Beyond Structured Settlements

Taxation of Emotional Distress Damages - 1

Some of the most challenging federal income tax issues for settlement planners and their clients involve damages related to emotional distress and, even more specifically, damages compensating for stress-induced physical ailments.

This blog post summarizes federal legislative and regulatory tax history related to emotional distress damages and highlights recommendations for related legislative changes. In a subsequent blog post, S2KM will review articles by Jeremy Babener and Robert Wood analyzing recent related case law and offering their advice to settlement planning stakeholders.

Before enactment of the Small Business Job Protection Act of 1996, IRC section 104(a)(2) exempted from federal income tax payments received from settlements or judgments resulting from claims for personal injuries or sickness.

As the result of the 1996 amendment, however, Section 104(a)(2) now exempts from federal income tax “damages (other than punitive damages) received … on account of personal physical injuries or physical sickness.” Section 104(a) now also provides "emotional distress shall not be treated as a physical injury or physical sickness" for purposes of subsection (2). However, damages received on account of emotional distress that are attributable to a physical injury or physical sickness are excludable. The related legislative history provides that “emotional distress” includes “physical symptoms (e.g., insomnia, headaches, stomach disorders) which may result from such emotional distress.”

Since 1996, there have been many tax cases and many IRS rulings addressing damages for emotional distress. In a private letter ruling issued in 2000 (“the bruise ruling”), the IRS established “the observable bodily harms” standard in a case involving sexual assault and harassment in an employment context: “we believe that direct unwanted or uninvited physical contacts resulting in observable harms such as bruises, cuts, swelling and bleeding are personal physical injuries under section 104(a)(2).”

The United States Treasury did not issue new regulations for IRC section 104(a)(2), to address the 1996 amendments, until proposed regulations were published in 2009. A public hearing followed on February 23, 2010. On January 20, 2012, Treasury published final regulations for IRC section 104(a)(2) which were essentially the same as the 2009 proposed regulations.

Although the 2012 regulations confirm that damages for emotional distress attributable to a physical injury or physical sickness are excluded from income under section 104(a)(2), they do not provide any explanation to help define “physical” or “physical sickness”.

In addition to the tax rules outlined above, recipients of damages related to emotional distress, and their advisers, should also consider the following:

• IRS Form 1099 - When defendants settle cases involving taxable damages, they are required to complete an IRS Form 1099 and send copies to the claimant and the IRS. Most section 104(a)(2) cases, according to Robert Wood in his article "Tax-Free Physical Sickness Recoveries in 2010 and Beyond", have said a Form 1099 means the defendant/payer thought the damages were taxable. Conversely, Wood states, some courts have noted that the failure to issue a Form 1099 does not make a payment tax free.
• IRC Section 6661 - IRC Section 6661 establishes a 25% penalty for “substantial understatement of income tax.” However, according to case law cited in section 2.03 of “Structured Settlements and Periodic Payment Judgments”, (S2P2J) where a taxpayer reasonably relies on the advice of professionals in claiming a tax exclusion for emotional distress damages, the taxpayer may be able to escape application of an accuracy-related penalty - even though the exclusion was not accepted,
• Medical Care Exception - IRC section 104(a) excludes from gross income “damages not in excess of the amount paid for medical care … attributable to emotional distress.” In his article titled "Maximizing the Medical Care Exception to the Tax on Emotional Distress Damages", Jeremy Babener points out: "...when a client plans to receive damages on account of emotional distress, taking advantage of the medical care exception requires deliberate planning." Babener adds, however, "... while excluding damages based on past medical care expenses is relatively straightforward, excluding damages based on future medical care expenses is anything but."

