Annuity payment money must be transferred from the liability insurer directly to the annuity issuer, not from the liability insurer to the victim’s lawyer’s trust account or any other third party controlled by the victim. There are three reasons for this:
- During the settlement process it was agreed that the settlement would be a structured settlement.
- A key benefit of a structured settlement is that the victim’s payments from the annuity will be entirely tax-free.
- If the victim’s lawyer has the annuity purchase money for even an instant, the victim’s payments from the annuity will be taxed to the extent that those payments constitute gain over the annuity purchase price.
When settlement proceeds are received and invested, the gain (i.e., the interest or profit) on the same is taxable as ordinary income. (Rozpad, Joseph S., 154 F3d 1 (1st Cir. 1998); Greer, Yancy D., TC Memo 2000-25 (2000).)
To encourage victims to agree to receive periodic payments rather than lump sums, Congress provided an incentive in the form of a “tax break.” Specifically, Congress passed Public Law 97-473, which made the gain on a personal injury settlement excludable from income (i.e., tax free) if certain conditions are met. (See P.L. 97-473, Jan. 14, 1983 (97th Cong., 2d Sess.))
The conditions are set forth in the definition of “structured settlement” contained in Internal Revenue Code section 5891(c)(1). One condition is that the payments to the victim must be made by either the defendant in the lawsuit, a party other than the plaintiff in a pre-lawsuit claim, or a qualified assignee. The key condition in this analysis has to do with the payor: it can be any person or entity, but cannot be the victim, his attorney, his attorney’s trust account, or anyone who is the alter ego of the victim, or is controlled by the victim.
It cannot be the victim’s lawyer because of the doctrine of constructive receipt. If the victim or his or her representative have control of the settlement money, the gain on the settlement money is taxable.
Revenue Ruling 76-133 held that the gain on a minor’s settlement was taxable because it was sent to the clerk of the court which then transmitted it to a savings and loan association for deposit in certificates of deposit.
Revenue Ruling 65-29 held that the gain on a disabled woman’s settlement money was taxable because her husband had control over it.
The IRS summarized its position in Revenue Ruling 79-220: “[I]f a lump-sum damage payment is invested for the benefit of a claimant who has actual or constructive receipt or the economic benefit of the lump-sum payment, only the lump-sum payment is received as damages within the meaning of section 104(a)(2) of the Code, and none of the income from the investment of such payment is excludable under section 104.”
When a plaintiff’s lawyer accepts settlement funds of a client, the money is held in trust for the client. It is not the lawyer’s money but the client’s. For the purpose of determining whether the settlement funds are taxable, therefore, the IRS would take the position that the client had constructive receipt of the money, and thus the gain on it would be taxable.