Structured Settlement Payments Sales and Taxes

There are a number of different sources of structured settlement payments all the way from insurance claims for injury or damage to personal property to winning the lottery.  But all of them are structured in similar payout fashion.  There will be notice if the payouts are taxable or not.

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The payments are called a structured settlement because they are scheduled in an organized system of periodic, equal disbursements, either monthly or once yearly, until the entire value of the original settlement is paid out.  The amount of each periodic payment will run the duration of payments.  

For example, if a structured settlement awards $500,000 to an injured party, the insurance company may offer a structured settlement of that amount to be paid out in increments of $4,000 per month for 125 months, or a little over 10 years.  

The frequency of payments over time is usually preferred by most payers simply because a single, lump-sum payment of a settlement would be nearly impossible without severely impacting the company’s ability to stay in business considering that insurance companies, the typical payer of structured settlements, may have multiple concurrent structured settlements paying out.  If it were necessary to pay out on multiple lump-sum payments, it might ruin the company, leaving every payee with a settlement, but no payments.

Both parties, the payer and payee, will agree on the terms with a signed contract.

Since both parties are bound by the contract, unless modified in court if the payer defaults on payment, the payee may file a lawsuit to obtain the contracted payments, just as a mortgage payment default will permit the lender to seek legal action against the homebuyer.

However, at any time during the payout schedule, as long as there is still value in the settlement if the payee has encountered a financial crisis of a nature requiring a large payment, more than his monthly income, including the structured settlement payment, will cover, the payee may seek to sell a portion or all of the remaining settlement payment in a lump-sum.  

The payee is legally allowed to request a sale, but the court must contemplate on the issue and pass judgment.  If the justification for the request bears scrutiny by the judge, the sale may be approved by the court.  If approved, the lump-sum payout may also have tax ramifications.

Structured Settlement Payments and Taxes

If the original structured settlement payments were taxable, then probably the sale of the structured settlement will also be taxable.  Conversely, if the original settlement payments are tax-free, the

Sale disbursement will also be tax-free.  The contract for the structured settlement will clearly define whether the payments are taxable or not.

Generally, the payments of structured settlements are tax-free if they are payments due to personal injury because the payments qualify as such under section 103 of the Internal Revenue Code.  This is reiterated in the code under section 1045(a)(2) that confirms that payments received for personal injury are not taxable because these payments are not considered income.

These codes covered the payments of structured settlements, but until 2002, the sale of structured settlements were still considered taxable until Congress passed legislation, section 5891 of the Internal Revenue Code, which then considered structured settlement sale proceeds as not taxable if the original payments were not taxable.  This section also stipulated that the sale of a structured settlement must be approved by a court.

Because of the complications of structured settlement payouts and regulations of the tax code, it is recommended that professional or legal counsel be sought to understand the specifics of any structured settlement.

 Author: John Chan