During and/or concurrent with the February 23, 2010 public Treasury hearing related to the section 104 (a)(2) regulations, multiple persons recommended changes to the "physical" requirement added by the 1996 amendments including:

• The National Taxpayer Advocate - The National Taxpayer Advocate (NTA) addresses taxpayer considerations from inside the IRS. In a 2010 report to Congress, NTA representative Nina Olson recommended that section 104(a)(2) exempt non-physical damages, specifically emotional distress, mental anguish, and pain and suffering. To support her recommendation, Olson offered scientific data (that depression and other psychological illnesses included physical elements) and argued that existing tax law conflicts with public policy (the nondiscrimination requirement in the Mental Health Parity and Addiction Equity Act of 2008).
• John McCulloch - During the Treasury hearing, McCulloch proposed 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.
• David Higgins - 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 recommended 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.

For more detailed information about taxation of structured settlement payments, including emotional distress damages, see Chapter 2 of "Structured Settlements and Periodic Payment Judgments" (S2P2J).

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.

Structured Settlement Sales Decline

Compared with prior years, total United States structured settlement annuity premium dropped sharply in 2011 to $4,974,710,838 according to a newly released report by Melissa Evola. Evola, President of Structured Financial Associates, Inc., has tracked structured settlement industry sales since 2002 based upon input from life insurance companies that participate in the structured settlement market.

The 2011 structured settlement annuity premium total represents an approximate 10 percent decline from 2010 and an approximate 20 percent decline from 2008. Evola's report further indicates 28,811 structured settlement annuities were sold during 2011 for an average per case premium of $172,667.

Based upon Evola's report, MetLife and Prudential Life were the leading structured settlement annuity providers in 2011. Their combined structured settlement premium of $2,119,300,000 represented approximately 43 percent of total 2011 U.S. structured settlement sales. According to Evola's report, 12 life insurance companies comprised the U.S. structured settlement market in 2011 compared with 22 companies in 2002.

Evola's report also tracks "non-qualified" structured settlement sales which are included in her total structured settlement premium figures. Structured settlements that are non-qualified [under IRC sections 130 and 104(a)(2)] are utilized to defer future payments from immediate income tax. Only two annuity providers currently offer this product. Total non-qualified structured settlement annuity premium in 2011 was $119,513,424, according to Evola's report, compared with $123,532,247 in 2010 and an historic high of $192,501,540 in 2008.

Historic annual U.S. structured settlement annuity premium - as reported by Evola:

• 2011 - $4,974,710,838
• 2010 - $5,524,359,408
• 2009 - $5,383,998,395
• 2008 - $6,226,578,725
• 2007 - $5,998,277,764
• 2006 - $6,111,583,112
• 2005 - $6,125,251,601
• 2004 - $6,135,000,000
• 2003 - $5,965,000,000
• 2002 - $6,142,000,000

For estimated structured settlement annuity sales estimates from 1975-2011, see the structured settlement wiki which features estimates from the authors of "Structured Settlements and Periodic Payment Judgments" (S2P2J) based upon historical input from industry sources including Evola since 2002.

Many structured settlement industry participants attribute declining sales to low interest rates including future forecasts by the Federal Reserve. Market yields on U.S. Treasury securities at 30 year constant maturity peaked at 13.45 percent in 1981 according to reports published by the Board of Governors of the Federal Reserve System. Here are several historic average annual rates for 30 year Treasury securities based upon the same information source:

• 2011 - 3.91%
• 2010 - 4.25%
• 2009 - 4.08%
• 2008 - 4.28%
• 2007 - 4.84%
• 2000 - 5.94%
• 1990 - 8.61%
• 1980 - 11.27%

Although interest rates represent an important investment consideration, they impact all investment products not just structured settlement annuities. Regardless of interest rates, many other factors, such as mortality risk transfer and relative financial security, favor structured settlement annuities as the core settlement planning product for many personal physical injury victims. For additional information about structured settlement product suitability standards, 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.

S2P2J Release 50

Publisher Law Journal Press is currently distributing hardcopy supplements for Release 50 of "Structured Settlements and Periodic Payment Judgments" (S2P2J). Online S2P2J was also updated as of October 21, 2011 to include Release 50 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.

