Beyond Structured Settlements

Structured Settlements 2014 - Secondary Market

Is the bloom finally off the rose for structured settlement secondary market leader JGWPT Holdings, Inc. (JGWPT) whose subsidiaries include J.G. Wentworth (JGW) and Peachtree Settlement Funding (Peachtree)?

Despite strong sales since 2010, punctuated by the November 25, 2014 announcement that it had issued $207,501,000 of Fixed Rate Asset Backed Notes collateralized primarily by payment rights rights arising under court ordered structured settlement payment purchase contracts, JGWPT's NYSE per share price closed at $8.65 on December 12, 2014, down drastically from its 2014 high of $19.88 on March 4.

When JGWPT's Holdings IPO occurred November 8, 2013, with an initial offering price of $14.00 per share, one analyst opined the stock was worth at least $20 per share based upon JGW's "dominant franchise", access to securitization markets, low costs relative to competitors and "incalculable returns on capital", among other factors.

After JGW consolidated its 2011 merger with Peachtree, various industry experts estimated the combined combined company's structured settlement secondary market share totaled somewhere between 50% and 75%, and its share of industry profits exceeded 80%.

What happened?

Zacks Investment Research published two reports earlier this month on December 2 ("JG Wentworth - Bear of the Day") and December 9 ("What Falling Estimates & Price Mean for J.G. Wentworth").

Zacks' conclusion: "A key reason for this [downward stock price] move has been the negative trend in earnings estimate revisions. For the full year, we have seen four estimates moving down in the past 30 days, compared with no upward revision. This trend has caused the consensus estimate to trend lower, going from $1.71 a share a month ago to its current level of $1.45."

What has caused JGW's negative trend in earnings estimates?

As summarized in S2KM's 2013 annual report about the structured settlement secondary market, JGWPT faced a multitude of problems and controversies prior to 2014. New and/or expanded problems have occurred during the past 12 months - in particular:

• Brenston case law "progeny"; and
• Washington Square v. RSL.

Brenston Case Law "Progeny"

In the Brenston case, the Illinois Supreme Court in December 2013 denied Peachtree's petition for review of an Illinois Appellate Court decision which found multiple Peachtree-Brenston transfer orders, previously approved in accordance with the Illinois transfer statute, to be void ab initio because:

• Peachtree did not file all settlement documents with the transfer court.
• Peachtree concealed "by omission" the existence of anti-assignment provisions which the Appellate Court found "material".
• The conduct of Peachtree and it's attorney amounted to an "affirmative falsehood and a fraud upon the trial court".

The denial of Peachtree's petition for review has substantially reduced the secondary structured settlement market in Illinois according to industry sources. Some annuity providers reportedly have refused to waive anti-assignment provisions in Illinois cases while others evaluate them on a case-by-case basis. In addition, some annuity providers are citing Brenston to challenge transfers in other states.

The Brenston case was also quickly followed by Sanders v. JGWPT Holdings, a class action lawsuit, accusing JGWPT Holdings, Inc., several affiliate companies including JGW and Peachtree, and Illinois attorney Brian Mack, of violating the Illinois Consumer Fraud and Deceptive Business Practice Act (ICFA). The case has since been removed to the Federal Court in the Southern District of Illinois with that court expected to rule on various motions and petitions in February 2015.

Washington Square v. RSL

In this case, transfer company Washington Square (aka Imperial) sued transfer company RSL Funding in Texas for tortious interference with a transfer agreement that had not yet been approved in a final court order. The Court of Appeals of Texas, Fourteenth District, held:

• RSL was “justified” in interfering with Imperial’s proposed transfer agreement prior to court approval because obtaining a better price was in the seller's "best interest".
• Transfer agreements that have not received court approval are not enforceable on public policy grounds and therefore cannot justify legal actions for tortious interference with existing contracts.

As a result of this case, a strategic marketing shift appears to be occurring within the structured settlement secondary market as rival transfer companies increasingly search court records and seek to outbid other transfer companies who are awaiting court approvals. This marketing shift may provide lower discount rates for some structured settlement recipients when they sell their payment rights. The impact on the secondary market, however, will be "chaos", according to some participants, including extra "informational" demands on the judicial system responsible for administering the state protection acts.

