Annuities

<div class="Section1">Because of the economic performance requirement of IRC Section 461, payments made to a designated settlement fund (DSF) arguably may not be deductible by the defendant because the plaintiff has not actually received the funds transferred into the account. Despite this, IRC Section 468B provides an exception and allows a defendant to deduct "qualified payments" made to a DSF.<a href="#_ftn1" name="_ftnref1">¹</a> Qualified settlement funds (QSFs) receive the same tax treatment as DSFs pursuant to the regulations under Section 468B.</div><br /> <div class="Section1"><br /> <br /> A "qualified payment" is a payment made to a DSF or QSF pursuant to a court order other than payments that (1) may be transferred back to the defendant (or a related person), meaning that the transfer must be irrevocable, or (2) are transfers of stock or indebtedness of the defendant (or any related person).<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> If the fund is a DSF or QSF that meets the requirements of Section 468B, the economic performance requirement will be considered met upon transfer to the DSF or QSF so that the defendant will be entitled to a deduction as payments are transferred into the fund regardless of when they are eventually paid to the plaintiff.<br /> <br /> The gross income of DSFs and QSFs is taxed at the maximum tax rate applicable to trusts.<a href="#_ftn3" name="_ftnref3">³</a> Qualified payments (see above) made to the fund are not considered income to the fund.<a href="#_ftn4" name="_ftnref4">⁴</a> DSFs and QSFs are not subject to additional taxes, such as the alternative minimum tax, the accumulated earnings tax, the personal holding company tax or the capital gains tax.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC 468B(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 468B(d)(1).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 468B(b)(1), Treas. Reg. § 1.468B-2.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 468B(b)(3).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     Treas. Reg. § 1.468B-2(g).<br /> <br /> </div>

<div class="Section1">Yes. If the DSF or QSF meets certain requirements, it can make a qualified assignment (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="645">645</a>) of its obligations under a structured settlement. In order for an assignment of a defendant&rsquo;s obligations under a structured settlement to constitute a &ldquo;qualified assignment&rdquo; for tax purposes, the IRC requires that the assignee assume the liability from an original party to the lawsuit or agreement.<a href="#_ftn1" name="_ftnref1">¹</a> The IRS has provided the following guidance for determining when a DSF or QSF can be treated as an original party for purposes of Section&nbsp;130(c):<div class="Section1"><br /> <blockquote>(1)&nbsp;&nbsp;&nbsp;&nbsp; the plaintiff receiving periodic payments under the structured settlement must agree to the assignment by the DSF or QSF in writing,<br /> <br /> (2)&nbsp;&nbsp;&nbsp;&nbsp; the assignment must relate to a claim for personal physical injury or sickness and either (a) the claim is being satisfied under a DSF established pursuant to a court order that completely extinguishes the defendant&rsquo;s tort liability with respect to the claim or (b) the claim is being satisfied under a QSF established to resolve or satisfy liability (whether contested or uncontested) that resulted from an event that has already occurred and given rise to at least one claim asserting liability,<br /> <br /> (3)&nbsp;&nbsp;&nbsp;&nbsp; each qualified funding asset (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="645">645</a>) purchased by the assignee in connection with the assignment by the DSF or QSF relates to a liability to a single plaintiff to make periodic payments for damages,<br /> <br /> (4)&nbsp;&nbsp;&nbsp;&nbsp; the assignee is not related to the defendant who transferred the claim to the DSF or QSF, and<br /> <br /> (5)&nbsp;&nbsp;&nbsp;&nbsp; the assignee does not control the DSF or QSF.<a href="#_ftn2" name="_ftnref2">²</a></blockquote><br /> In addition to these requirements, the DSF or QSF must continue to satisfy all other requirements of IRC Section&nbsp;130 in order for the assignment to be qualified.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 130(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Proc. 93-34, 1993-28 IRB 49.<br /> <br /> </div></div><br />

