Beyond Structured Settlements

S2P2J Release 51

Publisher Law Journal Press anticipates an April 2012 distribution date for hardcopy supplements for Release 51 of "Structured Settlements and Periodic Payment Judgments" (S2P2J). Online S2P2J will also be updated April 2012 to include Release 51 materials. First published in 1986, S2P2J is co-authored and updated semi-annually by Daniel W. Hindert, Joseph J. Dehner and Patrick J. Hindert. Both the National Structured Settlement Trade Association (NSSTA) and the Society of Settlement Planners (SSP) utilize S2P2J as an educational resource for their certification programs.

Release 51 Highlights

Release 51 for "Structured Settlements and Periodic Payment Judgments" features a comprehensive Executive Life update including expanded and updated coverage for the Executive Life of New York (ELNY) liquidation proceedings now in progress. In related reporting, Release 51 also:

• Expands and updates prior reporting for life insurance insolvency procedures and state guaranty association laws;
• Offers advice to plaintiff attorneys about how to address the risk of non-payment by annuity providers; and
• Summarizes recent case developments impacting Aurora, the successor company to Executive Life Insurance Company of California (ELIC),

Release 51 also updates Medicare Secondary Payer (MSP) developments and conditional Medicare payment requirements. Contributing author Peter H. Wayne IV provides current analysis and advice about Medicare Set-Aside (MSA) arrangements in liability cases discussing new and related case law, new CMS pronouncements and new CMS field office guidance with practice tips for structured settlement and settlement planning consultants, attorneys and claim supervisors.

Release 51 expands existing coverage of structured settlement business standards and practices including analysis of the following legislation impacting settlement planners:

• The NAIC Suitability in Annuity Transactions Model Regulation;
• The NAIC Annuity Disclosure Model Regulation;
• Dodd-Frank's impact on fiduciary and suitability standards; and
• The Uniform Prudent Investor Act.

Other topics addressed in Release 51:

• Structured settlement metrics for defendants and liability insurers.
• The Treasury's final regulations for IRC section 104(a)(2) incorporating amendments resulting from the Small Business Job Protection Act of 1996.
• The new IRS Lawsuits, Awards and Settlements Audit Techniques Guide.

"Structured Settlements and Periodic Payment Judgments" is now available in both hardcopy and online versions. For summaries of prior Release Highlights, see the structured settlement wiki.

Treasury Publishes New IRC 104(a)(2) Regs

The United States Treasury has published new regulations for IRC section 104(a)(2) relating to the exclusion from gross income for amounts received on account of personal physical injuries or physical sickness.

Published January 20, 2012, the new section 104(a)(2) regulations make two primary changes to the current regulations. First, they incorporate amendments to 104(a)(2) made in Small Business Job Protection Act of 1996 (1996 Act). Second, they eliminate the previous regulatory requirement that damages must be based upon “tort or tort type rights” to qualify for the tax exclusion.

The 1996 Act included two legislative amendments narrowing the applicability of the 104(a)(2) exclusion. The first amendment prevents any punitive damages from qualifying for the tax exclusion in the personal injury context. The second amendment requires that injury or sickness damages must result from “physical” origins to be excluded. Although emotional distress is not considered a physical injury or physical illness, the new regulations confirm that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2).

The new section 104(a)(2) regulations also eliminate the previous regulatory requirement that damages must be “based on tort or tort type rights” to qualify for exclusion. In a 1995 case (Commissioner v. Schleier), the United States Supreme Court interpreted this requirement to disallow the exclusion of damages where the relevant law (a "no-fault" statute) provided a contractual remedy even though the claimant suffered a personal physical injury or physical sickness as a result of a breach of contract. The new regulations eliminate this prior requirement and allow the tax exclusion to apply even when the physical injury or sickness does not constitute a tort under state or common law.

The new, final regulations for section 104(a)(2) are essentially the same as the proposed regulations the United States Treasury issued in 2009 and which were the subject of a public hearing on February 23, 2010. The final regulations did not adopt any of the recommendations offered by commentators at the public hearing. These recommendations included:

•  Requests by Richard Risk and Jack Meligan that the final regulations address whether a claimant has constructive receipt or the current economic benefit of a damage award that is set aside for the claimant’s benefit in a section 468B qualified settlement fund;

• Requests by John McCulloch and David Higgins that the final regulations confirm several specific types of damages are "physical" and therefore tax-exempt.

