English Common Law basis for the “single recovery rule”, which was the basis for the rejection of settlements including periodic payments for almost 250 years.
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1913
The 16th Amendment to the Constitution made the income tax a fixture in the U.S. Tax Code.
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1916
The Federal Employees Compensation Act (FECA) provides compensation benefits to civilian employees of the United States for disability due to personal injury. The Act also provides for compensation for employment related disease.
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1919
Revenue Act of 1918. The exclusion for personal injury damages presently encoded in I.R.C. 104(a)(2) was enacted.
IRS Code Section 61(a)
Gross income includes all income from whatever source derived except as otherwise provided by law.
I.R.C. Section 104(a)(2)
Damages received from claims of physical injury or sickness are excluded from gross income for tax purposes.
1935
The Aid to Famifies With Dependent Children Act provided the Federal basis for the establishment of state alimony and child support systems.
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1960s
Thalidomide
These cases, most of which occurred in Canada, were meant to compensate children born with birth defects caused by this morning sickness drug. These cases marked the first time periodic payments were used in personal injury cases on a large scale. The drug manufacturer, Richard Merrill, did not have sufficient insurance or funds to settle all of the cases in a lump sum.
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1960
Revenue Ruling 60-31
Deferred compensation is not recognized as income until there is actual receipt when the agreement to defer receipt was entered into before the compensation was earned.
McGhee v. McGhee
Because it was heard in equity court the single recovery rule was disregarded and periodic payments were allowed.
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1965
Knuckles v. Commissioner
The determination of whether a settlement amount is excludable must be based on the reason for settlement, which is determined by the wording of the original complaint.
Revenue Ruling 65-29
Interest earned from investing a lump sum payment is not excludable from gross income.
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1972
Seay v. Commissioner
States that Personal Embarrassment is to be considered a “personal injury” under Section 104(a)(2), therefore, payments meant to remedy it are excludable.
Holden v. Construction Machinerv Co.
The Supreme Court of Iowa reviewed a trial court decision that permitted the parties to elect either periodic payment of damages or specific performance of an employment contract
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1978
IRS PLR 7839075, June 29,1978
Interest earned from investing a lump sum payment for damages is not excludable where:
• The lump sum was paid to the Guardian of a minor Claimant
• By court order, the lump sum was invested in time deposit accounts maturing not later than Claimant’s majority
• Neither principal nor interest can be withdrawn without express permission of the court
General Counsel Memorandum 37687, September 25,1978
Periodic payments are fully excludable when the Casualty company agreed to make fixed periodic payments to Claimant for the longer of twenty years or Claimant’s life, provided that Claimant does not have actual or constructive receipt of the economic benefit of the present value of the damages.
IRS PLR 7905017. October 31,1978
Periodic payments are fully excludable when:
• Casualty company agreed to make fixed periodic payments to Claimant for the longer of twenty years or Claimant’s life
• Casualty company purchased an annuity from its affiliate to provide a source of funds to satisfy the obligation
• Casualty company is the owner of the annuity and has all rights of ownership,
including the right to change the Beneficiary
• Casualty company instructed the affiliate to make payments directly to the Claimant
• Claimant has no right to the discounted present value of the periodic payments or to control the investment of that amount, and
• Any payments to Claimant’s estate are similarly excludable from
income.
Final report of the Royal Commission on Civil Liability and Compensation for Personal lnjury included a majority recommendation in favor of periodic payments being available in the case of liability claims involving death or serious and permanent disablement. (U.K.)
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1979
IRS PLR 7933078, May, 21,1979
Periodic payments are fully excludable when:
• Casualty company agreed to make periodic payments to Claimant for a term certain
• Casualty company is not required to set aside specific assets to secure any part of its obligation
• Claimant does not have the right to accelerate any payment or to increase or decrease the amount of any payment
• Claimant’s rights against casualty company are no greater than those of its general creditor
• Payments are not subject to assignment, transfer, commutation or encumbrance
• Casualty company is obligated to make final payment of a specific amount to Claimant’s estate in lieu of the obligation to make further payments if the Claimant should die before a specific date
• Casualty company also agreed to reimburse Claimant for future medical expenses that do not exceed a sum certain, and any such reimbursement must be offset against actual future medical expenses
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1980
IRS PLR 8020095, February 25,1980
Periodic payments are fully excludable where:
• Defendant agreed to make fixed periodic payments to Claimant
• Defendant reserved the right to purchase an annuity to provide a source of funds to satisfy the obligation and reserved the right to assign its rights and duties
• Defendants terminated its obligations to claimant by assigning its rights and duties to Assignee and paying Assignee the sum of Y
• Assignee was required to use the entire sum of Y to purchase an annuity sufficient to make the periodic payments to Claimant and was required to instruct the issuer of the annuity to make payments directly to Claimant
• Neither Claimant nor Claimant’s estate has the right to accelerate, increase or decrease the amount of any payment
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1982
IRS PLR 82190698219069, Februarv 12,1982
Payment by Employer to Employee in settlement for racial discrimination is not excludable, unless there is evidence (in the original complaint) that the claim was based on personal injury.