S2P2J Release 50 Highlights

Release 50 for Structured Settlements and Periodic Payment Judgments reviews the history of the receivership of Executive Life of New York ("ELNY"), tracks the status of its receivership and impending liquidation, updates discussion of the operation and role of U.S. life and health guaranty associations (“GAs”), and provides a comprehensive new chart summarizing coverage limits under the enabling statutes for all GAs in each of the U.S. states and territories.

This Release also expands and updates the discussions of several topics, including:

• Understanding the scope and meaning of “physical” as that crucial term is used in IRC § 104(a)(2) for claimants who receive damages on account of personal injuries that are not “physical” per se, such as wrongful incarceration and PTSD.
• Negotiating the important issue whether and pursuant to what terms a settlement payor will issue an IRS 1099-MISC form in cases where the tax treatment of agreed damages appears to be neither fully excludable under IRC § 104(a)(2) nor fully includable as income to the claimant.
• Determining choice of forum for establishing a 468B fund when one or more claimants against the 468B fund is a protected person.

In addition, Release 50 includes an extensive discussion of the IRS’s Structured Settlement Factoring Audit Technique Guide used to assist its examiners in determining taxability of structured settlement factoring transactions. The Guide describes the interplay between state law requirements and federal tax sanctions and presents a simplified conceptual framework to be used for determining taxability.

Joseph Dehner Interview

Joseph Dehner is a partner in the Frost Brown Todd law firm and co-author of "Structured Settlements and Periodic Payment Judgments" (S2P2J). He has been studying and writing about structured settlements since 1977 and agreed to be interviewed for this S2KM blog post.

S2KM: Your Frost Brown Todd biography highlights your expertise in multinational securities and business disputes. How do structured settlements fit into your legal practice?

Dehner: Through some of my clients, I was part of the birth of the structured settlement industry many years ago. It is great to see the structured settlement industry evolve into a robust part of the U.S. economy. I continue to advise attorneys and firms on structured settlement and periodic payment judgment issues. One example was the honor of serving as the U.S. Government’s expert witness in the criminal trial of James Gibson, who besmirched the good names of structured settlements and US Government bond trusts, and is now serving a long prison term.

S2KM: William T. Robinson lll, your Frost Brown Todd partner and President-Elect of the American Bar Association (ABA), was be a featured speaker at the NSSTA 2011 Annual Meeting. In addition to Robinson and yourself, does Frost Brown Todd have other attorneys with structured settlement expertise?

Dehner: We have a large litigation department, but I am the primary person specializing in structured settlement matters within our firm.

S2KM: You and your co-authors have been writing and updating S2P2J since 1986. Who is your target audience and how to you track new developments?

Dehner: Our target audience includes attorneys, as well as structured settlement consultants, judges and funding providers. We review on a monthly basis all reported cases and news reports about structured settlements and periodic payment judgments, and follow information as it flows about case and other developments.

S2KM: Having recently completed S2P2J Release 49, what important legal issues and developments do you see emerging?

Dehner: There is a growing experience of post-settlement issues emerging from a variety of directions – including fights among beneficiaries of holders of structured settlement rights, factoring company fights and disputes arising from Protection Act hearings, tax rulings (e.g., wrongly incarcerated persons can receive tax-free payments, despite prior uncertainty whether they suffered a “physical” injury), rights in bankruptcy, whether structured settlement rights are marital property, and many other issues that are being resolved over time by individual case rulings. The growing use of structured settlements outside the “tax-free” arena represents recognition that settlement is a time to put into place good financial planning.

S2KM: How do structured settlements in the United States differ from structured settlements in other countries?

Dehner: Many countries have more of a safety net philosophy and less of a litigation-driven means of addressing the needs of injured persons. But for common law countries, many have moved well ahead of the USA in insisting that compensation meet needs – meaning that payments should correspond over time to the actual needs of injured persons. So, in the UK, Ireland and elsewhere, we are seeing a conversion from the ancient lump-sum one-time system to what we in the USA would find normal in the workers compensation context. This is a real sea shift in thinking.

