What It Is and How It Works
Understanding what structured settlements are and whether you can benefit from them
Structured Settlement Definition
Basically, a structured settlement (SS) is a financial instrument that takes a lump sum of money that was awarded to a plaintiff (usually in a personal injury case) and organizes it into a series of regular payments over an agreed period of time or for the plaintiff’s lifetime. The specifics regarding the dollar amount of each payment, the number of payments per year and the number of years for which the payments will be made is set out in the SS agreement. This agreement is essentially a special type of annuity that is purchased by the defendant / insurance company, and as such, they are often referred to as Structured Settlement Annuities.
When a personal injury claimant receives an award, there are normally 3 main options for that award:
- they can receive the award as a lump sum amount
- they can receive the full award as a Structured Settlement, thus receiving a regular stream of payments for a specified time period
- they can receive the award as a partial lump sum with the remainder inside a Structured Settlement
For clarity’s sake, an annuity is a financial plan that is set up through an insurance company, where the insurance company is given a lump sum of money and in exchange, it provides periodic payments to a recipient. These payments are based on an agreement that specifies whether the payments will be monthly, quarterly, or yearly, the amount of these payments and whether these payments will be provided for the recipient’s life or for a specified amount of time.
Who Can Use a Structured Settlement?
Structured Settlements are used, for the most part, for awards that are won in personal injury lawsuits, including car accidents, lead poisoning etc… or out of court settlements in personal injury claims, but can also be used in worker’s compensation cases.
A SS plan can also be set up for other situations such as large lottery winnings, or damages other than personal injury, but in such cases they may not provide the same tax-free benefits enjoyed for personal injury plans.
The history of structured settlements
Structured Settlements first appeared on the scene in Canada in the late 1960’s to settle the Thalidomide cases, where a number of children were born with birth defects due to the mother’s use of the drug Thalidomide during pregnancy. The Canadian government accorded these settlements a tax free status with the reasoning that since they provided a guaranteed source of payments throughout the recipients’ lifetime, there was less chance that these recipients would later become more dependent on government funding.
The SS financial instrument migrates south of the border to the USA
The use of structured settlements (also referred to here as SS) then moved south of the border. They were first used in the US in the 1970s where they gained popularity, and are now in wide use as a means of settling personal injury lawsuits. Their popularity is in great part due to the security they provide as well as their tax-free status. There have been many instances where an injured party who received their settlement as one large lump sum were ill equipped to handle such a large sum of money and found themselves having spent through their entire settlement amount and unable to work.
Making Sense of Structured Settlements
There are always two parties involved in personal injury cases, the injured party or plaintiff and the defendant.
The settlements awarded to injured plaintiffs are intended to compensate them for the wages they may have lost and/or may lose in the future due the injuries they sustained, as well as any medical care the plaintiffs will need, whether ongoing or periodically.
Estimates show that 15 million civil cases are filed every year across the US. Now, many of these are frivolous and end up being thrown out due a lack of evidence, but a huge number get through, and many end up being settled out of court. Since most people and businesses are protected by insurance, it will often be the insurance company’s lawyers that will be representing the defendents in court.
These lawyers are very experienced in what they do, and they have skilled accountants behind them crunching the numbers on each and every case. When the odds of winning a case are not in their favor, they will usually push for an out of court settlement, which can save them thousands of dollars in legal fees, court costs, and witness fees and helps them average their risk over many similar cases. In cases of out of court settlements, the insurance company’s preference is a Structured Settlement over a lump sum payment, as it is the less costly alternative.
The defendants/insurance companies will then buy these structured settlements for an amount of money that is far less than the huge, upfront costs of a lump sum settlement. Most states however, now require that the insurance companies be transparent and provide their full cost of providing these payments, so that all parties involved are fully aware of the costs of different options to ensure the injured party’s needs are met.
The Pros and Cons
In many cases, structured settlements provide a win/win benefit for both parties, but is a Structured Settlement ideal for your particular situation?
Here are some of the pros and cons to help determine if it’s right for you.
- Provides the security of a guaranteed income – in most states there are insurance laws that guarantee that an insurer’s obligations will be covered in the case of financial insolvency.
- Payments are tax free. Lump sum injury awards are also tax free, but as soon as they are invested, any earnings will be taxable. With a structured settlement however, as long as the plan was structured properly, the payments are entirely tax free
- Payments are creditor-proof
- The terms of the SS can provide a limited amount of flexibility within certain constraints as the plans are fully customized to each recipient’s specific needs i.e. the recipient can determine when payments start, stop, how long, how much and can even include provisions for payments to increase during specified periods of time i.e. where a surgery is expected, a mortgage comes due etc… However, everything has to be determined when the settlement is set up as the terms cannot be renegotiated.
- Payments can be set aside to provide for the possibility of future medical advances that may help the recipient, so that the resources are available to take advantage of potential new treatment options
- They can provide a death benefit for estate planning purposes
- There are no fees to be paid by the recipient
- No flexibility after the plan has been set up. Although Structured Settlements provide some flexibility when it is being set up, this changes once the plan is in effect. Once in place a SS can’t be changed and therefore offers little flexibility over the longer term as it cannot address any unexpected changes in circumstances. It is therefore, not a liquid instrument that can easily meet unanticipated financial needs. In the case of unanticipated liquidity needs, the only option is to sell the annuity’s future payments or a portion of these future payments, but this is usually at a greatly reduced discount.
- Economic uncertainty may mean that the recipients’ payments may no longer meet their needs as originally anticipated
- Inability to take advantage of future financial innovations/investments/business opportunities
- Terms cannot be renegotiated
In summary, a structured settlement is definitely a useful tool for anyone dealing with injuries that will either take some time to heal or will prevent them from earning an income for some time, but it may not be ideal for everyone. It is therefore advisable to seek professional advice before making a final decision.
Are Structured Settlements Tax-Free?
The tax-free aspect of structured settlements is one of the major benefits of this type of financial instrument, but the structure must meet strict conditions in order for the Periodic Payment Settlement Tax Act of 1982 to apply. This Act was set up for the very purpose of encouraging the creation of structured settlements because of the high level of security they provide to recipients.
If at some point the SS is sold, then the lump sum payment could be taxable. However it may be possible to include a clause when setting up the plan, that will allow for cash to be taken out or the payments to be sold with no tax penalties. Such a clause should definitely be a consideration to discuss with the SS consultant in the initial phases.
Structured Settlements created for personal injury and illness cases, wrongful death, workman’s compensation, benefit from a tax-free status. The idea is that an award provided in such cases is not a gain, but instead it is more of a compensation of income that was lost.
There are certain instances where structured settlements will not be able to benefit from the tax-free status. If the SS involves money that would have been taxed such as lottery winnings, punitive damages, divorce payments etc… then the payments will be considered taxable.