<div class="Section1">The defendant-payor under a structured settlement can assign responsibility to provide future payments to the plaintiff who is receiving payments under the settlement if the settlement was negotiated to compensate the plaintiff for personal physical injuries or sickness.<a href="#_ftn1" name="_ftnref1">¹</a> If the assignment is a "qualified assignment," (see below) the assignee is not taxed on any amounts received from the defendant except to the extent that these amounts exceed the cost of any "qualified funding asset."<a href="#_ftn2" name="_ftnref2">²</a></div><br /> <div class="Section1"><br /> <br /> A "qualified assignment" is defined as the assignment of a defendant's responsibility to make periodic payments as damages for a plaintiff's personal injury or sickness if the following requirements are met:<br /> <blockquote>(1)     the assignee is assuming liability from a party to the original lawsuit or settlement agreement,<br /> <br /> (2)     the periodic payments are fixed and determinable as to the amount and time of payment,<br /> <br /> (3)     the recipient of the payments does not have the right to accelerate, defer, increase or decrease the payments,<br /> <br /> (4)     the assignee's obligations under the structured settlement are no greater than the obligations of the person assigning the liability, and<br /> <br /> (5)     the periodic payments that the plaintiff receives under the structured settlement are excludable from the plaintiff's gross income under IRC Section 104.<a href="#_ftn3" name="_ftnref3">³</a></blockquote><br /> If the assignment satisfies the IRC requirements for a qualified assignment, any amounts that the defendant pays to the assignee who assumes payment obligations under the structured settlement will be tax-free to the assignee unless these amounts exceed the cost of purchasing a qualified funding asset (see below). If the cost of purchasing the qualified funding asset is less than the total amount that the assignee receives as consideration for assuming the settlement obligations, the difference must be included in the gross income of the assignee in the year in which the assignment took place.<br /> <br /> A "qualified funding asset" is defined in the Code as an annuity contract used by the assignee to fund the periodic payments he or she has assumed under the structured settlement that meets the following requirements:<br /> <blockquote>(1)     the payment periods provided under the annuity are reasonably related to the periodic payments under the structured settlement (and the amounts of the annuity payments do not exceed the amounts to be paid under the structured settlement),<br /> <br /> (2)     the annuity contract is designated as an obligation purchased to satisfy the terms of the structured settlement, and<br /> <br /> (3)     the annuity contract must be purchased not more than 60 days before the assignment and not more than 60 days after the assignment.<a href="#_ftn4" name="_ftnref4">⁴</a></blockquote><br /> The basis of the qualified funding asset will be reduced by any amounts that the assignee is able to exclude from gross income. If the assignee later sells the annuity contract used to fund payments, any gain realized on the sale is taxed as ordinary income to the assignee.<a href="#_ftn5" name="_ftnref5">⁵</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 130(c).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 130(a).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 130(c).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 130(d).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>.     IRC § 130(b).<br /> <br /> </div>

<div class="Section1">Yes.<div class="Section1"><br /> <br /> The payee, however, generally may elect not to have anything withheld, which is commonly chosen. In addition, only the amount that is reasonable to believe is includable in income is subject to withholding, not any return of principal payments.<br /> <br /> If withholding occurs from periodic payments (i.e., an annuitized contract), the amounts are to be withheld at the same rate as wages. Payments are periodic, even if they are variable, if they are payable over a period of more than one year.<br /> <br /> If payments are not periodic, 10&nbsp;percent of the includable amount is withheld. Payments made to the beneficiary of a deceased payee are subject to withholding under the same rules.<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> An election out of withholding generally will be ineffective if a payee does not furnish his or her taxpayer identification number (&ldquo;TIN,&rdquo; usually the payee&rsquo;s Social Security number) to the payor or furnishes an incorrect TIN to the payor and the payor is so notified by the IRS.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> Payments under qualified pension, profit sharing, and stock bonus plans are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="3972">3972</a>; payments under IRC Section&nbsp;403(b) tax sheltered annuities are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4083">4083</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="4085">4085</a>; and private annuities are discussed in Q <a href="javascript:void(0)" class="accordion-cross-reference" id="603">603</a>.<br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect;&sect; 3405(a), 3405(b); Temp. Treas. Reg. &sect; 35.3405-1T (A-9, A-10, A-12, A-17, F-19 through 24).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; IRC &sect; 3405(e)(12).<br /> <br /> </div></div><br />