For JGW and Peachtree, who have invested millions of dollars to build their TV and Internet brands, this strategic marketing shift promises new, much less-well financed competitors. Like pilot fish, these competitors can be expected to offer competitive bids based upon public court filings of not-yet-approved transfers proposed by JGW and Peachtree (as well as other established transfer companies) rather than based upon their own independent marketing. Assuming this occurs, the likely per case results for JGW and Peachtree will be lower success ratios and higher costs.

ADDENDUM (added December 15, 2014) - JGWPT's September 10, 2014 Form S-1/A filing with the SEC identifies multiple "Risk Factors" at least two of which could impact other structured settlement stakeholders:

• "[T]he insolvency or downgrade of a material number of structured settlement issuers." S2KM will discuss these rating downgrades, which include Genworth, Hartford and Aviva, in a subsequent 2014 annual report about ELNY and Reliance.

• "[T]he impact of the March 2014 Consumer Financial Protection Bureau inquiry and any findings or regulations it issues as related to us, our industries, our products or in general." (emphasis added)

Change of Directions for JGWPT?

One apparent result of JGWPT's continuing problems and controversies has been a change of CEOs with Stewart Stockdale replacing David Miller in July 2014. Another result appears to be a more diversified strategy away from structured settlements.

In a November 13, 2014 press release, Stockdale stated: "We are in the early stages of transforming J.G. Wentworth and are excited about the groundwork we have laid to achieve the three key strategic pillars -- Grow the Core, Become an Information-Based Company, and Diversify." To date, this proposed transformation does not appear to have impressed investment analysts or positively impacted JGWPT's common stock.

Other 2014 Secondary Market Developments

• Educational Dialogue - For the first time, educational programs sponsored by the National Structured Settlement Trade Association (NSSTA) and the Society of Settlement Planners (SSP) featured representatives of the National Association of Settlement Planners (NASP) as participants in secondary market panel discussions. For the ninth consecutive year, NASP featured primary market representatives speaking about primary market issues at their annual educational conference. For summaries of these conferences, see the structured settlement wiki.
• Case Law - In addition to the Washington Square and Brenston-related cases summarized above, noteworthy 2014 case law developments occurred in Texas and New York related to split payments and servicing arrangements. Two Texas cases required JGW to continue servicing arrangements under prior court approved orders and also to service subsequent assignments by the same payees to another transfer company. Multiple New York judges expressed their concerns about servicing arrangements while approving structured settlement transfers. At least 27 state structured settlement protection acts prohibit partial transfers. During 2013, MetLife began actively opposing transfers that involve split payments as well as court-approved servicing arrangements. Under such servicing arrangements, structured settlement annuity providers remit the entirety of specific periodic payments to transfer companies to administer even when the original recipient/transferor only assigns a portion of the payments.
• State Legislation - Although structured settlement protection act (SSPA) activities occurred in Florida, Wisconsin, Minnesota, Louisiana, and Mississippi during 2014, only Minnesota enacted a legislative amendment. Minnesota amended its SSPA to require notice of the date and judicial district of any prior application for transfer filed by the transferee relating to a prior proposed transfer with the payee including whether the proposed transfer was approved or denied. If granted, such notice must provide the amount and due dates of transferred structured settlement payments, the aggregate amount, the discounted present value and the gross amount payable to the payee.
• PLR-143928-13 - Issued by the Internal Revenue Service in August, this two-part private letter ruling approves favorable tax treatment for a structured settlement annuity which includes the possibility of a commutation by the recipient pursuant to a Notice of Hardship Conversion. In a prior blog post, S2KM described this PLR as potentially "game changing" because it overcomes an industry concern (enunciated in a 2006 Robert Wood article) that commutations do not qualify for favorable tax treatment afforded third party factoring transactions under IRC 5891.
• Re-cycled payment rights - Representing a small fraction of secondary market sales, the resale to personal injury victims and their attorneys of payment rights previously acquired in a structured settlement factoring transaction (sometimes misleadingly referred to as "recycled structured settlements") continues to cause serious concern among most primary market participants. NSSTA considers engaging in or promoting the marketing or distribution of re-cycled payment rights to be risky, confusing and unregulated investment activity and inconsistent with its Mission.
• Discount rates - Discount rates for structured settlement transfers vary widely depending upon multiple factors including: single vs. multiple bids; fixed vs. life contingent payments; size of payments purchased; length of payment deferral; perceived financial strength of the annuity provider; and/or state law (eg. North Carolina rate cap). The NCOIL State Structured Settlement Protection Model Act, which NSSTA and NASP have agreed to support, contains a definition for "discounted present value" which is generally higher than, and unrelated to, the discount rate actually incorporated into most structured settlement transfers. Regardless of discount rates, judges continue to deny proposed transfers that do not otherwise satisfy the "best interest" test. Reasons include: funds from prior transfer(s) were not used for stated purposes; stated purposes do not justify approval.
• Secondary market sales
  • Based on interviews with industry experts in 2012, S2KM estimated 2012 structured settlement activity to be:
    • 12,000 secondary market transfers - with less than 120 contested by annuity owners and/or providers.
    • $360 million of total secondary market purchases (money paid to transferors).
    • $30,000 average individual transfer.
  • Opinions differ as to secondary market sales growth during 2013 and 2014 ranging from no growth to 7% growth per year.