IRS PLR 8307015, November 10, 1982
Periodic payments are fully excludable when:
• Defendant agreed to make fixed periodic payments to Claimants
• Defendant was given the right to assign and arrange for the assumption of its obligations
• Pursuant to an assumption agreement entered into by the parties, defendant terminated its obligations to Assignee
• The assumption agreement gave Assignee the right but not the duty to purchase an annuity to fund the obligation
• Assignee instructed the issuer of the annuity to make payments directly to Claimants, and these instructions cannot be revoked or modified without Claimants’ written consent
• Neither Defendant nor Claimants have any ownership or other rights in the annuity
• Claimants will have recourse only against Assignee in the event of a default under the settlement or assumption agreements
• Claimants will not actually receive funds until the annuity payments are made and have no present right to receive payments.
(Any payments to Claimants’ estates are similarly excludable from income.)
Periodic Payments Settlement Act of 1982
This law expanded allowable conditions for qualified assignments, including:
• The assignment of the duty to make periodic payments may include a provision granting Claimant creditor’s rights greater than those of a general creditor, and
• The determination of when the claimant is treated as having received any payment pursuant to the qualified assignment shall be made without regard to any such provision of the assignment
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1983
IRS PLR 8321045, February 18,1983
Periodic payments are fully excludable where:
• Defendants agreed to fixed periodic payments
• Defendants were given the right to assign their obligation
• Pursuant to agreement of both parties, Defendant assigned all of their obligation to Assignee
• The agreement gave to Assignee the right, but not the duty to establish a trust to fund the obligation
• Assignee established a trust where:
• A bank is a Trustee
• Neither Claimants nor Defendants have any ownership or other rights in the trust
• Assignee was irrevocably designated as trust Beneficiary
• Assignee instructed trustee to make payments directly to Claimants Pursuant to terms of the settlement agreement
• Assignee’s instructions to Trustee can be revoked or modified by Assignee
• Claimants have no right to compel payment from trustee if Assignee stops payments, and
• Claimants’ sole remedy if periodic payments are not received is to bring an action against Assignee
IRS PLR 8325054, March 21,1983
Periodic Payments are fully excludable when:
• Defendant proposes to make fixed periodic payments to Claimants
• Defendant will purchase an annuity from an Insurance Company to fund the periodic Payments
• Defendant will own and control the annuity and will have the right to change the Beneficiary
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1984
IRS PLR 8435154, June 1, 1984
Periodic payments are fully excludable when:
• Claimant, casualty company and re-insurer executed a Settlement Agreement in which, pursuant to a reinsurance agreement previously entered into between casualty company and re-insurer and consented to by Claimant as part of the settlement, re-insurer shall make periodic payments to Claimant
• Casualty company shall be discharged from all liability for said payments
• Claimant’s right to receive periodic payments conforms to all of the guidelines set forth in paragraphs 83 and 91 supra.
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1985
Burford v. United States
All damages from wrongful death action, including punitive damages are excludable under 104(a)(2).
IRS PLR 8527050, April 9,1985
• Damages in this action made due to wrongful discharge, age discrimination and State Handicappers’ Civil Rights Act violations were paid on account of personal injuries, and are excludable from gross income. Nor do they constitute wages for purposes of FICA, FUTA, or income tax withholding.
• The portion that was paid on account attorneys’ fees, costs and interest thereon is included in gross income but does not constitute wages for purposes of FICA, FUTA, or income tax withholding.
• The portion to be paid in annual installments on account of lost wages and interest thereon will be includable in gross income in the taxable year received
• Only the lost wages and not the interest thereon will constitute wages for purposes of FICA, FUTA, or income = withholding
IRS PLR 8547025, August 23, 1985
The amount received in settlement of this wrongful death action is fully excludable, even though the complaint alleged both punitive and compensatory damages, so long, as:
• Applicable state law allows for recovery of punitive damages only after compensatory damages have been proven
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1987
Thompson v. Commissioner
Liquidated damages received under the Equal Pay Act of 1963 were excludable (even though this portion of the award was measured by the amount of back pay) because this amount was received through prosecution of a tort-type claim for personal injuries (sex discrimination).
An additional amount received as back pay, under the Equal Pay Act and Title VII of the Civil Rights Act of 1964, was not excludable on grounds that it was more in the nature of a payment for a contract violation than for tort-type right.
Bent v. Commissioner
Amount received in an unallocated settlement of a claim under 42 U.S.C. § 1983 for abridgment of speech (which the IRS attempted to characterize as a substitute for wages) was excludable under 104(a)(2) because: 1) it was received on account of personal injuries, and 2) A § 1983 claim is based on tort type rights
McShane v. Commissioner
The total amount of this settlement was excludable under I.R.C. § 104(a)(2) and no portion of the proceeds was characterized as taxable interest where:
• The parties agreed to a post verdict settlement before judgment was entered
• The plaintiff would have been entitled to pre-judgment interest, post-judgment interest, or both, if the settlement had not occurred and
• The settlement agreement made no express allocation to interest
The court was persuaded by the following factors
• There was no unconditional, enforceable obligation to pay the amount of the verdict because final judgment has not been entered
• The settlement agreement stated that no interest was included in the award; and
• All parties and their attorneys testified “in an honest and forthright manner” that tax consequences of the settlement were not a part of the negotiations.