For background information about the new section 104(a)(2) regulations and their application to structured settlements, including commentary and analysis by Jeremy Babener, see these prior S2KM blog posts:

• Treasury Hearing on IRC 104(a)(2) Regs
• A Common Cause at the Treasury Regulation Hearing
• Treasury Hearing Commentary
• Voices at the Treasury Hearing
• Speaker Comments at the Treasury Hearing
• Legislation to Expand the Structured Settlement Industry
• Babener Proposes Expanded S2 Tax Subsidy

For a copy of the new section 104(a)(2) regulations, see the structured settlement wiki.

SSP and NSSTA 2011 Annual Meetings - 3

Whether and when personal injury settlements are taxable to their recipients represents one of the most important structured settlement legal issues. Both the Society of Settlement Planners (SSP) and the National Structured Settlement Trade Association (NSSTA) featured multiple tax presentations during their 2011 educational conferences.

At the SSP conference, Robert Wood and Jeremy Babener each separately addressed multiple settlement tax issues. Wood discussed: "468B Qualified Settlement Funds" (QSFs) and "Common Settlement Tax Mistakes and How to Fix Them". Babener's SSP presentation addressed three topics:

• Maximizing the medical expense deduction;
• Emotional distress and the medical care exception; and
• Inheritance of personal injury proceeds.

The NSSTA conference also featured a QSF presentation by Martin Jacobson titled "The Ins and Outs of 468B Funds". In addition, NSSTA's Legal Committee Update included a summary of a 2011 tax case, Espinoza v. Commissioner, plus an introduction to IRC Section 5891 as part of a discussion about the secondary structured settlement market.

Wood, who has written both a textbook and a Tax Management portfolio about QSFs, utilized case examples to explain several QSF issues: when is a QSF available; formation of a QSF; who should serve as QSF administrator; what are the QSF administrator's responsibilities; determining QSF income and deductions; information reporting responsibilities; amounts to report and forms to use; reporting of structured settlements; and terminating a QSF.

In his presentation about identifying and fixing settlement tax mistakes, Wood highlighted several issues: the need for professional tax computations; interest is always taxable; punitive damages; attorney fees; tax allocations; miscellaneous itemized deductions; above-the-line deductions; the unclear scope of section 104; sex abuse and wrongful imprisonment cases; the Murphy case; constructive receipt; employment disputes; Form 1099; as well as qualified and non-qualified structured settlements. For related writing by Wood, see the Wood & Porter website as well as S2KM's structured settlement public policy wiki.

Like Wood, Babener is both a prolific writer about settlement tax issues, as evidenced by Babener's website and related commentary appearing on S2KM's structured settlement public policy wiki, and a frequent speaker at educational conferences sponsored by SSP and the National Association of Settlement Purchasers (NASP). Also similar to Wood, Babener's SSP presentation and handouts utilized case examples (as well as tables) to help communicate his analysis. Equally appropriate for their audience, both Wood and Babener emphasized settlement tax planning and incorporated structured settlements into their discussions.

Jacobson's QSF discussion at the NSSTA conference specifically addressed the single claimant issue. Jacobson focused his analysis on the statutory language of IRC 468B, related Treasury Regulation 1.468B-1(c) and related Revenue Procedure 93-34.

• Treasury Regulation 1.468B-1(c) requires and permits a QSF to be "established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability ..." (emphasis added).
• Revenue Procedure 93-34 sets forth the rules under which a QSF will be considered a "party to the suit or agreement" for purposes of Section 130 and includes a stipulation that all Section 130 requirements still apply (emphasis added).

