Attorney Settlement Planning FAQ
A structured settlement is simply a future periodic payment arrangement that is made a part of a personal injury settlement. Under Section 104(a)(2) of the Internal Revenue Code, all of the future periodic payments are completely tax-free to the injury victim even though the payments include interest they earn. The structured settlement is spendthrift as it can’t be accelerated, invaded or sold. Fixed annuities are used as the funding mechanism for a structured settlement. These annuities are offered by large well capitalized life insurance companies. Annuities are used because of their flexibility and because many different payments options are available for the injury victim to meet their needs.
While the transaction and the concept might seem very simple, there are many issues that trial lawyers should be aware of as well as concerned about. If you review the sections in this part of the site it will give you a good idea of the issues and also why it is important to have your own settlement planner looking out for these issues.
Constructive receipt is a tax doctrine that says even though a taxpayer might not have actual possession of money, they have constructively received the money if it has been set aside, credited to an account or otherwise is available without limitation to the taxpayer. Money held in a plaintiff attorney’s trust account that belongs to the personal injury victim is constructively received for tax purposes. This concept is important because once triggered; the plaintiff forever loses the ability to structure his or her settlement and possibly could lose public benefits.
Understanding the Transaction
In order to have a tax-free structured settlement in a personal injury settlement, a release with the required language for a structured settlement must be executed, a uniform qualified assignment must be executed and the structured settlement annuity must be funded by the defendant with a check made payable to the assignment company. The premium which goes from the defendant to the assignment company is used to purchase the qualified funding asset (the annuity contract) from the annuity issuer. The assignment company is the obligor (owes the payments to the injury victim) and the annuity issuer (the life insurance company) guarantees the payments. The release must set forth the obligation of the defendant to make the future periodic payments and then that obligation is assigned to the assignment company relieving the defendant of any future liability or obligation. The qualified assignment is the document that transfers the future periodic payment obligation from the defendant to the assignment company and is a required document in the transaction.
Reducing Default Risk
The only major risk an injury victim takes when entering into a structured settlement is the solvency of the company selected to provide the future periodic payments. However, this is a relatively small risk given the financial size of the major life insurance companies that provide structured settlement annuities. Nevertheless, when a “substantial” structured settlement is done one must always consider split funding the structured settlement with multiple companies to spread out the risk. The premium can be spread out amongst as many different companies as the client would like. However, if the case involves a rated age it may be detrimental to the client to split fund. This issue must be examined on a case by case basis.
In addition, when a structured settlement is done secured creditor status can be requested. This is accomplished by doing a special kind of assignment document called a Uniform Qualified Assignment Release and Pledge Agreement. This gives the injury victim secured creditor status which means in the event of the insolvency of a life insurance company they would stand in line only behind the government as a creditor. It moves them to the front of the line.
Explanation of State Insurance Guaranty Associations
According the National Organization of Life and Health Insurance Guaranty Associations (NOLHGA):
“What is a life & health insurance guaranty association?
Life & health insurance guaranty associations were created to protect state residents who are policyholders and beneficiaries of policies issued by a life or health insurance company that has gone out of business. All 50 states, the District of Columbia, and Puerto Rico have life and health insurance guaranty associations.
All insurance companies (with limited exceptions) licensed to write life and health insurance or annuities in a state are required to be members of the state’s life and health insurance guaranty association. If a member company becomes insolvent (goes out of business), the state guaranty association obtains money to continue coverage and pay claims from member insurance companies writing the same line or lines of insurance as the insolvent company.”
Substandard Age Ratings
You may have heard of “Substandard Age Ratings” or “Rated Ages” if you have had a case where the injury victim had a reduced life expectancy and a structured settlement was offered to settle the claim. A “rated age” is a life expectancy adjusted age used to calculate the cost of a structured settlement. If a person receives a rated age it means that the life insurance company has decided that the person’s life expectancy is less than normal. The shortened life expectancy results in a lower structured settlement cost for the same benefit stream when compared to the cost for a person with a normal life expectancy. For example, a case we consulted on involved a two year old brain injured girl who had a rated age of sixty-four. Therefore, a life annuity, the most common funding vehicle for a structured settlement, is priced as if the plaintiff is chronologically age sixty-four. This results in a significant cost savings on the price of the life annuity.