S2KM will address 2014 developments related to personal injury settlement planning and the ELNY liquidation in subsequent blog posts,

For additional related S2KM reporting, see:

• NASP 2014 Annual Conference.
• Primary Market 2014 Report
• Prior Year Annual Reports

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 Settlements in 2011 - 3

Prior S2KM 2011 year-end structured settlement blog posts have highlighted the historic significance of the ELNY liquidation and provided a strategic 2011 industry retrospective . This blog post summarizes additional important 2011 structured settlement developments and information.

Taxation

• IRS Audit Guides - The Internal Revenue Service published an Audit Guide in 2011 to assist its examiners in determining the tax treatment of proceeds from lawsuits, settlements and awards received after August 21, 1996. That date marked the enactment of the Small Business Job Protection Act of 1996 which added a "physical" requirement to IRC § 104(a)(2). The IRS had previously published an Audit Guide to assist its examiners in determining whether the IRC §5891 excise tax applies to specific structured settlement factoring transactions.
• JTC Structured Settlement Estimate - The Joint Committee on Taxation (JCT) in 2011 released its Estimates of Federal Tax Expenditures for Fiscal Years 2010-2014 (JCT Report). For the first time, the JCT Report calculated an estimated tax revenue loss for the "exclusion of investment income from structured settlement arrangements". The JCT estimate projected structured settlement tax revenue loss to be "de minimis" - meaning less that $50 million for Fiscal Years 2010-2014 or less than $12.5 million per year.

Government Benefits

• Medicare Secondary Payer Protocol - Although no statutory or regulatory authority requires Medicare set-aside arrangements (MSAs) in third party liability settlements, confusion continues as to whether and when MSAs are necessary and/or appropriate for such cases. On May 6, 2011, the United States Attorney's Office for the Western District of New York (USAOWDNY) released a one page "Medicare Secondary Payer Protocol" (MSP Protocol) establishing a voluntary process by which that U.S. Attorney's Office will review MSA proposals for liability cases provided certain conditions are met.

• U.S. v. Stricker - In this case involving periodic payments and the MSP Act, a U.S. District Court in Alabama denied a motion by the U.S. Government to reconsider the court's earlier dismissal based upon its finding that the applicable statutes of limitations barred the Government's complaint. The Government had argued on appeal that the court erred in granting its motions to dismiss without considering the Government's theory of continuing accrual argument.

• WCMSA portal - The Centers for Medicare and Medicaid Services (CMS) announced the creation of an Internet portal for submission of workers compensation MSA (WCMSA) proposals. The new web-based application:
  • Enables WCMSA proposals to be submitted electronically for CMS review;
  • Accepts submission documents and supplemental information CMS may request;
  • Provides online status updates for MSA applications;
  • Generates email alerts when approval letters are issued.
• Conditional payment guidelines - CMS released guidelines during 2011 to provide certainty and finality for conditional Medicare payments. This "self-calculated final conditional payment amount" option, will be initiated in February 2012 for claims with a total settlement value of $25,000 or less allowing attorneys and/or claimants to receive a final amount owed number from CMS prior to settlements. For additional information see the Medicare Secondary Payer Recovery Contractor (MSPRC) website.

