. Settlements can present problems in this regard because a large cash settlement is likely to disrupt eligibility for these benefits.

Social Security income and Medicaid are primary concerns in the settlement planning process. Social Security is widely considered an entitlement and the retention of Medicaid can result in a great deal of cost savings to an injured client over the course of his/her lifetime. A Special Needs Trust (SNT) can be used alone, or in conjunction with a settlement annuity in order to circumvent the eligibility pitfalls related to these programs.

An SNT allows an individual with disabilities to have both the benefit of a settlement award and still retain means tested government benefits. The term "Special Needs Trust" commonly refers to the type of custom-drafted disability trust established under sub section (d)(4)(A) of the Federal statute that authorizes such trusts (42 U.S.C. §1396p).

Medicare Set Aside Trusts (MSAT)

An MSAT can be a valuable planning tool for clients who are currently on, or who will soon be receiving Medicare benefits. Claimants and, perhaps more importantly, plaintiff attorneys need to be aware that when settling future medical benefits from Worker's Compensation or a liability carrier/self-insured entity, if Medicare's interests are not considered and protected by establishing an MSAT, stiff penalties can follow.

Settlement planners are well-versed in both Special Needs Trusts and Medicare Set Aside Trusts. Your planner should have the ability to evaluate the need and appropriateness of both SNT's and MSAT's and help you navigate the confusing government entitlement waters.

The following are means tested programs that may be lost at settlement with imprudent planning:

• Medicaid
• Supplemental Security Income (SSI)
• Food Stamps
• Qualified Medicare Beneficiary (QMB)
• Adult Day Care Centers
• Mental Health & Mental Retardation Centers (MHMR)

The following websites may be useful resources:

Please note that the websites listed below are independently maintained and do not represent the views of the Society of Settlement Planners. The SSP makes no warranties and takes no responsibility for the advice or representations of such websites.

Incapacitated or specially challenged people often require sophisticated settlement planning to ensure they do not lose the government entitlements they desperately need. Their plan also needs to leave them flexibility to handle unexpected future expenses and replace their lost income. A well-designed settlement plan can address all of these issues.

A "Qualified Settlement Fund" is a unique settlement planning tool. From billion-dollar mass torts to small claims with one claimant, qualified settlement funds have become an indispensable financial and tax-planning tool for settling a variety of injury and taxable damages claims.

Created by IRC Section 468B, a QSF is treated as a "party to the suit or agreement" and allows a defendant or its insurer to settle one or more claims by agreeing to pay a cash settlement into the fund. The defendant can release its liability and receive a tax deduction for the full amount paid, just as it would with any cash settlement.