Structured Settlements – the Tax and Planning Considerations for Injured and Disabled Clients
 
October 1, 2004
 
Joshua Husbands - Portland
J. Alan "Alan" Jensen- Portland

Engage a special needs planning expert early to preserve eligibility for government benefits.

Personal injury claims for bodily injury, medical malpractice and wrongful death by minors, the elderly and other disabled clients often result in monetary awards in amounts that could cause the claimant’s loss of eligibility for ongoing governmental assistance. Personal injury claim awards and settlements are usually paid to the claimant by the responsible party as a lump sum (one immediate payment) or in periodic payments, or some combination of the two. In either case, the expectation is that the money will be managed to meet long-term needs. A properly structured settlement can offer disabled clients a steady stream of income that is tax free, available regardless of the client’s money management skills, and designed to preserve the client’s eligibility for Social Security and Medicaid benefits.

Because of the need for planning in this area, the federal government has long supported the use of structured settlements. In 1982, Congress enacted The Periodic Payment Settlement Act of 1982,[1] which formally recognized and encouraged the use of structured settlements in physical injury cases. In addition, provisions of the Internal Revenue Code, the Social Security Act, and the Federal Medicaid Program impact these settlements.

Generally, structured settlements are defined as the payment of money for a personal injury claim where at least part of the settlement calls for future payment, which may consist of installment payments and/or future lump sums.[2] For example, there may be a need for a partial payment in a lump sum up front to pay for one-time big-ticket purchases of housing and medical equipment or procedures.[3] Structured settlements are an innovative method of compensating injury victims through a completely voluntary agreement entered into between the injury victim and the defendant. These settlements have attracted strong support from plaintiff’s attorneys, state attorneys general, legislators, judges, and consumer and disability advocates. As indicated, the settlement may be structured as a stream of tax-free payments that may be funded with an annuity, tailored to meet future medical expenses and basic living needs, and usually involves setting up a trust carefully drafted to comply with myriad complex tax rules and regulations. Once the decision is made to receive a structured settlement, it is irrevocable.

Prior to structuring any settlement and establishing an estate plan, many plaintiff attorneys and estate planners favor the creation of a Qualified Settlement Trust (QST). QSTs became available in 1986 with the adoption of Section 468B of the IRC. Advantages of QSTs or 468B Trusts include avoiding the constructive receipt of the court judgment or settlement and allowing time to negotiate the resolution of medical liens and other expenses against the settlement. The fund which is created by court order can be for one person or many plaintiffs. They are particularly advantages in multiple plaintiff suits where plaintiffs and defendants have agreed on a total settlement but not on individual payments. In these instances, the defendant benefits by accelerating its deduction to the time of the creation of the QST instead of waiting until each individual sum is distributed. A planning advantage for plaintiffs includes allowing additional time to create Supplemental Needs Trusts in order to preserve Medicaid and Supplemental Security Income (SSI) for existing or continuing medical and personal needs.

Funding and Tax Consequences

Under a typical settlement agreement, the defendant’s liability insurance carrier agrees to provide funds to purchase an annuity from a life insurance company. The life insurance company becomes the assignee of the defendant’s insurance company’s obligation to make settlement payments to the defendant during his or her lifetime. Annuities offer the disabled client flexibility in meeting living and medical needs, and can be tied to the individual’s life expectancy in an effort to provide the best deal for all parties.[4]

A qualified assignment permits the assignee life insurance company to avoid the recognition of the lump sum payment for the annuity as income until it receives the annuity payments, at which time it makes the periodic payment to the plaintiff, which gives the life insurance company a corresponding offsetting deduction for the amount of the annuity payment.[5] The annuity produces a stream of periodic payments to the plaintiff, which are excluded from the plaintiff’s gross income under the Periodic Payment Settlement Act.[6] Note that in general settlement proceeds received for personal physical injuries or sickness in lump sum or periodic payments are excluded from gross income; but the interest earned on the recovery is included in gross income. When, however, personal injury awards are allocated under a properly structured settlement, the interest portion also is excluded from taxation because it is considered part of the settlement amount, rather than interest per se.[7] Proper structure includes ensuring that the taxpayer (1) does not own the annuity, (2) does not have a right to accelerate payments, and (3) does not have any future payments that are unsecured. If the plaintiff dies during the annuity term, the payments are paid to his or her estate and also are excludable from income tax.

It also is important that a trust be funded with a qualified funding asset, which is defined as an annuity contract issued by a licensed insurance company or an obligation of the United States.[8] The annuity or obligation must be purchased not more than 60 days prior to nor 60 days after the date of the qualified assignment.[9]

Further, to get the tax benefits, it is critical that the plaintiff does not have actual or constructive receipt of the funds.[10] To avoid constructive receipt, the settlement agreement should require the defendant to purchase the annuity, with the ownership held in the name of a third party, usually the qualified assignee. The plaintiff cannot have the power to exercise ownership rights over the policy (for example, it cannot change the beneficiary, assign it or accelerate payments). Further, the remaining payments must be unsecured. Typically, the structured settlement agreement provides that the payment recipient is the trustee of a special needs trust.