Jacobson highlighted the issue of whether Revenue Procedure 93-34 means that constructive receipt and economic benefit apply to single claimant QSF-funded Section 130 Qualified Assignments. For purposes of the single claimant QSF issue, Jacobson identified what he termed "the real questions":

• Does a single claimant have economic benefit of the funds placed in the QSF?
• Does the single claimant have "unqualified availability" of those funds?
• Has IRC Section 130(c) been satisfied?
• Is there going to be an IRS ruling applicable to single claimant QSFs?
• In the continuing absence of such an IRS ruling, Jacobson quoted Robert Wood's recommendation to "avoid the single claimant controversy" by establishing QSFs with multiple claimants.

With deference to Martin Jacobson for his valuable presentation and gratitude that NSSTA's educational programs have begun to address important and controversial industry issues, S2KM suggests these additional "real questions" concerning single claimant QSFs:

• Why haven't any NSSTA or SSP members applied for one or more IRS rulings applicable to single claimant QSFs?
• For example, what constitutes "multiple claimants" for purposes of QSFs - multiple family members as claimants? government liens? a plaintiff attorney's compensation claim?
• Does public policy favor or not favor single claimant QSFs? If not, why not?
• As Jeremy Babener addresses in his important QSF paper, how far has existing federal legislation eroded the applicability of the constructive receipt and economic benefit tax doctrines to structured settlements:
  • Technical and Miscellaneous Revenue Act of 1988 - allowing "secured creditor status"; and
  • Victims of Terrorism Tax Relief Act of 2001 - allowing transfers of payment rights ("factoring") pursuant to state protection statutes.

For additional information about:

• Structured settlement tax issues - see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J);
• Single claimant 468B QSFs - see S2KM's blog post "Single Claimant QSF Update"
• SSP and NSSTA 2011 Annual Meetings - see S2KM's structured settlement wiki.

Expanding Section 104(a)(2)'s Tax Exclusion

In a 2010 article titled "How Plaintiffs Might Receive Emotional Distress Damages Tax-Free After 2010", published in the "North Carolina Lawyers Weekly", Jeremy Babener asked a pointed and strategic question: how can the structured settlement industry encourage more damages to be received tax-free? Doing so, presumably, would expand the structured settlement market.

Several proposals to accomplish these objectives have been offered during the past few months - some of which resulted from a U.S. Department of the Treasury public hearing held on February 23, 2010 to consider proposed new Treasury regulations for IRC section 104(a)(2). If adopted, these proposed new Treasury regulations would make two primary changes to current regulations: 

• Eliminate the requirement that damages be based on “tort or tort type rights” in order to qualify for the section 104(a)(2) tax exclusion, and
• Incorporate 1996 legislation requiring that personal injuries and sickness damages be “physical” in order to qualify for the section 104(a)(2) exclusion.

In the context of these proposed new Treasury regulations, the structured settlement industry would benefit from greater discussion and a better understanding of the following recent tax proposals to expand application of the section 104(a)(2) tax exclusion:

• The National Taxpayer Advocate, which considers taxpayer considerations from inside the IRS, has recommended that section 104(a)(2) exempt non-physical damages, specifically emotional distress, mental anguish, and pain and suffering.
• John McCulloch proposed, during the February 23, 2010 public Treasury hearing, that damages received by victims of prolonged sexual abuse or false imprisonment should always be deemed “physical” for purposes of IRC section 104(a)(2) whether or not evidence is available to demonstrate physical injury.
• Richard Risk and Jack Meligan each recommended, during the same public hearing, that Treasury issue regulations explicitly holding the economic benefit doctrine will not be triggered in the context of single-claimant 468B Qualified Settlement Funds.
• David Higgins has proposed two recent tax recommendations. In a written submission for the Treasury public hearing, Higgins argued that the IRS’ definition of "physical" is inadequate: “direct unwanted or uninvited physical contacts resulting in observable bodily harm such as bruises, cuts, swelling, and bleeding.” Higgins recommends a broader definition, including damages for:
  • A doctor’s misdiagnosis resulting in death or serious injury from delayed or missing treatment;
  • Child neglect resulting in starvation or illness;
  • Rape committed under threat of bodily harm; and
  • Other situations where traditional physical injury torts occur without unwanted or uninvited physical contact or observable bodily harm.
• Higgins directed his second recommendation to Senator Max Baucus (Chairman of the Senate Finance Committee), Congressman Dave Camp (Chairman of the House Committee on Ways and Means), and Michael Mundaca (Assistant Secretary of the Treasury for Tax Policy). In his communication, Higgins recommended a "rollover provision" to replace Section 130 of the Tax Code. Higgins' proposal would allow personal injury plaintiffs to accept a check from defendants and invest the money within a given period (likely limiting the investment options to annuities and Treasury bonds), without losing the tax benefit currently available to them only by agreeing to a structured settlement with a counter-party.
• Jeremy Babener has proposed a legislative conversion of the structured settlement exclusion to a refundable tax credit. The premise of Babener's proposal is that high-income taxpayers benefit more from the structured settlement subsidy than low-income taxpayers, who sometimes do not benefit at all. A refundable tax credit would provide the same incentive value to all structured settlement recipients, high-income or low-income.