A structured settlement consultant obtains rated ages by sending the plaintiff’s medical records to the life insurance companies that are in the structured settlement market. Usually, a consultant will send out at the most fifteen to twenty pages of records indicating any pertinent diagnosis and current medical conditions. A life company physician or medical underwriter determines the rated age after reviewing the records provided to them. I have heard many times from attorneys that none of the plaintiff’s physicians say she has a reduced life expectancy so don’t bother getting rated ages. Just because a doctor does not comment on reduced life expectancy or states there is no reduced life expectancy, does not mean there will be no rated age. While what the doctors say carries weight, the ultimate decision on whether to issue a rated age rests with the life insurance company. In most cases, the life insurance company will issue a rated age if certain medical conditions are present.
Physicians’ and Medical Underwriters’ rated age assessments can vary greatly among life insurance companies since they are based upon an examiner’s opinion and opinions among examiners will differ. For example, in the case mentioned above involving the two year old brain injured girl, we obtained rated ages with the highest being sixty-four and the lowest being twelve. The fifty-two year difference in the rated age makes a tremendous difference in the ultimate benefits to the victim. Even the thirteen year difference between the highest rated age of sixty-four and the second highest rated age of fifty-one makes a significant difference. In the case involving the brain injured minor, Pacific Life had the highest rated age and New York Life had the second highest rated age. A.M. Best rates both Pacific Life and New York Life A++ so they were both highly rated life insurance companies. The structured settlement consultant working for the defendant was not approved to represent Pacific Life. If we had not been involved in the case the defense consultant would have quoted New York Life and would not have gotten a rated age from Pacific Life. If the victim did not know about Pacific Life she would have lost a substantial amount of money.
How much would she have lost? If the rated age of fifty-one is used the plaintiff has lost $514,938 over the guarantee period and $2,439,987 over the expected period. As you can see even a relatively small variation in rated ages, such as thirteen years, can have a profound impact on a case. To add another layer of complexity, you must then compare all of the rated ages with each particular life insurance company’s rates to determine the best possible deal. It is very important that you have all of the facts when a rated age is involved.
The two main determinants of the price of a structured settlement annuity are rated ages and annuity rates (pricing). To figure out the best possible solution using a structured settlement you must compare the rated ages with the annuity rates. Annuity rates vary depending on how aggressively a life insurance company is going after business and on market conditions. Most life insurance companies offer what is called daily rates (special pricing) if the premium is $250,000.00 or more.
As an example, take the case of Ed. His highest rated age was from Allstate at fifty-three and $1,000 per month for life with a twenty year guarantee had a cost of $183,812. The second highest rated age at 38 was from Prudential and the same benefits had a cost of $202,374. Mass Mutual had the third highest at 35 and the same benefits had a cost of $212,358. Interestingly though the fourth best price was from Met which had one of the lowest age ratings at 14 but a cost of $216,314 which was lower than quite a few companies that had better age ratings. In some cases the highest age rating may not yield the lowest price as it normally does thus a complete market survey must be done to get the best possible deal for the injury victim.
Estate Taxes and Estate Planning Commutation Riders
Structured settlement annuities while income tax free are not free from estate taxes. The present value of the remaining guaranteed payments are includable in the estate for estate tax purposes. The estate taxes are due within nine months of death. How will the estate tax be paid if a structured settlement is established which provides only monthly income even after the plaintiff dies? Life insurance could be used except for the fact that most catastrophically injured victims are uninsurable due to their medical problems.
There is a solution to this problem and it is called an Estate Planning Commutation Rider. This rider provides that at death a certain percentage (up to 100%) of the remaining guaranteed structured settlement payments are commuted to a lump sum of cash. The rider can be added to any structured settlement annuity and is offered by all of the life insurance companies that provide structured settlements. There is no cost for this rider but it must be done at the time of settlement. The only thing that is required is that the settlement paperwork reflects that this rider is to be implemented at death.