<div class="Section1">A qualified settlement fund (QSF) is a type of designated settlement fund (DSF) that was developed in order to expand the use of DSFs in satisfying payment obligations under structured settlements. Unlike DSFs, QSFs can be used to facilitate the settlement of claims that do not involve personal injury or sickness. In order to qualify as a QSF, the following requirements apply:</div><br /> <div class="Section1"><br /> <blockquote>(1)     the QSF must be established pursuant to a governmental order (such as a court order or order of a state or the federal government) and must be subject to the continuing jurisdiction of that government entity,<br /> <br /> (2)     it must be established to resolve a claim (whether contested or uncontested) arising under (a) the Comprehensive Environmental Response, Compensation and Liability Act of 1980, (b) arising out of a tort, breach of contract, or violation of law or (c) designated by the Commissioner in a revenue ruling or revenue procedure, and<br /> <br /> (3)     the fund must be a trust under state law, or the assets must otherwise be segregated from other assets of the defendant-transferor (and related persons).<a href="#_ftn1" name="_ftnref1">¹</a></blockquote><br /> QSFs are also subject to certain limitations on the types of litigation claims they can be used to satisfy. For example, if the liability arises under the workers' compensation act or a self-insured health plan, it may not be settled through a QSF.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     Treas. Reg. § 1.468B-1.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     Treas. Reg. § 1.468B-1(g).<br /> <br /> </div>

<div class="Section1">Proposed regulations, which are currently in effect, have dramatically altered the tax treatment of private annuities. Under the current rules, the receipt of an annuity contract for property will be treated as the receipt of property in an amount equal to the fair market value of the annuity contract.<a href="#_ftn1" name="_ftnref1">¹</a> The fair market value of an annuity contract is determined under the rules of IRC Section&nbsp;7520 ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>). Therefore, all of the gain on the property will be recognized at the time of the exchange. The private annuity&rsquo;s investment in the contract will be the amount paid for the contract. Thus, where the value of the property exchanged and the value of the annuity are the same, the investment in the contract will be the fair market value of the property exchanged for the private annuity.<br /> <br /> <hr><br /> <br /> <strong>Planning Point:</strong> The general outcome of these rules is that subsequent payments will still be taxable to the payee under the rules for amounts received as an annuity, but the investment in the contract will be based on the fair market value of the property received in exchange for the annuity contract.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> <hr><br /> <br /> These proposed regulations were intended to be effective for exchanges of property for private annuity contracts that occur after October&nbsp;18, 2006. For certain transactions, however, the proposal was for a later effective date for transactions occurring after April&nbsp;18, 2007. This delayed effective date was for exchanges where: (1) the issuer of the annuity is an individual; (2) the obligations under the contract are not secured; and (3) the property transferred in the exchange is not sold or otherwise disposed of during the two year period beginning on the date of the exchange. A disposition includes a transfer to a trust or any other entity, even if wholly owned by the transferor.<br /> <br /> For tax consequences to the obligor, see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="606">606</a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; Prop. Treas. Reg. &sect;&sect; 1.1001-1(j); 1.72-6(e).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Prop. Treas. Reg. &sect; 1.72-6(e).<br /> <br /> </div></div><br />

<div class="Section1">Annuity payments made by the obligor are treated as capital expenditures for the acquisition of the property. No interest deduction is allowed with respect to the payments.<a href="#_ftn1" name="_ftnref1">¹</a> Depreciation deductions may be taken, however, if the property is depreciable. The initial basis for depreciation is the present value of the annuity, as determined by the appropriate Estate and Gift Tax Valuation Tables ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="921">921</a>). When actual payments exceed the initial basis, the basis for depreciation is the actual payments made less prior depreciation.<a href="#_ftn2" name="_ftnref2">²</a><div class="Section1"><br /> <br /> When payments exceed the initial basis, loss is not deductible until the property is sold.<a href="#_ftn3" name="_ftnref3">³</a> If the property is sold after the annuitant&rsquo;s death, the obligor&rsquo;s basis for determining gain or loss is the total of annuity payments made less depreciation taken, if any.<br /> <br /> If the property is sold before the annuitant&rsquo;s death, the obligor&rsquo;s basis for gain is the total payments actually made plus the actuarial value, as of the date of sale, of payments to be made in the future. The obligor&rsquo;s basis for loss is the total amount of payments made as of the date of sale. If the selling price is less than the basis for gain but more than the basis for loss, the obligor realizes neither gain nor loss. Adjustment for annuity payments made after the sale may be made by deducting loss or by reporting additional gain.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Garvey, Inc. v. U.S.</em>, 1 Cl Ct. 108, 83-1 USTC &para; 9163 (U.S. Cl. Ct. 1983), <em>aff&rsquo;d</em>, 84-1 USTC &para; 9214 (Fed Cir.), <em>cert. denied</em>, 469 U.S. 823 (1984); <em>Bell v. Commissioner</em>, 76 TC 232 (1981).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 55-119, 1955-1 CB 352.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.&nbsp;&nbsp;&nbsp;&nbsp; <em>Perkins v. U.S.</em>, 701 F.2d 771, 83-1 USTC &para; 9250 (9th Cir. 1983).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.&nbsp;&nbsp;&nbsp;&nbsp; Rev. Rul. 55-119, <em>supra</em>.<br /> <br /> </div></div><br />