Win-Win Environment

For the disabled client, a structured settlement offers several benefits, including the income tax benefits discussed above. Such a settlement arrangement can also preserve the client’s eligibility for important government benefits. In addition, periodic payments can spell better financial security, with a guaranteed income stream for a term of years or the entire life of the plantiff and professional management of the assets. By ensuring a certain stream of income for living and medical expenses, the client who is unsophisticated in investing or preoccupied with meeting care needs is assured that he or she will continue to receive a periodic income amount despite adverse changes in economic conditions—either the client’s or the defendant’s.

For the defendant and its liability insurance carrier, the involvement of insurance and similar experts making an independent, professional assessment of the plaintiff’s medical needs, condition and life expectancy can be advantageous. A structured settlement specialist can assist in funding the defendant’s obligation with an annuity product that is optimally advantageous from an economic standpoint. At the close of a qualified assignment and settlement transaction, the defendant and its carrier are off the hook for the obligation. The federal tax code has made these arrangements palatable to defendants from a tax standpoint.[11]

Preserving Social Security Income and Medicaid Eligibility

Under applicable federal and state law, if a person who has established or is attempting to establish eligibility for certain benefits (including Social Security income and Medicaid) receives more than $2,000 of assets, that person can lose his or her eligibility for continued benefits. This can be the effect of the proceeds of a judgment or settlement in a tort case being paid to a person who may have waited years for completion of the legal proceedings. This result can be avoided by involving a special needs planning expert early in the settlement process.

Establishing a Special Needs or Supplemental Needs Trust that meets the requirements of federal law[12] and funding it with the court awarded or settlement proceeds can preserve the disabled claimant’s eligibility for SSI and Medicaid. The only types of self-funded disability trusts clearly sanctioned under federal law are so called “D4A” trusts, so named because of the law under which they are recognized.[13] The public policy objective is to permit a person to qualify for or maintain government benefits, while allowing trust funds to be used to supplement but not replace those benefits. Supplemental benefits may include special medications, educational programs, transportation, telephone charges and personal items and services—anything in addition to basic food, clothing or shelter, which can enhance the person’s quality of life. These trusts cannot be created by the disabled person, although he or she is treated as the grantor of the trust for income tax purposes. Thus, the D4A trust is often created by court order in the context of a personal injury or malpractice settlement. Depending on the circumstances, for example, whether the client is receiving Medicaid or SSI benefits, it may be prudent to obtain the approval of the appropriate government agency.

For example, an SSI beneficiary, who is also receiving Medicaid health benefits, is involved in a car accident. A third party’s creation of a D4A trust can protect the SSI and Medicaid benefits. Thus, the parties’ agreement to settle the litigation would include a provision that the net proceeds will be held in a D4A trust, and the court order would include a provision for creating that trust. In the case of a settlement where no civil suit has been filed, the plaintiff’s attorney must coordinate a post-settlement suit and file the settlement agreement with a copy of the trust in seeking court approval. In some jurisdictions, the court will allow the filing of the suit, a hearing on the complaint, and approval of the settlement within the same day. Any court order should also include any special provisions required by the structured settlement life insurance company.[14]

As indicated above, the D4A trust must strictly comply with the law and otherwise meet the qualifying criteria. If a Medicaid or SSI applicant/recipient is the grantor and beneficiary of a trust, the principal and income are considered available resources unless the trust is a D4A trust. For example, A establishes a fully discretionary trust for his own benefit, which is not a D4A trust. The assets of this trust will be fully counted in determining his eligibility for Medicaid because it was created by the beneficiary himself, is not limited to supplemental benefits, and has no payback provision. Two key provisions included in the D4A trust are (1) payment of the beneficiary’s taxes directly to the government and (2) repayment to the state Medicaid agency of amounts paid for government benefits for the beneficiary during the beneficiary’s life (the so-called “payback provision”).

Conclusion and Outlook for the Future

The structured settlement is a valuable litigation and estate planning tool in the context of personal injury claims for the disabled. In conjunction with the use of qualified annuities and special needs trusts, these settlements offer benefits to both parties. Estate planning attorneys should be aware of the availability of these settlement arrangements and the rules and regulations applicable to them when representing disabled clients.

For more information, contact Sandra Sheets at sandra.sheets@hklaw.com, David Correira at david.correira@hklaw.com, Joshua Husbands at joshua.husbands@hklaw.com or J. Alan Jensen at jajensen@hklaw.com or call toll free 1-888-688-8500.

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1. Pub.L. 97-473.

2 See The National Structured Settlement Trade Association web site at www.nssta.com.

3 See Jeffreys, J., What Every Elder Law Attorney Should Know About Structured Settlements, The ElderLaw Report vol. XIV, no. 10 at p. 3 (May 2003).

4 ^{See Jeffreys at p.2.}

5 See I.R.C. § 130; 26 US.C.A § 130 (1998 & Supp. 2000).

6 See id. §§ 130, 104(a)(2).

7 See id. § 130.

8 See id.

9 Id.

10 ^{Rev. Rul. 79-220.}

11 See supra, p.3.

12 See 42 U.S.C. 1396p(d)(4)(A) or (C). OBRA 93’ (d)(4)(A).

13 See id.

14 See infra, text accompanying n.7.