S2KM: Are there any lessons or ideas the United States structured settlement industry can gain from other countries?

Dehner: Sure – read Chapter 1 of our book about other country experiences and approaches.

S2KM: How do you view the secondary market? Are structured settlement transfers good or bad for the industry generally - and more specifically for structured settlement recipients?

Dehner: It’s not a question of bad or good. It’s a question of how individuals react in the real world. People who hold structured settlement rights chose to take money over time at one point, and then decide for various reasons to get cash now in exchange for giving up future rights that have greater value overall. But that’s their choice. The reality is that high-pressure tactics, coupled with what would have been viewed as usury and heresy in the Middle Ages, robbed those individuals of a truly fair and efficient secondary market when the factoring industry arose. Protection Acts now exist in 47 states. When you review the reported decisions about transfers of structured settlement rights, virtually every case where a judge wrote an opinion rejects the transfer and recites in pointed language why discount rates and other factors compel denial of a transfer application. Most transfers go through anyway because of no real contest and no real focus by the court on the underlying issues. I would hope that the impact of factoring over time does not dissuade Congress from maintaining favorable government support for structured settlements through a continuation of 104(a)(2) treatment.

S2KM: What factors, in your opinion, have contributed to the recent decline in growth of the structured settlement annuity premium?

Dehner: It’s pretty simple really. Interest rates are so low for so long that structured settlements have not stood out as bargains compared to receiving a lump sum and investing it for potentially greater returns (though the performance of the US equity markets should cause a reasonable observer to think twice).

S2KM: Do you have any thoughts or ideas about how to improve and/or grow the structured settlement industry?

Dehner: Greater focus on its basic point is where to start. Regardless of tax treatment, putting into place a compensation plan that actually aims to match needs with resources makes sense. Although there is no solid statistical evidence to support the concept that recipients of windfalls have nothing left after five years, we all know the realities that confront anyone who obtains a large sum as a first time experience with wealth. Charities, friends and relatives want a piece. It’s easy to spend money sitting in the bank. And then at some point there is nothing left to deal with what in some cases is a lifetime of needs. My favorite structured settlement example was an elderly fellow I represented who was pushed over in a grocery store, broke his hip and ended up in a nursing home that at the time cost about $1100/month. He would have run out of money from his savings in about two years. Instead of getting a small lump sum settlement for what happened, the insurer provided a structured settlement that paid $1400/month for the rest of his life. The cost was minimal, given his age and the magic of actuarial science. He died 15 years later, but never had to worry about his nursing home bills. Keep the focus on this example and what it represents, and the structured settlement industry merits a bright and expanding future.

S2KM: What lessons, if any, do the Spencer v. Hartford and Macomber v. Travelers class action settlements provide for the structured settlement industry?

Dehner: Transparency. As long as underlying economic realities are known and disclosed to those involved, I don’t see an issue. One can argue about Spence and Macomber should ultimately have been decided, but there is an easy solution to the issues that underlay both cases – being up front and clear in documentation and negotiation as to what was going on. When we wrote "Structured Settlements and Periodic Payment Judgments" in 1986 (since updated 49 times), our negotiation chapter talked about how a good structured settlement negotiation should be about how much a claimant would receive when over time. It was not about negotiating an amount first, and then finding out what it would buy. Focusing on what payments will be received when (and the reliability of the financing mechanism) and disclosure of who does what and receives what are consistent with best practices, and should not be subject to later court challenges about what participants earned how much in the process.

S2KM: What impact, if any, would the expanded use of 468B funds in single event tort cases have on structured settlements?

Dehner: It would simplify matters for a defendant, of course, but would require clear IRS or statutory guidance that is missing now. It would give greater leverage to the claimant than exists now, so the defense side understandably is reluctant to embrace the tool generally, and absent clear guidance on the efficacy of single-claimant 468B funds, there is no point in the rhetorical debate that rages about this issue.

S2KM: Assuming federal malpractice reform legislation is enacted, should periodic payment of judgments be included?