Most recently, McCulloch has incorporated his earlier recommendations into a request to Treasury and the IRS that final regulations under IRC Section 104(a)(2) should clarify the scope of the exclusion for damages received on account of personal "physical" injuries or "physical" sickness. McCulloch's request seeks guidance and a determination as part of Treasury's 2011-2012 Guidance Priority List that sexual abuse cases and long-term wrongful incarceration (at least one year of restraint) are per se physical injuries under Section 104(a)(2).

In support of his proposal, McCulloch states: "There is a significant body of literature that recognizes sexual abuse as a serious medical problem with long lasting and severe physical effects, many of which can only be treated by a licensed medical practitioner or through the prescription of controlled medications. There are similar medical studies that demonstrate the persistent physical damage that results from long-term incarceration."

The purpose of the Treasury's Priority Guidance Plan is to focus United States government resources "on guidance items that are most important to taxpayers and tax administration." In reviewing recommendations and selecting projects for inclusion on the 2011-2012 Guidance Priority list, the Treasury and the IRS have stated they will consider whether the recommended guidance:

• Resolves significant issues relevant to many taxpayers;
• Promotes sound tax administration;
• Can be drafted in a manner that will enable taxpayers to easily understand and apply the guidance;
• Involves regulations that are outmoded, ineffective, insufficient, or excessively burdensome and that should be modified, streamlined, expanded, or repealed;
• Reduces controversy and lessens the burden on taxpayers or the IRS; and
• Whether the IRS can administer the recommended guidance on a uniform basis.

McCulloch maintains his request for guidance satisfies the above criteria:

• Since Section 104(a)(2) was amended in 1996, taxpayers have needed guidance to determine the scope of the terms "physical injury" and "physical sickness" for which no definitions exist.
• The 1996 amendment did not specifically consider its application to victims of sexual abuse and wrongful incarceration and needs modification because it affects a large and growing number of taxpayers:
  • For sexual abuse victims, because of greater opportunities for victims resulting from legislation in many states which extends applicable statutes of limitations.
  • For wrongful incarceration victims, because more widely available DNA-testing absolves wrongfully convicted prisoners.
• The requested guidance would promote sound tax administration by providing an understandable tax rule thereby minimizing the likelihood of future controversies.
• It would also provide consistency in tax treatment among such victims who face uncertainties and expense when they currently attempt to address these issues individually.

In S2KM's opinion, industry support for McCulloch's proposal would provide one immediate answer to Jeremy Babener's strategic question about how the structured settlement industry can cooperate to improve and grow its market by encouraging more damages to be received tax-free under IRC section 104(a)(2).

For additional information about taxation of damages received by personal injury victims, see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J)

Death and Damages

Jeremy Babener has written a new tax article titled "Death and Damages Can be Taxing" which appears in the April 2011 issue of Trusts & Estates magazine. Written for estate planning professionals, Babener's article addresses both income and estate tax issues involved with lump sum and structured settlements.

Babener's article considers physical and emotional damages resulting from three categories of cases: wrongful death, survivor lawsuits, and pre-death causes of action. In addition to his tax analysis, Babener provides three instructive case examples plus practice tips, a summary table and extensive footnotes.