Minors Settlements - Whether a structured settlement annuity that extends beyond the age of majority is "suitable" for, or in the "best interests" of, a minor (especially a minor without a debilitating injury) represents an important industry issue. In his 2009 presentation to the Society of Settlement Planners (SSP) titled "What Judges Look for When Approving a Minor's Settlement", Texas attorney Phillip McCrury surveyed state minors' statutes and concluded many states require judges to consider the "best interest" of a minor even though very few states directly address structured settlement annuities. Two 2011 cases (only one involving a structured settlement) highlight the potential for conflicting judicial interpretations when annuities are part of a proposed minor's settlement.

• Hancock v. Share - A Florida Appellate Court reversed a Florida Trial Court ruling that denied approval of a proposed structured settlement for a minor. Although the trial court had found that the proposed structured settlement was in the "best interests" of the minor, it refused to approve the structured settlement citing a Florida statute that prohibits a guardian "to bind the assets" of a minor beyond the age of majority.
• In the Matter of Sandra McDuffie - A New York trial court ruled against an estate administrator who proposed to purchase an annuity for a minor child of the decedent stating "the Court cannot authorize the administrator to restrict funds due to an infant after the infant has reached the age of [majority]".

Executive Life Insurance Company of California - In a legal dispute (Aurora S.A. v. Poizner) which it characterized as "another aspect of the dizzyingly complex and heavily litigated failure of the Executive Life Insurance Company", a California Court of Appeals on August 8, 2011 upheld a trial court decision that California's Insurance Commissioner correctly declined to approve the proposed sale of Aurora National Life Assurance Company (Aurora) by Aurora S.A. to Reassure America Life Insurance Company (REALIC), a Swiss Reinsurance subsidiary.

Structured Settlement Annuity Sales - S2KM acknowledges and appreciates receiving market recap reports highlighting quarterly structured settlement annuity sales (Melissa Evola) and weekly financial market data (Richard Nahill).

• Annuity sales - Evola's most recent quarterly compilation of 2011 structured settlement annuity sales (thru September 30) indicates 21,846 cases have been structured for a total premium of $3,633,489,474. These numbers represent a significant decrease from 2010 (also thru September 30) of 23,578 cases and $4,140,704,642 of premium.
• Interest rates - Nahill's most recent 2011 financial market recap (for week ending December 16) shows interest rates of 1.86 percent for 10-year U.S. Treasury bonds compared with 3.30 percent as of December 31, 2010.

For prior S2KM annual reports summaring structured settlement industry developments, 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.

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).

S2P2J Release 49

Publisher American Lawyer Media (ALM) has announced May 1, 2011 as the distribution date for Release 49 of "Structured Settlements and Periodic Payment Judgments" (S2P2J). 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 49 Highlights

• Expanded guidance on Medicare reimbursement procedures including:
  • A new section on how the Medicare Secondary Payer rules affect plaintiffs, defendants, plaintiffs’ attorneys and insurers; and
  • How each such case participant can comply with increasing government efforts to recoup prior payments from settlements.
• How allocations in settlement agreements affect a claimant's tax treatment.
• Structured settlement tax decisions in recent cases including:
  • No-fault;
  • Emotional distress; and
  • Wrongful incarceration.
• How the Gramm-Leach-Bliley Act privacy rules impact the structured settlement process.
• Discoverability of claimant Social Security numbers
• Impact of structured settlement tax and timing issues on potential legal liability for;
  • Defense and plaintiff attorneys; and
  • Structured settlement consultants.
• How inadequate beneficiary designations create subsequent legal disputes.
• Whether an arbitration award can be converted to a periodic payment judgment.
• Qualifying annuitists as expert witnesses.
• Impact of anti-assignment provisions in:
  • Workers compensation cases; and
  • U.S. government as defendant cases.
• Recent secondary market judicial decisions:
  • Rejecting transfers of structured settlement payment rights for failure to meet the "best interest" test; and
  • Approving the sale of payment rights in a payee’s bankruptcy.
• How structured settlement payment rights are treated in bankruptcy, child support, marital asset and minor cases.
• New structured settlement and periodic payment developments in Ireland, Canada, New Zealand and the United Kingdom.

For highlights from past releases of "Structured Settlements and Periodic Payment Judgments", see S2KM's structured settlement wiki.

Tax Penalty Imposed on Former Plaintiff

 Greenberg v. Commissioner (T.C. 2011-18), a January 24, 2011 Tax Court decision, highlights the risks and potential penalties for improperly reporting the tax consequences of a settlement and provides a warning for advisers, including structured settlement and settlement planning consultants, who offer tax advice to recipients of settlement payments.

