Use Caution in Writing Mediation Agreements

The language used in a mediation agreement can unwittingly trigger an undesirable tax event, if the claimant is considering periodic payments as part of the settlement proceeds.

All payments to workers’ compensation claimants are exempt from taxation under Section 104(a)(1) of the Internal Revenue Code and 104(a)(2) for personal physical injury or sickness tort claimants. If an annuity or Treasury obligation is used to fund any future payments that may be agreed upon, through a structured settlement, the payee may not have current economic benefit or ownership of this funding asset or the funds that will be used to purchase it. Even if the payee never physically handles the funds, constructive receipt of them is an incident of ownership and will cause all growth of the funding asset to be taxable.

Constructive receipt is the doctrine that taxes income before the income is actually received. It is contained in Treasury Regulations § 1.451-2(a) as follows:

“General Rule. Income although not actually reduced to a taxpayer’s possession is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”

Settlement agreement and qualified assignment documents do not use the cost of the annuity or Treasury obligation as the consideration for the future periodic payments. It is the income stream that is the consideration (along with any cash to be paid at the time of settlement).

Because mediation agreements are replaced by final settlement agreements, the document hastily written after a long day of settlement negotiations often is considered insignificant and temporary. But, any constructive receipt by the plaintiff can have adverse consequences.

Thus, if the mediation agreement says “defendant agrees to pay $500,000 to the plaintiff, subject to a structured settlement,” the $500,000 is constructively received. Instead, if the amount to be applied to the future payments is undecided at the time of mediation, it might be better to express the settlement consideration in terms of how much the defendant will spend toward the settlement, for the benefit of the plaintiff. Then specify that a portion of this amount may be used by the defendant or its assignee to purchase an annuity or Treasury obligation to fund future payments. State that the future payment schedule will be specified in the actual settlement agreement and that the plaintiff has no rights of ownership to the funds that will be used for this purpose.

Constructive receipt is usually not a problem in cases involving a minor or mental incompetent, since the settlement is subject to court approval. However, a mediation agreement signed by competent parties likely is a binding contract.

This article is not intended to provide tax advice. Consult your own tax advisor.