Babener's article re-affirms, from S2KM's perspective, several important settlement planning lessons:

• The complexity of settlement planning and the importance for many recipients of personal injury and wrongful death settlements to receive timely and related tax advice from tax professionals. Although Babener's audience consists of estate planning professionals who may not always contribute to case-specific pre-settlement planning, they may be called upon post-settlement to address income or estate tax problems created by a poorly planned settlement. Classic "red flag" structured settlement cases include large periodic payouts with long certain periods or large deferred lump sums.
• The importance, when planning settlements, to consider potential future tax changes including estate tax rates and/or the amounts of allowable estate tax exclusions and deductions. Recent estate tax exemptions that shelter extensive sums from any estate tax may not exist when current structured settlement recipients die with still-to-be paid periodic payments.
• The role of allocations in settlement tax planning and tax calculations. As one example, Babener discusses a wrongful death preceded by substantial pain and suffering related to the accident causing the death. Although proceeds from a wrongful death settlement are not subject to estate tax, proceeds related to the pain and suffering will be included in the decedent's estate and will be subject to a potential estate tax. In another example involving co-plaintiffs, Babener suggests naming the more injured party as the primary structured settlement payee and the less-(emotionally) injured plaintiff as contingent structured settlement beneficiary.
• The potential estate planning problems created by structured settlements including valuation of any periodic payments remaining when the primary payee dies and the potential lack of liquidity to pay estate taxes. Babener highlights a current judicial controversy potentially applicable to structured settlements related to Treasury regulations issued in 1995. These regulations provide that a "restricted beneficial interest subject to any contingency, power or other restriction" will be valued for estate tax purposes based on all facts and circumstances rather than by Treasury tables. Whether structured settlement payments are considered to be "restricted beneficial interests" (due to non-assignability clauses) becomes financially significant in calculating estate tax liability. Babener also points out the potential value or need for commutations or factoring transactions to pay estate taxes resulting from structured settlements.
• The risks for claimants and their attorneys in relying on non-tax professionals for settlement planning tax advice. This caveat was highlighted in Adrian v. Mesirow Financial Structured Settlements, a 2010 judicial decision (not mentioned in Babener's article) where a claimant alleged she was mislead by a defense broker about the favorable tax consequences of a structured settlement. In holding that the defense owed no duty to the claimant, the court found that the broker's education, certifications and years of experience related only to her work in life insurance and structured settlements and did not and should not suggest any expertise or special knowledge of tax law.

For additional tax and structured settlement articles by Jeremy Babener, see his Tax Structuring website and S2KM's structured settlement public policy wiki.

For additional information about the taxation of structured settlements, see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J).

Using Medical Costs to Lower Taxes on Emotional Distress Damages

Jeremy Babener, author of previous legal articles about structured settlements and taxation of personal injury damages, has published a new article titled "Maximizing the Medical Care Exception to the Tax on Emotional Distress Damages" in the September issue of Practical Tax Strategies.

Babener's new article, available on his Tax Structuring website, continues and expands Babener's analysis of medical expense deductions in personal injury cases. S2KM featured Babener's recent, related article titled "Taking Medical Expense Deductions Before and After a Personal Injury Suit" in this August 30, 2010 blog post,

Synopsis of Babener's new article: settlement attorneys and consultants should be aware that physical injury damages generally are received tax-free. Non-physical injury (e.g. emotional distress) damages without a physical cause, however, generally are not received tax-free. Moreover, damages received for physical symptoms resulting from emotional distress are taxable. However, if structured correctly, damages received to offset medical care costs incurred as a result of the injuries should not generate additional tax liability. Babener's new article explains how to design a settlement to maximize use of the medical care exception in cases involving emotional distress damages.

Babener has been named a 2010-11 NYU Tax Policy Fellow. In that role, he currently works at the U.S. Department of the Treasury’s Office of Tax Policy. Babener anticipates receiving his LL.M. in Taxation from NYU School of Law in Spring 2011. The NYU School of Law Magazine recently featured Babener and his writing about structured settlements.

S2KM has published a compendium of blog posts featuring Jeremy Babener's writing in S2KM's  structured settlement public policy wiki.