Structured settlements have become a common way to provide long-term financial support for people injured in accidents, cases of medical malpractice, and other scenarios involving physical harm and sickness.
In a structured settlement, the defendant’s insurance company purchases an annuity that provides regular tax-free income payments to the injured claimant. This income helps the injured person pay for medical care, daily living expenses, and other costs related to their injury.
But how exactly are structured settlements and income payments taxed? Are the periodic payments fully exempt from taxes? What about if you take a lump sum or sell your future payments? And can any parts of a settlement be taxable?
This comprehensive guide will examine the ins and outs of structured settlement taxation, including how both periodic payments and lump sums are treated for tax purposes. We’ll look at the key sections of the Internal Revenue Code that make structured settlements tax-free, as well as exceptions like punitive damages. You’ll also learn about the additional tax benefits structured settlements provide overtaking a lump sum.
Let’s dive in and find answers to the most pressing questions about the taxation of structured settlement payments.
What Makes Structured Settlement Payments Tax-Free?
The tax-free status of structured settlements for personal injury cases is written into the federal tax code. Specifically, Section 104(a)(2) of the Internal Revenue Code states that damages paid on account of physical injury or sickness are fully excluded from the claimant’s gross income and thus not subject to federal tax.
Section 130 of the tax code provides additional support for the use of structured settlements in physical injury and sickness cases by facilitating secure long-term funding arrangements.
As a result, structured settlements arising from the following types of cases and claims receive beneficial tax treatment:
- Personal injury cases – car accidents, slip and fall accidents, etc.
- Wrongful death cases
- Workers’ compensation cases involving work-related illnesses or injuries
- Claims involving physical sickness – medical malpractice, harmful side effects, etc.
There are a few key reasons why lawmakers allow tax-free treatment of structured settlement payments:
- The damages are considered compensatory rather than income, intended to make the claimant whole.
- It benefits both the claimant and the government by reducing the injured person’s dependence on public assistance programs.
- The regular payments provide long-term support that a lump sum might not if mismanaged.
So, in summary, structured settlements in injury cases involving physical harm or sickness are tax-exempt under Sections 104(a)(2) and 130 of the federal tax code. But other types of claims and damages may be treated differently, as we’ll explore next.
Taxation of Different Parts of the Settlement
While the periodic payments from a structured settlement are completely tax-free, other components like attorney fees, punitive damages, or a lump sum payment may have differing tax implications:
Periodic Payments
The regular annuity payments that make up a structured settlement are:
- Exempt from federal and state income taxes
- Exempt from taxes on interest, dividends, and capital gains
- Exempt from the Alternative Minimum Tax
So, the injured claimant pays no taxes on the payments received on a regular schedule via a structured settlement.
Lump Sum Settlements
In physical injury cases, a lump-sum settlement also qualifies as tax-free under Section 104(a)(2). However, any interest earned if the claimant invests the lump sum could be taxable. A structured settlement avoids this issue by providing regular tax-free payments over time.
Punitive Damages
Any punitive damages awarded separately from compensatory damages are considered taxable income by the IRS. So, even in a physical injury lawsuit, the injured party will owe taxes on punitive amounts received.
Attorney Fees
Attorney fees charged by the claimant’s lawyer may also be taxable, depending on how the settlement agreement structures them. If the entire settlement amount is structured to be paid over multiple years, this can help avoid extra taxes on attorney fees.
Emotional Distress Damages
Damages awarded for emotional distress are also taxable unless the emotional distress directly resulted from physical injuries or sickness. Changes to the tax code in 1996 established this.
So in summary, while the periodic payments that make up the core of a structured settlement are consistently tax-free, other components may be treated differently. Consult with financial and legal advisors to fully understand the tax consequences in your unique situation.
Tax Implications of Selling Future Payments
What if you opt to sell your future structured settlement payments in exchange for an upfront lump sum payment? Does that change the tax-free status?
The good news is there are no negative tax implications to selling your future payments. The proceeds you receive from such a sale are still completely tax-exempt:
- The lump sum received is treated just like structured settlement payments for tax purposes.
- You will owe no taxes on the sale proceeds themselves.
However, if you take the lump sum from the sale and invest that money, you would then owe applicable taxes on any interest, dividends, or capital gains earned on the invested amount. For example:
- If you invest the lump sum in stocks or bonds, dividends, and interest would be taxable at your income tax rate.
- If you purchase real estate as an investment with a lump sum and earn rental income, that income would be taxable.
- If you realize capital gains from selling stocks or an investment property, those would be subject to capital gains tax.
So, while structured settlement payments are tax-free even if sold, you may incur taxes by subsequently investing the proceeds from the sale into other vehicles.
When Can Settlements Be Taxable?
We’ve covered instances when settlement payments are tax-exempt. But there are also some scenarios where some or all of a settlement may be taxable:
- Awards for emotional distress, mental anguish, injury to reputation, discrimination, etc., can potentially be taxable if not connected to physical injury or sickness.
- As noted, punitive damages are considered taxable income, even for physical injuries.
- Changes to the tax code in 1996 established more stringent requirements around proving physical injury or sickness.
So, claims involving solely emotional, psychological, or non-physical harm may not qualify for the same tax-free treatment as a personal injury settlement. Cases involving defamation, discrimination, harassment, breach of contract, and more may lead to taxable awards.
It’s important to understand these nuances and involve financial and legal experts who understand the complex taxation of settlements. Subtle factors related to the origin, nature, and intent behind damages awarded can impact their tax status.
Additional Tax Benefits of Structured Settlements
Beyond the clear tax advantages on the payments themselves, structured settlements offer additional benefits relating to income tax:
Avoiding Large Lump Sum Tax Issues
Receiving a substantial lump sum settlement all at once could push the claimant into a higher tax bracket. However, the structured periodic payments spread taxable income over time. This helps avoid:
- The Alternative Minimum Tax (AMT) – Structured payments help keep income low enough in any given year to stay under the AMT threshold.
- The Net Investment Income Tax – Keeping income from settlement payments below the $200,000 / $250,000 thresholds avoids this additional 3.8% tax.
- The “Kiddie Tax” – Structures settlement payments to avoid this tax on minors’ unearned income.
Tax-Deferred Growth
With a structured settlement, any growth in the value of the annuity is tax-deferred. Taxes on interest or capital gains within the annuity only come due as payments are received by the claimant. This provides additional tax advantages over a lump-sum settlement.
In summary, structured settlements provide injured claimants with a tax-free, beneficial source of income that minimizes taxes in both the short and long term. Their unique tax treatment makes them a wise choice for many injury victims.
Conclusion
The use of structured settlements to resolve personal injury lawsuits continues to increase, thanks to the attractive tax benefits they provide. Both the regular periodic payments and any lump sums associated with a structured settlement are completely exempt from federal and state income tax.
However, some portions of a settlement agreement, like punitive damages, emotional distress claims, or attorney fees, may be taxable under certain situations. Selling your future payments for a lump sum today does not trigger any taxes, but investing the resulting money could generate tax obligations down the road.
Overall, structured settlements offer injury victims long-term financial security on a tax-free basis while avoiding issues like the Alternative Minimum Tax and Net Investment Income Tax. To determine the specific tax implications in your unique situation, always consult with qualified financial and legal advisors. However, the tax code undoubtedly provides advantages and incentives for structured settlements in physical injury and sickness cases.