Dehner: Of course. Read the recent paper of the Irish judiciary, or the UK Government’s papers that led to widespread use of periodic payment judgments there as a matter of course. Or just think about what the law really accomplishes at its best – matching compensation with actual need. This is not about favoring the defense or plaintiff side of the bar. And it is not about who wins and loses. This is about trying to make sure as well as possible that injured persons receive compensation that meets their needs. If it lowers cost, fine. If it increases cost, fine. I would argue that this is unknowable, but it is obvious to a rational individual that trying to match compensation against need is better than the equivalent of a lottery, where some people lose completely, others win it big, and many get a lump sum that does not last enough to get them through their lifetimes.

S2KM: Are there any opportunities for the structured settlement industry to benefit from proposed changes (including budget decreases) for Medicare, Medicaid and/or Social Security?

Dehner: Yes, and one can expect both further pressures for Medicare and Medicaid reimbursement at settlement time, as well as increasingly sophisticated settlement planning. Our book tries to keep abreast of these rapidly changing areas and how attorneys and other participants in the structured settlement industry can do a good job for their clients (and not make serious mistakes in the process).

S2KM: From an historic legal perspective, what impact have structured settlements and periodic payment judgments had on the U.S. tort system?

Dehner: The rule thought to be enunciated first in England in Fetter v. Beale that an injury should be compensated with a single one-time payment – the lump-sum system – has been met with deviation when it matters most – in workers compensation systems, in vaccine cases, in other applications. And even in England, the lump sum award system is slowly disappearing based on statutory changes. Structured settlements in the US have continued to chip away at lump sum thinking in America. History should show that structured settlements and periodic payment judgments will prove to be a far better alternative to the jackpot theory of litigation. Do we really want injured people to go to courthouse casinos for justice?

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.

SSP and NSSTA 2011 Annual Meetings - 2

This blog post continues S2KM's discussion of the 2011 annual conferences of the Society of Settlement Planners (SSP) and the National Structured Settlement Trade Association (NSSTA) with a strategic perspective. A prior S2KM blog post identified speakers and topics featured by SSP and NSSTA. Subsequent S2KM blog posts will summarize and provide commentary about selected speaker presentations.

SSP's conference, open to members and non-members, addressed two general topics: "Special Needs Settlement Planning" and "Practice Improvement: Marketing and New Products". NSSTA's conference, for members only, celebrated NSSTA's 25th anniversary. It also included a NSSTA business meeting with reports from immediate Past-President Michael Kelly, new President Dan Finn, Executive Director Eric Vaughn, Assistant Executive Director Peter Arnold and the Chairpersons of NSSTA's several committees.

One of the highlights of NSSTA's 2011 conference was the honoring of NSSTA's past presidents. David Ringler, NSSTA's first president, spoke briefly at the conference and re-stated his original vision for NSSTA:

"Although we do need to constantly be on the watch for legislative change, I still believe having a place where everyone and anyone can sit down with each other and discuss the issues and viewpoints regardless of beliefs is the most important reason for NSSTA. I have called it a common “talk table”, although I agree that is not exactly a very elegant term. If we can continue this tradition, there is no problem we cannot overcome."

Many industry participants, including some NSSTA members, question whether NSSTA has lost sight of this original purpose and tradition. Does NSSTA continue to represent "a place where everyone and anyone can sit down with each other and discuss [structured settlement] issues and viewpoints regardless of beliefs"? The answer, unfortunately, is "no".

For the past several years, NSSTA's leadership has superimposed a strict political litmus test for membership as well as for topics and speakers at its educational conferences. As one result, structured settlement industry participants with alternative issues, viewpoints, beliefs and educational interests have founded two other national structured settlement associations: the National Association of Settlement Purchasers (NASP) in 1996 and SSP in 2000.