<div class="Section1">A structured settlement is a settlement of a lawsuit that calls for periodic payments to be made over time, rather than as a lump sum. Structured settlements are common in tort actions (usually personal injury lawsuits) where the amount of the judgment can be particularly large.</div><br /> <div class="Section1"><br /> <br /> Structured settlements are typically employed where either the financial position of the defendant requires that payments be spread over time or the plaintiff prefers to receive steady income over time, rather than a lump sum. The defendant may also prefer a structured settlement because the present dollar value needed to fund a stream of settlement payments into the future will be smaller than that which would be required with a lump sum payment.<br /> <br /> </div>

<div class="Section1">If a structured settlement of a personal physical injury or sickness claim is properly planned, each payment will be tax-free to the recipient.</div><br /> <div class="Section1"><br /> <br /> Usually, when the plaintiff in a personal injury lawsuit receives a settlement, the proceeds of that settlement are taken tax-free.<a href="#_ftn1" name="_ftnref1">¹</a> Despite this, if the payments are structured so that the plaintiff receives the settlement funds over time, the earnings on the settlement will be taxable to the plaintiff unless a "structured" settlement is created.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> The plaintiff may prefer to receive settlement payments over time. For example, although the plaintiff can invest a lump sum payment, earnings on that investment would be fully taxable. In contrast, if a structured settlement is used, any earnings on the settlement are not taxed.<br /> <br /> Whether or not the earnings on the settlement amount will be taxed depends largely on how the parties to the lawsuit characterize the payments. For example, the Tax Court has concluded that portions of a settlement that were labeled by the parties as "interest" were taxable as ordinary income (the case did not specifically deal with structured settlements).<a href="#_ftn3" name="_ftnref3">³</a> However, in the usual case, a structured settlement will avoid this result because it will not distinguish between amounts paid to satisfy the claim and amounts paid as interest (e.g., the settlement will require the defendant to pay $150,000 per year for 10 years). As such, the entire amount of each payment will be treated as proceeds of the settlement and can be taken tax-free.<br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 104(a).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 104(a)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     <em>Kovacs v. Commissioner</em>, 100 TC 124 (1993).<br /> <br /> </div>

<div class="Section1">A designated settlement fund (DSF) is a fund that is established pursuant to a court order to completely extinguish a defendant's liability with respect to a claim for personal injury, death or property damage.<a href="#_ftn1" name="_ftnref1">¹</a></div><br /> <div class="Section1"><br /> <br /> A DSF must also meet the following requirements: (1) no amounts may be transferred to it except in the form of "qualified payments," (2) it must be administered by persons, a majority of whom are independent from the defendant transferring the claim, (3) it must be established for the purpose of resolving and satisfying claims against the defendant (or related persons) for claims arising out of personal injury, death or property damage, (4) the defendant (and related persons) may not hold any beneficial interest in the income or corpus of the fund, and (5) the defendant must make an election to treat the fund as a DSF.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A "qualified payment" is a payment made to a DSF pursuant to a court order other than payments that (1) may be transferred back to the defendant (or a related person) or (2) are transfers of stock or indebtedness of the defendant (or any related person).<a href="#_ftn3" name="_ftnref3">³</a> Once a defendant has made the election to treat a fund as a DSF, it is revocable only with the consent of the Secretary of the Treasury.<a href="#_ftn4" name="_ftnref4">⁴</a><br /> <br /> </div><br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%" /><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.     IRC § 468B.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.     IRC § 468B(d)(2).<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>.     IRC § 468B(d)(1).<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>.     IRC § 468B(d)(2).<br /> <br /> </div>