For these reasons, and because McShane is a “memorandum” opinion by only one judge, this decision offers limited tax guidance to plaintiffs who are considering a post verdict settlement.
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1988
Comprehensive Environmental Response, Compensation and Liability Act
In a study mandated by this law, the EPA detemined that structured settlements demonstrated the highest potential as an incentive to promote personally responsible party (PRP) settlements with the EPA.
IRS PLR 8831021, May 6,1988
Code Section 104(a)(2) treatment of amounts received by a claimant pursuant to a qualified assignment does not appear to be jeopardized if:
• Defendant will be the sole owner of the annuity and will have all rights of ownership including, without limitation, the right to chance the Beneficiary.
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1989
Wuff v. City of Wichita.
Settlement amount received pursuant to civil rights action for wrongful discharge in violation of First Amendment was excludable under Code Section 104(a)(2).
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1990
Uniform Periodic Payment of Judgments Act
This Act was approved by the National Conference of Commissioners on Uniform State Laws in order to assist state legislatures as they continue to develop large personal injury awards in periodic payments rather than lump sum payments.
IRS PLR 9015046, January 16,1990
Periodic payments made to a trust established on behalf of a minor claimant, and to be made directly to the claimant upon his majority,. are excludable where the periodic payments are made in accordance with the requirements of Revenue Ruling 79 220. No opinion is express concerning:
• Income tax consequences to the minor’s parents if trust distributions are made to discharge the minor’s expenses for which they would otherwise be liable as parents; or
• Tax consequences of the transaction under any other provision of the Code.
IRS PLR 9017011, January 24, 1990
Knowledge of the existence, cost and present value of an annuity contract used to fund a settlement offer does not cause these claimants to be in constructive receipt of the annuity contract or the amount invested in the annuity contract; therefore, periodic payments received pursuant to that settlement are excludable under I.R.C. § 104(a)(2).
Commissioner v. Miller
All money from personal injury settlements is excludable from gross income, whether it is labeled as compensatory or punitive damages.
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1992
United States v. Burke
Back pay awarded in settlement of a sex discrimination action under Title VII of the Civil Rights Act is not excludable under Code Section 104(a)(2).
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1994
Childs v. Commissioner (download the court document [PDF:56KB])
Allowed for Plaintiff’s attorneys to structure a portion of all of their associated legal fees when representing a client with a legitimate case under 104(a)(2).
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1995
Commissioner v. Schleier
Recovery under the ADEA is not excludable from gross income. A taxpayer must meet two independent requirements before a recovery may be excluded under 104(a)(2):
• The underlying cause of action giving rise to the recovery must be “based upon tort or tort-type rights”, and
• The damages must have been received “on account of personal injuries or sickness.”
New test for determining taxability: “First the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is ‘based upon tort or tort-type rights’, and, second, the taxpayer must show that the damages were received ‘on account of personal injuries or sickness”‘.
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1996
O’Gilvie v. United States
Petitioners’ punitive damages were not received “on account of’personal injuries; hence the gross income-exclusion provision. Does not apply and the damages are taxable.
Small Business Job Protection Act.
• Any damages flowing from tort claims that do not have a physical injury or physical sickness at their origin are taxable,
• Damages, other than punitive damages, that flow from tort claims having physical injury or sickness as their origin are excludable from gross income whether or not they are suffered by the injured party.
• Damages from wrongful death claims are also excludable from the recipient’s gross income.
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2001
Structured Settlements Protection Law enacted in Idaho, Louisiana, Massachusetts, New Jersery, Oklahoma, Rhode Island, South Dakota, Texas, Virginia, and Washington
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2002
Federal Structured Settlements Protection Law Enacted
Federal legislation was enacted setting forth requirements for a structured settlement recipient to to “sell” his right to receive future payments in exchange for a lump sum. Under these guidelines, a sale cannot go forth unless a judge determines that:
• It is in accordance with State and Federal Law
• It is “in the best interest” of the Claimant
• It contains provisions whereby the Claimant (Seller) is told:
• The amounts and due dates of the payments to be transferred;
• The aggregate amount to be transferred;
• The amount received by the Claimant for the transaction;
• The discounted present value of the transferred payments; and
• The expenses to be paid by the Claimant for the transaction
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2004
IRS Issues New Confidentiality Rules confirming that physical injury cases are not subject to disclosure requirements to the IRS
Code Section 213 allows deduction of certain medical expenses. The allowable deduction is always less than the actual medical expense incurred because:
• This deduction is limited to the amount of expense in excess of five percent of adjusted gross income
• For purposes of this calculation, allowable expenses for medicine are
limited to the amount in excess or one percent of adjusted gross income
California, Colorado, and Illinois Structured Settlements Protection Law Enacted
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