Structured settlements are a popular option for many injury plaintiffs who have been successful in their lawsuits or settlement negotiations. A structured settlement offers plaintiffs a guaranteed annuity over a certain time period, thus allowing plaintiffs to be able to rely on a stable supplement to their income for well into the future. One of the reasons many plaintiffs choose structured settlements is because of their significant tax benefits. In personal injury cases, for example, structured settlements are largely tax-free. However, while it is true that structured settlements can protect plaintiffs from most tax penalties, it is important to realize that the tax rules surrounding such settlements can be quite complex.
How do structured settlements work?
Very few lawsuits actually make it to trial. Instead, both parties typically reached a negotiated settlement before litigation becomes necessary. In almost all cases, a negotiated settlement consists of the defendant offering the plaintiff financial compensation in exchange for the plaintiff agreeing to cease pursuing his or her lawsuit. The plaintiff can usually choose to accept this financial compensation as a one-time lump sum payment or as a structured settlement. Structured settlements are paid out over an extended period of time and tend to be highly flexible in how they are structured. Furthermore, rather than the defendant giving the money directly to the plaintiff, an annuity policy is set up through a life insurance company. The defendant pays the money to the life insurance company (or its subsidiary) and the insurer, in turn, will pay the plaintiff.
Tax benefits of structured settlements
While such a structure may sound arcane and convoluted, it does have significant tax benefits. Section 104(a)(2) of the federal Internal Revenue Code exempts damages paid out on a personal injury or wrongful death claim from being considered as income for federal tax purposes. While this exemption applies to both lump sum and structured settlements, with lump sum settlements plaintiffs will still have to pay taxes on interest and dividends earned from their settlement. Structured settlements, in contrast, are exempt from taxes on interest, dividends, capital gains, as well as from the Alternative Minimum Tax (AMT).
There are, however, some exceptions to this rule. While personal injury damages that are compensatory in nature–such as compensation for the pain and suffering that resulted from an accident–are exempt from federal and state taxes, the same cannot be said of all damages that may be awarded to a plaintiff. Punitive damages, for example, are not compensatory in nature; rather, they are designed to punish the defendant for his or her reckless or negligent behavior. As such, punitive damages are taxable. Other damages, such as damages awarded due to slander, discrimination, and breach of contract, are also taxable in many cases.
Of course, the above is just a broad outline of how structured settlements are treated under the U.S. tax code. While it is true that structured settlements, particularly in personal injury cases, have significant tax benefits, there are instances where a plaintiff could still find him or herself paying state or federal taxes on a structured settlement. Before accepting any structured settlement plaintiffs should talk to a qualified tax attorney.