Historically, injury victims who were successful in pursuing lawsuits received their settlements or jury awards in cash, as a one-time lump sum payment. While this framework allowed injured individuals to meet their immediate medical needs with confidence, the money often ran out quickly.
As thousands of plaintiffs have learned, you gain far more than just financial compensation in securing a settlement. Receiving a substantial amount of money is a serious responsibility, one that many plaintiffs, through no fault of their own, simply aren’t prepared to shoulder.
How Does A Structured Settlement Work?
In 1982, Congress decided to encourage a different option: structured settlement. That year, the American legislature adopted a number of special tax rules that would help support plaintiffs over the long-term. Signed by President Ronald Reagan, the Periodic Payment Settlement Tax Act clarified a plaintiff’s right to receive a steady stream of tax-free payments, rather than accept a lump-sum.
A structured settlement is a legal and financial arrangement, negotiated between the plaintiff and (in most cases) the defendant’s insurance company. In exchange for the plaintiff’s agreement to dismiss the lawsuit, the defendant’s insurer agrees to provide the plaintiff with a series of regular payments over a number of years. In effect, the settlement becomes a right to receive periodic payments in the future.
What Is An Annuity?
In the majority of cases, the defendant’s insurance company will purchase an annuity from a third-party life insurance company. The life insurance company will invest the settlement money itself, paying out a regular stream of income to the plaintiff depending on the terms established in the annuity contract.
This arrangement provides the plaintiff with steady payments, rather than the burden of making significant, and often complex, financial decisions about what to do with a lump-sum. Structured settlement annuities can be remarkably flexible, tailored to fit the specific needs of individual plaintiffs, both now and in the future.
Benefits: Long-Term Security & Tax Advantages
Ongoing medical needs can be met with confidence, an especially important priority when young children have been injured by the negligence of a medical professional. In fact, structured settlements were first used to benefit plaintiffs during the Thalidomide scandal of the 1960s, in which thousands of infants were born with severe birth defects after their mothers took the notorious morning sickness drug. Rather than receiving settlements in the form of a lump-sum, Canadian families affected by thalidomide were compensated with a life insurance annuity, ensuring that their children were protected with long-term financial support.
While much has changed in the intervening decades, structured settlements continue to offer plaintiffs a major advantage in the form of long-term financial security.
Equally as important, structured settlements provide significant tax benefits. While most personal injury settlements are not subjected to federal or state taxes, that advantage does not extend to the income generated once the settlement has been invested. Income from a structured settlement annuity, on the other hand, is completely exempt from federal and state taxes, including taxes on dividends, capital gains and interest.
How Are Legal Settlements Taxed?
The Internal Revenue Service taxes settlements and court judgement based on the “origin of the claim.” When one company sues another over lost profits, any settlement or award intended to make up for those lost profits will be taxed, just like the company’s normal income would be. Likewise, an employee who sues their employer for lost wages will have their settlement taxed as wages.
Claims arising from personal injuries, on the other hand, are treated differently. Damages from personal injury lawsuits, including birth injury claims, are almost always excluded from federal and state income tax. While the US tax code makes damages related to “emotional distress or mental anguish” taxable, that’s not the case when these so-called “non-physical” forms of injury are the result of a physical injury.
To summarize, the majority of birth injury settlements and court awards will not be taxable, on either the federal or state level.
Punitive Damages Can Be Taxed
There is one major exception to this general rule, though, and it kicks in when a judge or jury determines that a defendant’s conduct was particularly egregious or reckless. In order to punish defendants for extreme negligence, and deter negligent behavior in the future, many states allow their courts to add on extra “punitive” damages. Punitive damages are always taxable, whether they relate to physical or non-physical injuries.
Careful attorneys will ask the judge or jury to separate their judgment clearly, distinguishing between compensatory damages and punitive awards. That provides plaintiffs a simple way to show the IRS that a portion of their judgment is not taxable.
While the initial lump-sum settlement in most personal injury cases is non-taxable, any income earned from the settlement’s investment certainly is. As we already mentioned, this isn’t the case with structured settlements, where income generated through the settlement’s investment is also considered non-taxable.