4 Common Tax Questions on Structured Settlements
Tax questions are plentiful especially at this time of year. But there are some questions that come up less often than others, especially for the standard taxpayer. Some of these surround the question of structured insurance settlements. Here are some quick answers to the basics of structured settlements.
What is a structured settlement?
When a lawsuit is settled in court, especially a very large one, some courts allow the option of a structured settlement. Instead of paying one large lump sum, the courts set up a system where the payer gives out regular payments over a period of time. This is a structured settlement. This benefits both parties. The payer has a better chance of paying out over time and the recipient doesn't have to deal with the stress of receiving a large amount of money at once.
Which taxes apply to structured insurance settlements?
Nearly all structured insurance settlements are completely free from taxation. This includes federal & state taxes, taxes on interest, dividends, and capital gains, and AMT. The reason for this is that the government believes that receiving compensation for a physical injury, wrongful death, or worker's compensation isn't a gain in income. It's a restoration to the state prior to the loss.
However, if a structured insurance settlement involves money that would have been taxed under normal circumstances, such as a backpay settlement, divorce payments, punitive damages, lottery prizes, or liquidation damages, then it would be treated like normal income. It is important to inquire into the reasons behind the structured settlement.
What about inheritance, selling, and other transfers of the settlement?
In 2001, the law was changed to allow all of these activities. If another individual is listed as a beneficiary, all they have to do is present a death certificate and proof of identification to the company paying the annuity. The annuity will remain tax free for new recipient if it is eligible.
If someone wants to sell a structured insurance settlement, most often done to receive the remaining lump sum, that money is also not taxable so long as the original contract isn't changed.
If someone wants to give away their structured settlement, they also have to keep the original terms in place. The person giving it away will not be able to get it back after they give it away, so this is something that must be done carefully.
Is a structured insurance settlement the same as an annuity?
No. While on paper the mechanism of payment appears to be the same, annuity payments fall under a different set of tax laws. The court has to set up a structured settlement to avoid taxes. An offer of an annuity outside of a structured settlement or receiving a lump sum will trigger tax liabilities.
In short, structured settlements are among the least-taxed forms of money that can come to someone. Depending on the reason for the settlement, there could be no tax at all, and they are transferable and inheritable. However, accountants must know the reasons behind the structured settlement to see if it was because of personal injury, wrongful death, or worker's compensation. Otherwise, it may still be taxable.