Fortunately for NSSTA members and the structured settlement industry, based upon its 2011 conference, NSSTA appears to be expanding the scope of its educational programs to address important but controversial industry topics such as IRC 468B Qualified Settlement Funds, IRC 5891 and state structured settlement protection statutes. The educational programs offered by both NSSTA and SSP also increasingly discuss three fundamental transitions reshaping the structured settlement industry:

• From structured settlements to settlement planning;
• From a singular, illiquid, and non-assignable product to multiple products with greater flexibility to address changing needs and circumstances of injury victims;
• From traditional (pre-Internet) to web-based business models, processes and skill sets.

With the structured settlement industry facing these and other challenges, including aging leadership, declining structured settlement annuity sales, anticipated legislative changes plus an increasingly complex legal and regulatory business environment, where is the strategic vision and what are the strategic priorities for NSSTA and SSP?

NSSTA President Dan Finn and Executive Director Eric Vaughn identified the following:

• NSSTA challenges:
  • Promote the expanded use of structured settlements
  • Expand the structured settlement market
  • Protect structured settlement annuitants
  • Defend IRC sections 104(a) and 130
  • Enhance the Certified Structured Settlement Consultant (CSSC) program
  • Unify the structured settlement industry
• NSSTA objectives
  • Expand IRC section 104 (a)(2) to include wrongful imprisonment and sexual abuse cases
  • Expand government use of structured settlements
  • Promote structuring of MSAs in liability cases
  • Promote the structuring of Social Security disability payments
  • Promote the professionalism of structured settlements

SSP President Jack Meligan prioritized three objectives:

• Improve SSP's marketing to plaintiff attorneys
• Create an SSP lobbying presence
• Enhance the Registered Settlement Planner (RSP) certification program

Two of NSSTA's featured speakers, Jim Morris, President, Chairman and CEO of Pacific Life Insurance Company, and William T. Robinson lll, President-Elect of the American Bar Association (ABA), added important and positive assessments for structured settlements.

Morris accentuated the current financial strength of U.S. life insurance companies and explained why structured settlement annuities represent an excellent strategic product for life companies. As corollaries to Morris' presentation:

• NSSTA announced that two highly rated annuity providers, Mutual of Omaha and Berkshire Hathaway, have re-entered the structured settlement market; and
• Thomas Ronce and Craig Ulman clarified the life and health guaranty association system and how that system applies to structured settlements.

Robinson praised structured settlements as "professional and dignified solutions" for injury victims based upon his first-hand experience as a litigation attorney. Structured settlements represent "state of the art" tools for all attorneys to consider when negotiating and resolving personal injury cases according to Robinson. In his capacity as President-Elect of the ABA: Robinson also:

• Spotlighted the current funding crisis facing state courts; and
• Suggested the ABA and NSSTA should identify shared interests and lobbying opportunities.

For S2KM's reporting and commentary about past SSP and NSSTA conferences, 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)

Deducting Punitive Damages

The income tax exemption provided in Section 104(a)(2) of the Internal Revenue Code for "any damages" received "on account of personal physical injuries or physical sickness" specifically excludes "punitive damages".

A separate but related issue: should defendants be able to deduct punitive damages on their tax returns?  Right now, they can. The benefit to defendants is obvious. What about plaintiffs?  Since the after-tax cost of every dollar paid is lower, should plaintiffs receive more?

Proposals to disallow the deduction have been made multiple times. The Clinton administration proposed it in the 1990s, and the Obama Administration has resurrected the idea. In response, several policy articles have been published debating the merits of allowing defendants to deduct punitive damages, and discussing alternative policies. SK2M asked Jeremy Babener, a 2010-11 NYU Tax Policy Fellow, to explain the tax issues involved and the arguments being made.

Introduction

As part of his 2010, 2011, and 2012 revenue proposals, President Obama proposed to end defendants’ ability to deduct punitive damages.

Currently, punitive damages incurred in connection with a defendant’s business are tax deductible. Consider a plaintiff’s request to a jury for $1 million in punitive damages. If the defendant can deduct the $1 million of damages against $1 million of income taxed at 35%, the true cost of the award to defendant is $650,000. Juries are sometimes informed of the tax consequences of damages, and sometimes not.

