Structured Settlements Tax Treatment and Benefits of Structured Settlements 2 — Questions and Answers
Question 1: To preserve the tax-free status of structured settlement payments under IRC Section 104(a)(2), the annuity used to fund payments must be purchased by:
- The claimant using proceeds from a separate investment account
- The defendant, insurer, or a qualified assignment company — not the claimant (Correct answer)
- The claimant's attorney on behalf of the claimant
- A government-approved trustee designated by the court
Correct answer: The defendant, insurer, or a qualified assignment company — not the claimant
If the claimant purchases the annuity directly, they have constructive receipt of the settlement funds and lose the tax exclusion; the annuity must be purchased by the defendant's side.
Question 2: Under IRC Section 5891, when a structured settlement factoring transaction occurs without proper court approval, what excise tax is imposed on the factoring company?
- 10% of the discounted present value
- 25% of the face value of transferred payments
- 40% of the factoring discount (Correct answer)
- 15% of the gross purchase price
Correct answer: 40% of the factoring discount
IRC Section 5891 imposes a 40% excise tax on the factoring discount (the difference between the present value of future payments and the purchase price paid to the payee) when court approval is not obtained.
Question 3: The total stream of structured settlement periodic payments, including the portion attributable to earnings growth within the annuity, is:
- Taxable only for the earnings portion above the original principal
- Entirely excluded from the claimant's gross income under IRC Section 104(a)(2) (Correct answer)
- Subject to the 3.8% net investment income tax on the earnings portion
- Taxable if payments extend beyond 30 years
Correct answer: Entirely excluded from the claimant's gross income under IRC Section 104(a)(2)
Unlike a direct investment, all structured settlement payments — including the interest and growth component — are fully excluded from gross income, providing a significant advantage over taxable investments.
Question 4: Workers' compensation structured settlements derive their tax-free status from which IRC section?
- IRC Section 104(a)(1) (Correct answer)
- IRC Section 104(a)(2)
- IRC Section 105(a)
- IRC Section 130(c)
Correct answer: IRC Section 104(a)(1)
Workers' compensation benefits are excluded from gross income under IRC Section 104(a)(1), which specifically covers amounts received under workers' compensation acts, not tort-based personal injury claims.
Question 5: A plaintiff receives a structured settlement for a physical injury claim. Their attorney's contingency fee is paid directly from the settlement. How is this treated for tax purposes?
- The attorney fee is tax-free to the attorney as part of the physical injury exclusion
- The attorney fee is taxable income to the attorney, and the claimant's full settlement remains excluded (Correct answer)
- The claimant must include the attorney fee in gross income under the assignment of income doctrine
- The attorney fee reduces the claimant's excludable amount dollar-for-dollar
Correct answer: The attorney fee is taxable income to the attorney, and the claimant's full settlement remains excluded
Attorney fees from a physical injury structured settlement are taxable income to the attorney, while the client's entire settlement — including the portion paid as attorney fees — remains excluded from the client's gross income under IRC 104(a)(2).
Question 6: The 'economic benefit doctrine' is relevant to structured settlement design because it:
- Requires payments to provide a measurable economic benefit to the claimant
- Could cause the present value of future payments to be taxable if the claimant has a secured, vested economic interest (Correct answer)
- Mandates that structured settlements outperform alternative lump sum investments
- Sets minimum payment amounts to satisfy the economic benefit test
Correct answer: Could cause the present value of future payments to be taxable if the claimant has a secured, vested economic interest
The economic benefit doctrine taxes a benefit when it is received, even if not yet paid; structured settlements use qualified assignments and unfunded promises to avoid triggering this doctrine.
Question 7: When comparing a $1 million structured settlement to a $1 million lump sum invested in taxable accounts, the structured settlement's primary tax advantage is:
- A one-time tax credit equal to 10% of the settlement amount
- All earnings growth within the annuity accumulates and is paid out tax-free, whereas investment income on a lump sum is taxable each year (Correct answer)
- Structured settlement payments are exempt from state income taxes in all 50 states
- The claimant pays only long-term capital gains rates on structured settlement growth
Correct answer: All earnings growth within the annuity accumulates and is paid out tax-free, whereas investment income on a lump sum is taxable each year
The core tax advantage is that all structured settlement payments — including the internal growth component — are tax-free, whereas a lump sum investor pays annual taxes on dividends, interest, and capital gains, significantly reducing net returns.
Structured Settlements Tax Treatment and Benefits of Structured Settlements 2
To preserve the tax-free status of structured settlement payments under IRC Section 104(a)(2), the annuity used to fund payments must be purchased by: