Avoiding Structured Settlement Traps for the Unwary

Constructive receipt of the purchase money for the annuity

Properly established, a structured settlement provides a stream of payments that is entirely free of tax, meaning that both the original settlement amount, as well as the gain on the investment, are 100% tax-free. However, the structured settlement has to be properly established. Even if documented correctly, the settlement will lose its tax benefits if there is constructive receipt of the purchase money for the annuity.

An attorney representing State Farm Insurance Co. wrote to Attorney Phillips several years ago, saying: If your client wishes to obtain an annuity through [a structured settlement professional], State Farm will make the settlement draft out to your client’s parents, after which they may purchase the annuity.

This was a veiled threat that, unless the annuity was purchased from State Farm Life Insurance Co., State Farm would see to it that the tax benefits of the settlement were destroyed.

If the plaintiff’s side were deemed to be in constructive receipt of the portion of the settlement funds used to purchase the annuity, the plaintiff would receive no tax benefits which otherwise would be provided under the laws pertaining to structured settlements.

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.))

It is essential, however, that the funds not pass through the hands of the plaintiff or his or her attorney. This was addressed in Rev. Rul. 79-220, 1979-2 C.B. 74, which concludes that a right to receive certain periodic payments under the facts of the ruling does not confer an economic benefit on the recipient.

In Rev. Rul. 79-220, a taxpayer entered into a settlement with an insurance company for the periodic payment of nontaxable damages for an agreed period. The taxpayer was given no immediate right to a lump sum amount and no control of the investment of the amount set aside to fund the insurance company’s obligation. The insurance company funded its obligation with an annuity payable directly to the taxpayer. The insurance company, as owner of the annuity, had all rights to the annuity and the annuity was subject to the claims of the general creditors of the insurance company. The ruling concludes that all of the periodic payments are excluded from the taxpayer’s gross income under § 104(a)(2) because the taxpayer did not receive, or have the economic benefit of, the lump sum amount used to fund the annuity.

The triggering of either constructive receipt or economic benefit by a claimant precludes the ability of an obligor to make periodic payments under a 26 U.S.C. § 130 “qualified assignment” and preserve the tax benefits. References to constructive receipt and economic benefit are not included in either section 104 or 130. However, Congress stated that: “The periodic payments of personal injury damages are still excludable from income only if the recipient taxpayer is not in constructive receipt of or does not have the current economic benefit of the sum required to produce the periodic payments.” S. Rep. No. 97-646, at 4 (1982).

Consequently, there is a certain procedure that has developed with regard to these structured settlements. The plaintiff’s attorney and the adjuster for the homeowners insurance company (or the liability insurer for the dog owner) form an agreement as to whether to purchase an annuity from any company or from a company related to or approved by the homeowners insurance company. At that point, the plaintiff’s attorney engages a structured settlement specialist to arrange for the purchase of the annuity. The parents of the minor select a payment schedule from several proposals obtained by the structured settlement specialist. The plaintiff’s lawyer then does a master accounting and, based on that, the attorney obtains court approval of the settlement. The court order covers a number of issues, one of which is the purchase of the annuity. The plaintiff’s lawyer sends the order to the liability insurer, which purchases the annuity. In this way, the money for the annuity never passes through the hands of the victim or his attorney, and consequently there is no constructive receipt of those funds.

There are at least two stratgies for dealing with insurance companies that attempt to coerce victims into purchasing annuities at inflated prices. See “Counter-measures available to plaintiffs,” below.

Delaying the court approval process, thus causing the annuity quote to expire

The annuity quote will have an expiration date. Usually, it is 30-60 days after the “lock-in” date. This means the annuity purchase money must reach the annuity issuer by that date. Otherwise, the annuity quote will expire and one of two things will have to occur: either the expiration date must be formally extended by the annuity issuer, or the broker will have to find another annuity quote. The replacement quote will usually be different than the original one, meaning that the settlement documentation and court paperwork will have to be amended or redrafted. 

A remedy for this is to include a clause in the settlement documentation and court paperwork along the following lines:

With respect to the funding of any Periodic Payments to be purchased as part of this settlement, it is further agreed and understood that if the structured settlement is not funded by mm/dd/yyyy (purchase date) for any reason, including but not limited to delay in obtaining final court approval, delay in satisfying Medicare requirements, and/or any other reasonable cause, the above payment beginning dates and the first increase dates (if applicable) may be deferred the number of days needed to maintain the agreed to benefit amount(s). Alternatively, the annuity benefit amount(s) may be adjusted to maintain the agreed premium cost.

Fraudulent practices by liability insurers

The complexity of a structured settlement makes it not only difficult to understand but provides unscrupulous insurance companies with the ability to defraud accident victims. Attorney Richard Risk, one of the nation’s leading practitioners in the field of structured settlements, has chronicled the many ways that insurance companies skim proceeds, take kick-backs, cheat their policyholders, defraud the courts, and routinely engage in unethical, tortious, and even criminal conduct. See History of Abuse Tarnishes Structured Image and the many other informative offerings to the legal profession at his excellent website, Risk Law Firm.

Consider this example from the files of Attorney Kenneth M. Phillips:

In 2002, Attorney Phillips represented a very young child named Tyler V whose nose had been amputated by a dog bite, then re-attached, resulting in scars. Phillips negotiated a settlement of the dog bite claim from the dog owner’s homeowners insurance company. Because of the tender age of the victim, a structured settlement was necessary. Knowing this, the homeowners insurance company offered an annuity that provided a series of payments over the course of Tyler’s life which would total $1.1 million. A lifetime stream of payments was the first choice of Tyler’s parents.

Nevertheless, after receiving that offer, Phillips engaged an independent broker who specialized in handling victims as opposed to representing insurance companies. That broker did a market survey and notified Phillips that other companies were offering payment streams that totaled $2.2 million. In other words, Tyler’s settlement would purchase not just a $1.1 million annuity, but a $2.2 million annuity. Someone was planning on keeping that other $1.1 million which Tyler’s money was going to earn. That “someone” was the homeowners insurance company.

There was another nasty feature that the homeowners insurance company had slipped into Tyler’s offer, which the broker uncovered. The annuity from the homeowners insurance had only a 15-year guarantee. In other words, it contained a clause saying that if Tyler died any time after the age of 32, all of the remaining payments would stop. To put it another way, if Tyler died at or after age 32, married with children, the homeowners insurance company was planning on keeping the money that his widow and children would have inherited. The other companies, which were offering $2.2 million, were offering a 50-year guarantee — in other words, they were agreeing to make the payments until Tyler turned 68 even if he died while still a child.

To put it in plain English , the homeowners insurance company was planning to (a) skim $1.1 million from Tyler’s settlement and (b) steal as much of the remaining $1.1 as they could in the event of his untimely death. This was not only a bad offer but an unjust, immoral attempt to defraud Tyler — a child who had been injured.

When Phillips confronted the homeowners insurance company with this information, it initially replied that this was a “take it or leave it” offer. The homeowners insurance representatives, including its attorneys, knew that they had leverage over Tyler because they could make the gain on his settlement taxable by refusing to cooperate in the purchase of a tax-free annuity from another company. They told Phillips that he had no choice other than to buy from them because otherwise Tyler would have to pay at least $500,000 in income taxes.

In response, Phillips contacted two national magazines whose names are well known to the public. Both magazines agreed to publish the story of the Tyler V. case and this insurance company if Phillips would write it. Upon learning about this development from Phillips, the homeowners insurance company did an about-face, for obvious reasons, informing Phillips that they would cooperate fully in the purchase of the annuity from the other company that would pay Tyler $2.2 million instead of $1.1 million, and would guarantee his payments for 50 years instead of 15. Soon thereafter, this insurance company was the defendant in a class action lawsuit which alleged that it persisted in using this exact same tactic against thousands of other injured children, skimming from their settlements, and defrauding them.

This particular company is one of many that have been engaging in this practice since structured settlements became tax-free in the mid-1980s. In other words, for more than 20 years a segment of the insurance industry has been taking money that otherwise would have been paid to injured victims, including innocent children, by exploiting a loophole in the complex legal construct known as the structured settlement. Incredibly, the majorities of both the legal community and the judiciary appear to be entirely oblivious to this 20-year-old crime spree by major American liability insurance companies.

It should be noted that not all insurance companies engage in such practices. The more cautious companies do not offer to sell anything to victims or their attorneys. This avoids both the appearance of and opportunity for fraud. Some companies offer annuities that give market rate benefits to the victims, but at the expense of the brokers who represent them. This is less morally blameworthy but nevertheless can deprive victims of the benefit of full representation by the most competent brokers.

Harassment of victims and their lawyers

Some of the most difficult and time-consuming tasks in a dog bite case take place after settlement has been achieved.

At that point, one must select an annuity and obtain court approval of the minor’s compromise. The liability insurer usually offers to sell the victim the annuity or demands that the sale be made through a specific broker or from a specific life insurance company. With few exceptions, such offers or demands work to the detriment of the victim because the annuity being offered is either over-priced or lacking important features, the broker pays kickbacks to the liability company, and the life insurance company is commonly owned or pays kick-backs — meaning that the victim will not receive all that he would be entitled in an arms-length, free-market transaction.

As the victim’s lawyer, should you choose to simply go along with these practices, you face the real possibility of a malpractice claim at some point in the future, perhaps when you are retired and without errors and omissions insurance. If you refuse to succumb to the industry’s tactics, a battle ensues which can take longer and be more stressful to resolve than the underlying case. You are interfering with a segment of the insurance business that was bringing insurers up to $8 billion in annual profits in the recent past, until more plaintiffs’ lawyers, state attorneys general, and state legislatures began taking action to stop these schemes. In response to your challenge, the liability insurer will refuse to settle the underlying claim, refuse to obey the court’s order approving the settlement, refuse to issue the settlement funds, refuse to issue your court-ordered fees, refuse to write the check out to the annuity issuer chosen by you, refuse to sign the settlement agreement, and/or refuse to sign the qualified assignment. They have been known to employ each of these tactics in sequence, carrying on for months, only to do exactly what you requested, and the court-ordered, at the very last minute. From time to time, litigation has ensued, including class actions.

Fraud upon the courts

One of the strangest aspects of the structured settlement field is the bold fraud that has been committed upon the courts. When minors are injured, their settlements have to be confirmed by state court judges. It is in this confirmation that the child’s rights are waived in exchange for the settlement funds. The segment of the insurance industry that engages in these illegal, immoral and unethical practices depends upon the courts to make these settlements binding upon the children. Without the approval of the judges who are required to supervise minors’ compromises, these settlements could not take place. This is not meant to imply that judges conspire with insurance companies, but rather to suggest that attorneys who represent minors have the duty to fight the corrupt practices of this segment of the insurance industry, and then to bring them to the attention of the judiciary as well as Congress.

For this reason as well as the duty to represent their clients, attorneys need to be familiar with the practices of the industry as well as the technical requirements of the structured settlement, because this knowledge will help to spot any attempt to manipulate or skim from a settlement, and will enable the lawyer to educate the judiciary. One of the most important educational tools for lawyers is Attorney Richard Risk’s Structured Settlements: The Definitive Guide. See also his article, Common Mistakes in Documents Create Risks. His article Doing What’s Right and Avoiding What’s Wrong presents a catalog of insurance company abuses, as well as countermeasures. Attorney Risk is one of the nation’s leading legal authorities in structured settlements, and his website is one of the best places for other lawyers to learn about this treacherous area of practice. Mr. Risk also is available to serve as trustee when the victim’s attorney employs the “qualified settlement fund” to avoid many of the pitfalls discussed herein.

Counter-measures available to plaintiffs

A number of countermeasures are available to combat attempts by insurers to manipulate settlements.

Many homeowners insurance companies will “match the market” if the attorney representing the victim so demands. The word “match” is in quotes because insurance companies have ways of manipulating the pricing of annuities that still give them a little bit of the victim’s settlement money even if they pay what an unrelated company has agreed to pay. For example, because the homeowners company merely has to shift funds from one account to another, it can use today’s price for the annuity rather than the higher price associated with a later purchase date. Keeping the “lock-in fee” can put $1000 in future funds into the pocket of the homeowners company at the expense of the victim.