The key issue is determining the commutation percentage. Your settlement planner should hire an accounting firm to determine the potential estate tax. The accountant should always be asked to determine the largest potential estate tax, which would occur if the plaintiff died in the first year of the annuity. That way you can commute enough of the annuity to cash to cover a worse case scenario. It certainly does no harm to commute too much. However, if too little is commuted that could cause an immense liquidity problem. Once you know the worse case scenario estate tax liability, you can then determine the commutation percentage.
IRC 5891 (Commutation)
Section 5891 of the Internal Revenue Code regulates factoring transactions (selling annuity payments) or commutation (turning annuity payments into a lump sum immediate payment). Any company that does not comply with 5891 gets hit with a 40% excise tax on the transaction. A court must make a finding that it is in the best interest of the annuitant to sell/commute the annuity payments. If the factoring transaction or commutation is allowed there are no adverse tax consequences for any of the parties. Because of the way 5891 was written, if a life insurance company is provided with a qualifying order under 5891 they themselves can commute the annuity to a single lump sum payment. Some life insurance companies may do this at the rate they normally charge when an estate planning commutation rider is used which is 6 – 7%.
5891 is an important addition to the law because it gives structured settlement recipients some flexibility. If there is a large future medical need that arises suddenly they can request a commutation under IRC Section 5891. If unforeseen financial circumstances arise, they can pursue the 5891 option. Finally, on structured settlements that were done without an estate planning rider, they can use 5891 to provide sufficient liquidity to take care of estate taxes.
Please check back soon for the full text of IRC 5891 (Commutation).
Most states also have state laws that protect structured settlements recipients in the event of a sale of some or all of the future periodic payments. You should check your state law to see if there is a state structured settlement protection act.
Qualified Settlement Funds
Qualified Settlement Funds grew out of Internal Revenue Code Section 468B. 468B was passed by Congress in 1986 and created Designated Settlement Funds (“DSF”). The DSF was fairly limited in the way it could be utilized and in 1994 passed regulations creating a new type of fund, Qualified Settlement Funds (“QSF”). The DSF and QSF were created for use in mass tort litigation enabling a defendant to settle a claim by depositing money into a central fund that could then settle with each individual plaintiff. The defendant could walk away from the fund after its creation and funding taking a deduction for the entire settlement amount in the year it was deposited into the fund. However, the QSF is not limited to situations involving mass torts. A Qualified Settlement Fund can be used to settle cases of any value involving multiple plaintiffs including cases involving the personal injury victim with a derivatively injured spouse, child or parent. It can arguably be used in single plaintiff cases based upon the plain language of the Treasury Regulations.
Using a 468B Qualified Settlement Fund settlement proceeds can be placed into a QSF trust preserving the right to do a structured settlement and protecting public benefit eligibility temporarily. While the money is in the QSF, a financial settlement plan can be designed and liens can be negotiated. Additionally, if the settlement recipient is on public benefits the QSF avoids issues with constructive receipt of the settlement, which could trigger a loss of public benefits. While the funds are in the QSF, there is time to create a public benefit preservation trusts for the settlement recipient. The structured settlement or other financial products can then be set up to work in concert with a special needs trust or Medicare Set Aside so that the injured victim does not lose their public benefits.
IRS Code § 468B and Income Tax Regulations found at § 1.468B control the use of a QSF. These provisions provide that a defendant can make a qualifying payment to the QSF and economic performance would be accomplished, crucial for tax reasons to the defendant. Thus the QSF trustee can receive settlement proceeds allowing the defendant a current year deduction releasing them from the case. The QSF trustee can, after receiving the settlement proceeds, agree to pay a plaintiff future periodic payments, assign that obligation to a third party, and allow the plaintiff to receive tax-free payments under IRC § 104(a)(2) (the provision excluding from gross income periodic payments from a structure). The transaction works exactly the same as it normally would when you have the defendant involved in the structured settlement transaction.
