Structured settlements: are factoring and commuting different?

• Author: Wood, Robert W.

Claimants in personal injury cases often structure their settlements, choosing periodic payments rather than a lump sum. If claimants who take a structured settlement later realize that they need some or all of the funds earlier than scheduled, they may turn to a factoring company. Factoring occurs under an agreement between the claimant (i.e., the payee) and a third party. The payee usually assigns future payment rights to a factoring company in return for a lump sum. Subsequently, the payer of the annuity continues making periodic payments, but to the factoring company.

Factoring companies are not insurance companies, nor do they issue annuities. However, some insurance companies are entering the factoring business. If an insurance company factors periodic payments under an annuity it issued, this is not factoring, but rather, "commuting."

Commuting is similar to factoring, in that the payee receives a lump sum for giving up future periodic payments. However, in a commutation, the payee is not paid by a third party. From a payee's viewpoint, factoring and commuting both produce cash, but the factual differences are significant. Although these two vehicles may both get cash to the payee, it is unclear whether an insurance company can commute periodic payments under its own annuity policy and still comply with Federal income tax law.

Periodic Payments

A structured settlement begins with a tax-free personal physical injury or workers' compensation recovery. The plaintiff may want a structure to control spending, conserve assets or enhance eligibility for public benefits. Because structuring a settlement also makes otherwise-taxable interest tax free, the tax benefits alone can be enormous.

Mechanically, the defendant assigns its obligation to make periodic payments (a qualified assignment) to a third party (the qualified assignee), by paying it a lump sum. The qualified assignee purchases an annuity to fund the periodic payments, often from a related insurance company. Although the qualified assignee receives a lump sum, this payment is not included in its gross income (up to the purchase price of the funding annuity), provided several requirements are met.

Perhaps most important, under Sec. 130(c)(2)(B), the periodic payments cannot be accelerated, deferred, increased or decreased by the recipient. Settlement agreements and qualified assignment and annuity contracts often contain anti-assignment clauses designed to prohibit payees from...