Taxed Structured Settlements

Abstract

Congress has granted a tax subsidy to physically injured tort plaintiffs who enter into structured settlements. The subsidy allows these plaintiffs to exempt the investment yield imbedded within the structured settlement from federal income taxation. The apparent purpose of the subsidy is to encourage physically injured plaintiffs to invest, rather than presently consume, their litigation recoveries. Although the statutory subsidy by its terms is available only to physically injured tort plaintiffs, a growing structured settlement industry now contends that the same tax benefit of yield exemption is available to plaintiffs' lawyers and nonphysically injured tort plaintiffs under general, common-law tax principles. If the structured settlement industry is correct, then all tort plaintiffs and their lawyers may invest their litigation proceeds in a tax-free manner simply by using structured payment arrangements. Structured arrangements, therefore, would be far superior to traditional tax-favored retirement accounts (e.g., 401(k)s, IRAs), which provide the same tax benefit of yield exemption but are subject to significant constraints. Accordingly, if proponents of structured arrangements are correct in their interpretation of the tax law, these arrangements can be described as "super-IRAs" because they provide full yield exemption without any corresponding limitations or restrictions. This Article examines the taxation of structured payment arrangements, ultimately concluding that the structured settlement industry's positions are unpersuasive. Nevertheless, because of the muddled state of the tax law on the issue, this Article recommends legislative and administrative action to close the yield-exemption loophole with respect to its unintended beneficiaries.