The Tax Court agreed with the IRS that Gary Greenberg failed to report the required portion of a $3.3 million bad faith and breach of contract award and imposed a substantial penalty for the underpayment.

Mr. Greenberg became disabled in 1990 and began receiving payments from a private disability income insurance policy he had purchased in 1988. When the life insurance company stopped making payments after eight years, Mr. Greenberg sued for insurance bad faith and breach of contract. An Arizona federal court awarded him $940,000 for past and future disability payments and premiums plus costs fees and interests. In addition, the court awarded Mr. Greenberg $2.4 million in punitive damages for a total of $3.3 million.

Mr. Greenberg failed to report any portion of the award on his tax return and did not otherwise disclose the award to the IRS. In Tax Court, Mr. Greenberg conceded the interest portion of his award was taxable but he argued that the $2.4 million of punitive damages should be received tax free "for personal injuries or sickness" under IRC section 104(a)(3).

The Tax Court disagreed and held that the punitive damages were not received "for personal injuries or sickness" and therefore constituted taxable income as did the portion of the costs and fees attributable to the punitive damages.

Gross income under IRC sections 104(a)(1)-(5) does not include amounts received for:

• (1) - Workers compensation ("as compensation for personal injuries or sickness")
• (2) - Traditional injuries ("on account of personal physical injuries or sickness")
• (3) - Accident & health insurance ("for personal injuries or sickness")
• (4) - Government pensions & annuities ("as a pension, annuity, or similar allowance for personal injuries or sickness")
• (5) - Terrorism injuries ("by an individual as disability income attributable to injuries incurred as a direct result of a terroristic or military action")

In Commissioner v. Schleier (1995), the U.S. Supreme Court implied that the language in each of the section 104(a) exclusion provisions should be read the same even if not written the same.  In 1996, Congress specifically included punitive damages in a taxpayer's gross income under section 104(a)(2).

As a result, the Tax Court in Greenberg determined a large understatement of tax and imposed an accuracy-related penalty under IRC 6662. The penalty under IRC 6662 amounts to 20% of the underpayment attributable to a taxpayer's "negligence" or "disregard of rules or regulations" or "substantial understatement" of income tax. Significantly, Mr. Greenberg did not produce any evidence that he relied on professional advice nor did he make any relevant disclosures on his tax return.

For purposes of IRC section 6662:

• "Negligence" includes any failure to make a reasonable attempt to comply with the provisions of the Tax Code.
• "Disregard of rules or regulations" includes any careless, reckless, or intentional disregard.
• A taxpayer is "careless" if he or she does not exercise reasonable diligence to determine the correctness of a tax return position contrary to the rules or regulations.
• The penalty will not be imposed on any portion as to which the taxpayer acted with reasonable cause and in good faith.
• A substantial underpayment of tax exists if an underestimate exceeds the greater of 10% of the tax required to be shown on the tax return or $5000.
• The amount of understatement is reduced if there is or was substantial authority for the taxpayer's treatment of any portion, or if the taxpayer disclosed the relevant facts affecting the tax treatment and there is a reasonable basis for the taxpayer's treatment.

Based upon these rules, Mr. Greenberg probably would not have been able to avoid tax penalties simply by visiting with a tax adviser or making disclosures on his tax return. On the other hand, had Mr. Greenberg met with a competent adviser, he probably would have reported the income on his tax return and avoided the penalty.

The Greenberg case can be compared and contrasted with the Texas case of Grillo v. Pettiete. In the Grillo case, the defendants offered periodic payments (structured settlement) to settle a medical malpractice case. Although the case settled for $2.5 million, the plaintiff attorneys rejected the structured settlement. When the settlement funds subsequently were exhausted, the Grillo family sued the plaintiff attorney and guardian ad litem for negligence and legal malpractice. The parties settled for more than $4 million.

Both the Greenberg and Grillo cases highlight why settlement recipients need good professional advice. The Grillo case more specifically points out the potential risks for settlement advisers who give bad or incomplete advice.

Thanks to Jeremy Babener for alerting S2KM about the Greenberg case. Currently a NYU Tax LL.M. Candidate, and a former Fellow at the U.S. Treasury's Office of Tax Policy, Babener's writing appears on his website Tax Structuring and is featured on S2KM's structured settlement public policy wiki.