Structured settlements and nonqualified assignments.

• Author: Wood, Robert W.

EXECUTIVE SUMMARY

* Structured settlements and qualified assignments, in widespread use in physical injury cases, facilitate settlement of recoveries excludible from gross income under Secs. 104(a)(2) and 130.

* In nonphysical injury cases, structured settlements, paired with nonqualified assignments, may provide plaintiffs with payment security and tax deferral resulting from periodic payments.

* Plaintiffs may be able to defer income recognition from nonphysical injury recoveries to when the payments are actually received.

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Structured settlements and assignments are commonly used in physical injury cases when the recoveries are excludible from income, but can also be very helpful in nonphysical injury suits. This article describes how such arrangements work and focuses on the ramifications of their use with nonphysical injury recoveries.

In today's increasingly litigious society, recoveries for tort actions stemming from physical injuries frequently eclipse seven figures. Structured settlements are being used in such tort actions in increasing numbers. Of course, most traditional structured settlements involve excludible periodic payments made "on account of personal physical injuries." These traditional settlements are frequently paired with Sec. 130 qualified assignments. However, similar settlements may be used with nonqualified assignments in nonphysical injury cases.

This article discusses the basic characteristics of structured settlements and assignments and focuses on how the emerging use of structured settlement payments, in conjunction with nonqualified assignments outside of the physical injury context, affects a plaintiff's income recognition.

Recent Sec. 104 Cases

Sec. 104(a)(2) provides an exclusion for physical injury recoveries; Sec. 130 provides for qualified assignments of the payment obligation. However, the Sec. 104 exclusion was narrowed considerably by the enactment of the Small Business job Protection Act of 1996 (SBJPA). Thus, one of the reasons for a growing interest in (and a growing need for) structures outside of Sec. 104 cases is that Sec. 104 does not go far enough.

Indeed, in a slew of recent decisions, the Tax Court has continually held sex discrimination recoveries not excludible under Sec. 104(a)(2). (1) Although the facts vary, the ultimate result (and the underlying rationale) has become almost boilerplate. Courts generally cite Schleier (2) for the proposition that, for a recovery to be excludible under Sec. 104(a)(2), the (1) underlying cause of action must be based on tort or tort-type rights; and (2) resulting damages must be recovered on account of personal injuries or sickness. For recoveries after Aug. 20, 1996 (the SBJPA's effective date), the second prong of Schleier requires that the personal injuries or sickness be physical in nature. (3)

In each of these sex discrimination cases, the Tax Court essentially determined that, even if the cause of action was based on tort or tort-type rights, the resulting recovery was not paid on account of personal physical injuries. Accordingly, the recovery was often not excludible from gross income under Sec. 1(14(a)(2), because sex discrimination alone does not constitute a personal physical injury..

The tax consequences of a racial discrimination recovery are not much different in this respect. For example, in Oyelola, (4) the Tax Court held that a taxpayer was not entitled to exclude a racial discrimination recovery, because he failed to prove that the recovery was received on account of personal physical injuries or sickness. The court reached a similar conclusion in Cares. (5)

Wrongful termination recoveries in recent years have followed a similar path. For example, in Tamberella, (6) the Tax Court held that an individual could not exclude the proceeds of a wrongful termination recovery under Sec. 104(a)(2), because he failed to show that any portion of it was received on account of personal physical injuries or sickness.

Structured Settlements

In its purest form, a structured settlement merely calls for periodic payments--payments over time. The use of such payments to compensate victims of personal injuries was not widespread until the late 1970s. The idea that a tort victim would receive a stream of payments payable over his or her life (as opposed to a lump sum) raised a variety of issues, including the appropriate tax treatment of such a payment stream.

The future of structured settlements became more certain after the IRS issued three revenue rulings establishing their tax treatment. (7) The Service clarified that the plaintiff would receive all amounts from a periodic payment settlement free from Federal income tax. These rulings were later codified in amendments to the Code enacted by the Periodic Payment Settlement Act of 1982, providing further impetus for the widespread use of structured settlements. These three fundamentally important rulings involved different facts, but all considered settlement situations of continuing interest.

Qualified Assignments

Having a structured settlement in place does not necessarily mean that the defendant will make each payment. Under a "qualified assignment," for...