The Obama Administration argues that the deduction's effect of lowering the true cost to defendants “undermines the role of such damages in discouraging and penalizing certain undesirable actions or activities.”

Polsky and Markel

Gregg Polsky (University of North Carolina School of Law) and Dan Markel (Florida State University College of Law) argue in Taxing Punitive Damages that rather than changing tax law, juries should be informed of the tax consequences of damages. Thus, in the above example, a jury might award plaintiff $1.5 million, knowing that the after-tax cost to defendant would be $1 million. The effect of the Obama proposal, they posit, would likely be circumvented by settlements that allocate less to nondeductible punitive damages, and more to deductible compensatory damages. The IRS may find it difficult to identify and correct such improper settlement allocations.

Zelenak

Lawrence Zelenak (Duke University School of Law), in response to Polsky and Markel, makes two points. First, he suggests that while it might be better to end deductions for punitive portions of damage awards, punitive portions of settlements should remain deductible. Less than five percent of plaintiffs who go to trial are awarded punitive damages. Since it is impossible to identify which settling defendants would have been forced to pay punitive damages, and to determine the amount of such damages, Zelenak argues that punitive damage portions of settlements should be fully deductible.

Second, Zelenak argues that the Polsky and Markel solution ignores the deterrence role of punitive damages. In part, punitive damages are supposed to force a defendant to pay for the costs to injured parties who could not or would not bring legal action. If those injured parties had sued, the defendant would have been able to deduct the resulting compensatory damages. From a deterrence point of view, therefore, the defendant should be able to deduct the punitive damages paid to plaintiff that substitute for deductible compensatory damages. Zelenak writes that Polsky and Markel focused only on the punishment rationale for punitive damages, which suggests that a reduction in the true cost of punitive damages, via deductibility, reduces defendants' intended punishment. Of course, as Zelenak concludes, balancing the punishment and deterrence rationales of punitive damages is very difficult.

Mogin

Paul Mogin (Williams & Connolly, LLP), also in response to Polsky and Markel, argues three separate points. First, many courts prevent defendants from encouraging reductions in damage awards by either informing juries when plaintiffs will receive damages tax-free, or by introducing evidence of a plaintiff’s previous reimbursement for economic losses. Therefore, Mogin writes, allowing plaintiff to introduce defendant’s ability to deduct punitive damages would create a “pro-plaintiff imbalance.”

Second, Mogin asserts that providing juries with additional encouragement to increase punitive damages would exacerbate juries’ already distorted pro-plaintiff perception of corporate defendants. While evidence of a defendant’s wealth is generally inadmissible in court, the rule does not typically hold for punitive damages. The U.S. Supreme Court has recognized that the presentation of a defendant’s wealth “creates the potential that juries will use their verdicts to express biases against big business.” Thus, Mogin argues, juries should not be further encouraged to increase punitive damages awards.

Third, Mogin criticizes Polsky and Markel for elevating the jury’s assessment of punitive damages above its rightful place. Historically, judges have reduced or set aside unduly harsh punitive damages. Moreover, while the jury’s role is one of fact-finder, the measure of punitive damages is hardly factual. Why then should it be so important that the true cost of defendant’s damages are exactly equal to the amount the jury intended?

There's Always More

Several other papers have been written on disallowing defendant deductions for punitive damages, including a 2010 article published by the Heritage Foundation, and a 2001 report by the New York State Bar Association.

Jeremy Babener's articles on the taxation of personal injury damages and structured settlements are available at TaxStructuring.Com. Babener is a 2010-11 NYU Tax Policy Fellow. Having worked for the U.S. Department of the Treasury's Office of Tax Policy in the Fall of 2010, he will graduate from NYU School of Law's Graduate Tax Program this Spring.

For additional information about Internal Revenue Code Section 104(a)(2), punitive damages and the allocation of damages for tax purposes, see section 2.03 of "Structured Settlements and Periodic Payment Judgments".