In an appropriate case, the victim’s attorney can make an “end run” around the homeowners insurance company by employing the device known as the “qualified settlement fund.” First, he must obtain an order from a state judge which establishes a settlement trust, appoints a trustee, and dismisses the claim against the homeowners insurance company and dog owners. The trust then can receive the settlement funds from the homeowners insurance company and obtain the court’s approval to purchase the annuity for the child and make other disbursements such as payments to lien holders, parents, and the lawyer. This method entails additional expense and can be difficult because it needs to be carefully explained to the court while kept out of sight of the insurance company, which will do everything possible to delay or thwart it. When the victim is a minor, as many as three court appearances are necessary: first, to establish the trust, second, to dismiss the defendants, and third, to approve the disbursements to the annuity issuer and others. See Richard Risk, Qualified Settlement Fund Sequence. Hardly any judges in the USA have experience with the qualified settlement fund, making it difficult for the victim’s attorney. The advantages of the qualified settlement fund, however, are that it provides full tax advantages to the victim while depriving the homeowners insurance company of the ability to manipulate or retain part of the settlement.

As a last resort, the courts are available to restore a moral, ethical, and just balance to the otherwise very unequal and difficult relationship between victim and liability insurer. For one example of a current class action against insurance companies, see Attorney Richard Risk’s summary of the class actions against State Farm and Allstate for their alleged practices of forcing victims to purchase annuities at inflated prices. Also, see his summary of the class action against Hartford for shortchanging.

Another example of a suit that alleges such practices is Macomber v. Travelers Property & Casualty Corp., 804 A.2d 180 (Conn. 2002), also 277 Conn. 617 (2006)(the latter decision pertains to the class action certification and is interlocutory in nature). The Macomber case alleges that Travelers has engaged in two schemes to fraudulently deprive victims of a portion of their settlements. These schemes are referred to as “rebating” and “shortchanging.” Rebating is the practice of funneling victims through brokers who pay kickbacks to liability insurance companies. Shortchanging is the practice of agreeing to settle a claim for a certain amount but then, by rebating and selling overpriced annuities, expending less than the amount that was promised in the settlement.

The courts have the ability to level the playing field by making appropriate orders. For example, in the case known as Pacheco, et al., v Clark, Case No. D0101 CV 2002 00855, the First Judicial District Court in Santa Fe County, New Mexico, issued in Order on Emergency Motion to Enforce Settlement on August 4, 2003, requiring insurance company CNA to allow the plaintiff to purchase an annuity from any company he chose. The plaintiff had alleged that CNA breached the settlement agreement reached at mediation by unilaterally requiring the plaintiff to use CNA to structure his settlement. The court awarded the plaintiff $2183.88 (the amount of interest lost during the period of this dispute), fees and costs to his attorney, an expert witness fee to the broker who testified as to the practice of CNA, and ordered CNA to pay the annuity costs as directed by the plaintiff.

Courts have recognized that post-settlement arm-twisting on the part of insurance companies results in delay and therefore causes damages to victims who of course do not receive interest during that period. When that conduct consists of attempting to steer business toward the insurer or broker selected by the insurer, the insurance company can be made to pay damages and sanctions to the victim. See Richard Risk, Insurer Sanctioned for Delay.

Importance of settlement documentation

The documents that memorialize a structured settlement are of critical importance to the victim, as opposed to those that involve an ordinary lump-sum settlement. One of the most pernicious of the liability insurers’ practices is the use of settlement documents that will deprive the victim of his expected tax benefits.

A structured settlement relies on the favorable tax treatment provided by Congress through the Internal Revenue Code. The annuity’s internal rate of return might be four percent, but the taxable equivalent rate might be double that amount. In a lump-sum settlement, there are no tax nuances and the documentation is entirely for the benefit of the defendant, but in a structured settlement the paperwork must serve to protect the tax benefits intended by Congress and expected by your client.

One would think that the structured settlement documents promulgated by liability insurers would and should ensure that victims will receive these advantages, but in fact the opposite is usually the case: insurance company documents contain language that will enable the IRS to tax and penalize victims’ structured settlements. For example, the forms currently used by State Farm contain the victim’s acknowledgement that the consideration for the settlement has been received, a provision that triggers the doctrine of constructive receipt and makes the gain on the settlement fully taxable. That is only one of many examples.

If you accept these documents, you commit malpractice. Properly drafted settlement documents have been made available through this website (see below). These include a Petition for Approval of a Structured Settlement, an Order of Approval, and a checklist of necessary provisions for inclusion in the structured settlement agreement.