There are only three requirements under 468B to establish a QSF trust. First, the fund must be established pursuant to an order of a court and is subject to the continuing jurisdiction of the court. Second, it must be established to resolve one or more contested claims arising out of a tort. Third, the fund, account, or trust must be a trust under applicable state law. One restriction is that it can’t be used in a Workers’ Compensation case.
Mechanically, it is easy to establish a QSF. First, the court having jurisdiction over the litigation must be petitioned to establish the fund. The court is provided with the fund document and an order to establish the fund. Once the order is signed, the defendant is instructed to make a check payable to the QSF and the defendant is given a cash release in return for the payment. The QSF then can fund a structured settlement, pay liens and fund a special needs trust. Once all funds have been distributed, the fund dissolves.
There are several advantages to utilizing a QSF. First, funding the QSF removes the defendant and defense counsel from the settlement process. It is very much like an all cash settlement in the eyes of the defendant. Once the Trustee receives the settlement money, economic performance has occurred and the defendant is out of the case. Second, the attorney’s fees and other expenses can be paid immediately from the 468B fund. Third, the 468B trust removes the defendant from process of allocating the settlement amounts between the various plaintiffs. Fourth, the plaintiffs receive the interest income from the settlement fund. The plaintiffs can take their time, carefully considering the various financial decisions they must make and addressing public benefit preservation issues. Finally and probably most importantly, the time crunch is alleviated with regards to the lien negotiations, allocations, and probate proceedings.
The end of a personal injury case is typically one big time crunch which I call the “settlement time crunch”. There is enormous pressure to wrap up the case quickly to get the client paid and yourself paid. However, in the rush to finalize the settlement you may overlook or miss important settlement planning issues. Instead, a Qualified Settlement Fund can be created to receive the settlement proceeds thereby giving everyone the time necessary to carefully plan for the future. You can get your fees and costs quickly. The funds are obtained from the defendant, they are released and the client’s settlement dollars can begin to earn interest for them. The liens can be negotiated, allocation decisions can be made, public benefit preservation trusts can be implemented and structured settlements can be considered. Your option to structure your attorney fees is also preserved. The QSF is an important tool for trial lawyers to consider using.
Attorney Fee Structures
A fee structure can help a lawyer avoid the highest tax brackets by leveling off income spikes due to large fees and spreading the income out over several years. An attorney who otherwise would have an unusually high income in the current year, but elects to spread the income over several years, may avoid paying taxes in the highest bracket or at the very least will defer taxation over a number of future years. Couple the tax savings with guaranteed earnings on the deferred funds, and the benefits of an attorney fee structure becomes very obvious. An attorney fee structure allows an attorney to set up a personally tailored retirement plan without the monetary and age restrictions or other drawbacks of a qualified plan.
Structured attorney fees work very much like a non-qualified deferred compensation plan. The taxes that would be otherwise paid on the fee earned at the time the case is settled are deferred, and that money grows without tax on the growth. When distributions are made, the entire amount distributed during a year is taxable for that year. Based upon a taxpayer’s tax bracket, there may be some distinct tax advantages to entering into this type of arrangement as opposed to being taxed on the entire fee in the year it was earned and then investing it after tax.
Fee structures can be done by one attorney in a firm, without the requirement that other attorneys and employees participate, as would be the case in a qualified retirement plan. Also, there is no limit as to the amount of income deferred. By comparison, there are statutory limits to the amount one can defer in a qualified retirement plan. Even if the attorney participates in a qualified retirement plan or individual retirement account (IRA), he or she may still defer additional income through an attorney fee structure. Unlike traditional retirement plans, there is no requirement of annual deferments. An added bonus is that the attorney fee structure annuity has enhanced creditor and judgment protection other investments can’t provide.
In summary, a fee structure allows a plaintiff lawyer to not only defer receipt of (and tax on) his fees until he receives them, he can have the deferred fees invested, and have the income produced from it also taxable over time rather than immediately. A lawyer may want to consider structuring his fees as part of his or her own income tax planning, financial planning, and estate planning.
A SAM planner can assist you and your tax planner to decide if a fee structure is appropriate for you.