Federal tax policy & structured settlements

Under Section 104(a)(2) of the federal Internal Revenue Code, damages paid "on account of" a physical injury or wrongful death are excluded from an individual’s income tax. But importantly for those who depend on this settlement, the investment income earned from a lump-sum settlement can be fully taxable.

Under a structured settlement, all future payments are completely free from:

  • Federal & state income taxes,
  • Taxes on interest, dividends and capital gains, and
  • The Alternative Minimum Tax (AMT).

Why are your structured settlement payments exempt from so many taxes? What follows are highlights of federal tax policy through the years as it relates to injury compensation. This timeline is based in part on information contained in Structured Settlements & Periodic Payment Judgments by Patrick Hindert, Daniel Hindert and Joseph Dehner (Law Journal Press). NSSTA is grateful for their cooperation.

Year Tax Development
1919 The exclusion of income for personal injury damages, presently a part of Internal Revenue Code §104(a)(2) was signed into law by President Woodrow Wilson in 1919. The legislative history of the Revenue Act of 1918 suggests that primary reason was that Congress did not view compensation for physical injury or accident as a gain. Therefore, it was not income within the meaning of the 16th Amendment.

1920

In Eisner v. Macomber, Supreme Court Justice Mahlon Pitney, writing for the majority, rules that a stock dividend was not a realization of income by the taxpayer-shareholder for purposes of the Sixteenth Amendment:

We are clear that not only does a stock dividend really take nothing from the property of the corporation and add nothing to that of the shareholder, but that the antecedent accumulation of profits evidenced thereby, while indicating that the shareholder is richer because of an increase of his capital, at the same time shows he has not realized or received any income in the transaction.

1922 In a tax ruling (Solicitor’s Opinion 132, I-1, C.B. 92,94), the federal government holds that compensatory damages for invasion of a personal right do not constitute taxable income, as defined in Eisner v. Macomber decision.

1928
The IRS rules that an award paid by the Mixed Claims Commission of the U.S. and Germany to the surviving spouse of a passenger on the Lusitania is not taxable since the award is designed to "restore [the decedent's wife] to substantially the same financial and economic status as she possessed prior to the death of her husband."
1955 In Commissioner v. Glenshaw Glass Company, by a 7-1 decision, the U.S. Supreme Court holds that the Eisener definition of income is not exclusive and that all realized accessions to wealth may be taxable as income. Chief Justice Earl Warren, writing for the majority, held that the income in question constituted "instances of undeniable accessions to wealth, clearly realized, and over which the taxpayers have complete dominion."

1983
President Ronald Reagan signs P.L. 97-473, which formalized structured settlement’s benefits in federal law. The law amended §104(a)(2) to clarify that the full amount of a structured settlement’s payments constitutes damages which are received by the victim free of any federal tax liability.

Congress also adopted IRC Section 130 to facilitate secure, long-term funding arrangements, funded by annuity contracts or Treasury securities, for physical injury victims.

1995

In Commissioner v. Schleier, the U.S. Supreme Court holds that the amount received in settlement of a claim for backpay and liquidated damages under the Age Discrimination in Employement Act fails to qualify for §104(a)(2) exclusion. In establishing a standard for excludability, Justice John Paul Stevens, writing for the Court in the 6-3 opinion, stated, in part that 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.'

1996 President Bill Clinton signs the Small Business Job Protection Act of 1996. The new law provides that henceforth any damages, other than punitive damages, that originate from a physical injury or sickness caused by a tort are excludable from the recipient’s gross income.

NSSTA successfully fought to preserve the tax-free treatment under Code section 104(a)(2) of wrongful death claims and derivative claims of family members in physical injury cases.

1997 President Clinton signs legislation (Taxpayer Relief Act of 1997, Public Law No. 105-34) designed to facilitate the use of structured settlements to resolve workers' compensation cases. The law allows employers and their worker’s compensation insurers to settle workers' compensation claims on the basis of periodic payments under a structured settlement and to assign that periodic payment liability to a structured settlement company that will purchase an annuity to fund that liability.

NSSTA strongly supported this law, which allows an employer/workers' compensation carrier to deduct on a current basis the full amount of the lump sum paid to the structured settlement company.

2002 President George Bush signs the Victims of Terrorism Compensation Act of 2001. This includes language regulating a structured settlement annuitant’s ability to transfer rights to receive future annuity payments.

The law includes multiple consumer protections supported by NSSTA including disclosure requirements and approval by a federal court.