Review of "Structured Settlements: Factor vs. Commute?"

Robert W. Wood, an expert tax attorney whose specialties include structured settlements, has written a provocative new article titled "Structured Settlements: Factor vs. Commute?" for the December 25, 2006 edition of "Tax Notes". The article is also accessible on the Wood & Porter website.

Wood's article addresses the strategic question of "whether an insurance company can commute periodic payments due under its own annuity policy (or that of an affiliate) and still comply with the federal income tax law."

Note: quotations and italics are from Wood's article.

Summary of Wood's Conclusions

• There is "no clear answer" - which, in and of itself, Wood characterizes as "unnerving";
• "Factoring someone else's annuity is clearly okay" (meaning in the context of Wood's article, the transaction does not violate section 130's prohibition against acceleration) - provided the parties obtain a court order pursuant to IRC Section 5891 and meet the requirements of the appropriate state structured settlement protection statute.
• But a commutation (see analysis below) "appears to accelerate payments" - in violation of IRC section 130's prohibition against acceleration.
• Wood also differentiates "automatic commutations" (see analysis below) whose features, according to Wood, do not appear (based upon LTR 9812027) to cause an acceleration in violation of IRC section 130;
• Because commutations and third party factoring produce different results for the qualified assignee and annuity issuer, Wood argues they should be treated differently for tax purposes.
• "Issuers risk violating section 130 when they commute their own annuities (with or without a qualified order under section 5891)" and whether directly or using an affiliate company.
• "Given the preponderance of authorities discounting the value of court orders as controlling (or even bearing on) federal income tax consequences, a court order .... cannot prevent (or cure) a violation of section 130."
• Based upon his "serious concerns" about potential adverse and unexpected tax results from commutations used as a substitute for third party factoring, Wood concludes such commutations "should not be recommended by prudent tax practioners."

Summary of Wood's analysis:

• Key terminology
  • Insurance companies - for Wood's article, insurance companies also specifically include "companies that do not actually issue structured settlement annuities but are wholly owned by companies that do. That may include a qualified assignee."
  • Third Party Factoring - For Woods, IRC section 5891 creates a safe harbor for third party factoring. Although commutations and third party factoring produce the same result for the payee (a lump sum), Woods differentiates the results for the qualified assignee and annuity issuer.
  • Commutations
    • One difference between a commutation and third party factoring "is that in a commutation, the payee receives payment from the payer of the periodic payments, not from a third party."
    • A second difference: "in factoring the payments continue (without alteration of amounts or payment frequency) - not so with commutation (which effectively ends the payment stream)"
  • Automatic Commutations -Terminology Wood uses to differentiate commutations meeting the following requirements set forth by the IRS in LTR 9812027 which was issued in 1997:
    • Contemplated in the original structured settlement documents and funding annuity;
    • Caused by events outside the payee's control;
    • The payee has no ability to affect whether a commutation might occur; and
    • The commutation is made to the payee's beneficiaries and not to the payee.
  • Acceleration
    • Both IRC sections 130 and 5891 include prohibitions against acceleration of payments;
    • Acceleration can occur for one party to a structured settlement (payee) and not others (qualified assignee or annuity provider);
      • For the payee, both factoring and commuting represent acceleration;
      • For the annuity issuer and qualified assignee, acceleration only occurs with a commutation. With a factoring transaction, annuity payments continue but to a new person or entity or as part of a new financial security.
• LTR 9812027
  • In which the IRS ruled favorably for a commutation meeting the "automatic commutation" requirements identified above:
    • Structured settlement payments subject to the commutation clause were "fixed and determinable" under IRC section 130(c) (2)(a);
    • The commutation provisions did not cause the assignment to fail to comply with IRC section 130(c);
  • Although a private letter ruling cannot be cited as precedent and LTR 9812027 was issued prior to enactment of IRC section 5891, Wood views LTR 9812027 as important because:
    • No specific IRC section addresses commutations;
    • Besides LTR 9812027, the IRS has not provided any guidance for commutations.
  • Because IRC Section 130(c) prohibits acceleration, Wood characterizes LTR 9812027 as support for his conclusion that automatic commutation features do not cause an acceleration in violation of IRC section 130;
  • As Wood points out, however, in LTR 9812027, the IRS did not expressly address whether an automatic commutation (or any type of commutation) causes an acceleration for 130 purposes.
• Relationship between IRC Sections 130 and 5891:
  • Wood's analysis begins with some fundementals: IRC section 130 provides an exclusion from gross income for the qualified assignee;
  • Without this exclusion, a US-based qualified assignee has a potential tax mismatch - recognizing income immediately, then deducting each periodic payment as paid;
  • If IRC section 130 is satisfied originally, IRC section 5891 provides that any subsequent transfer does not affect the application of IRC section 130 in any year;
  • Third party factoring (pursuant to IRC Section 5891) does not impact the income taxation of any party to the structured settlement including the qualified assignee;
  • IRC section 5891 provides a safe harbor for satisfying the section 130 prohibition against acceleration;
  • There are no statutory pronouncements as to whether a commutation contravenes IRC section 5891;
  • Wood's analysis concludes: whether or not a commutation triggers an IRC section 5891 excise tax, it may still violate IRC section 130's acceleration requirement.
• Significance of a court order
  • To avoid a confiscatory forty (40 per cent) federal income tax, IRC section 5891 requires an acquiring company to obtain a final order, judgment or decree of a state court or responsible administrative authority (court order);
  • Pursuant to IRC section 5891(b)(5), a court order is "dispositive" for avoiding the excise tax;
  • This court order must find that the transfer does not contravene any state or federal statute or the order of any court or responsible administrative authority; accordingly, any such order implicitly states that IRC section 130 (acceleration) is not contravened;
  • Under traditional tax principles, a ruling by a federal or state court is not binding on the IRS or the courts.
  • Therefore, Wood questions why a state court ruling that no statute is violated for IRC Section 5891 purposes should be "dispositive" that the transaction satisfies IRC section 130.
  • Conversely, the state court order required to satisfy IRC section 5891 begs the question: does that proposed transfer violate IRC section 130?

Impact of Wood's Article

• Wood's article represents valuable strategic thinking for three related and overlapping markets: structured settlements; structured settlement transfers (factoring); and personal injury settlement planning.
• His article calls into question the appropriate tax treatment for commutation programs as competitive substitutes for third party factoring.  Wood's analysis should have special interest for companies such as Symetra, All State and National Indemnity who already participate in the secondary market.
• His article helps to explain why most annuity providers have not offered factoring or commutation products and services. 
• Wood's analysis makes it less likely that annuity providers will compete directly with factoring companies - at least until further tax authority or guidance becomes available.
• Nevertheless, Wood's article implicitly challenges structured settlement annuity providers (as well as their distributors and advisors - especially settlement planners) to re-think current structured settlements products, programs and processes in the context of both IRC sections 130 and 5891.
• For astute annuity providers, Wood's analysis offers insights to improve their structured settlement products and simultaneously facilitate the efficient operation of federal and state settlement transfer legislation.
• Wood's article further highlights:
  • The need for additional tax authority and education about factoring and commutations - particularly for state judges; and
  • The important linkage between IRC section 130 and the court orders under state protection statutes required by IRC section 5891.
• Wood's article improves upon and completes Structured Settlements in 2006 - a year in which some of the most important industry developments and some of the best expert commentary have focused on factoring and factoring's impact on structured settlements and personal injury settlement planning.