Common Mistakes in Documents Create Risk
Plaintiff attorneys who rely on the defense to prepare structured settlement documents, without ensuring that they do not create an unnecessary tax liability to their clients, do so at their own peril.
It is customary, of course, for the defense to draft the “Release and Settlement Agreement,” “Release of all Claims,” “Full and Final Release,” or whatever name the defense selects. After all, the defense is obligating itself to pay money in exchange for a release from the tort liability, and it deserves to have the release language that it desires—as long as that language does not create for the claimant an exposure to an adverse tax ruling by the Internal Revenue Service—likely to occur after the defendants and their agents have been released—or to other harms. But, the claimant’s lawyer who fails to review the document for unnecessary errors or omissions that can come back to haunt the client, or to have the document reviewed by an expert independent of the defendant or its insurer, lives precariously.
If the recovery for damages is excluded from the claimant’s gross income under section 104 of the Internal Revenue Code because the claim arose out of a personal physical injury or physical sickness, and the intent is to extend that tax benefit to all future payments, a simple error or omission in a document can be a fatal flaw. If drafted correctly, a structured settlement for nontaxable damages can avoid taxes on not only lump sums paid at the time of settlement to the claimant and to a third-party assignee under a section 130 “qualified assignment,” it also avoids taxation of the internal growth of the annuity or U.S. Treasury obligation after the defendant has been released. If drafted incorrectly, the IRS can collect income tax not only on the growth but on the lump sums paid at the time of settlement.
IRS is Auditing Settlements
The government believes that a lot of potential tax revenue from lawsuit awards is going uncollected. Last year (2001) the IRS released for the first time an audit guide for its field agents that contains examination techniques for lawsuit awards and settlements. The focus of this effort, under the IRS Market Segment Specialization Program (MSSP), is to train IRS agents to look for damage recoveries that were improperly classified or allocated as nontaxable damages, and never reported. The IRS is examining cash lump sum settlements as well as structured settlements. The manual is called the MSSP Audit Guide for Lawsuit Awards, for proceeds received after August 20, 1996.
Understand the Concept
The most common error in structured settlement releases reflects a lack of understanding by the drafter in the concept of periodic payments. The amount being paid by the defendant or its insurer to fund the periodic payments is not the consideration being paid to the claimant. Rather, the consideration is the series of payments described by their amount and the time they are to be made.
Incorrect: Payable to [Plaintiff’s name] the sum of $1 million, of which $500,000 will be used to purchase an annuity. Receipt of which is hereby acknowledged.
Correct: Payable to [Plaintiff’s name] at the time of settlement the amount of $500,000. Periodic payments payable monthly, beginning one month after settlement, in the amount of $______, for 30 years certain and the life of the payee thereafter. The sufficiency of which is hereby acknowledged.
If the claimant acknowledges receipt of the entire amount being spent by the defendant or its insurer for the benefit of the claimant—but not all being paid directly to the claimant—the acknowledgement might be deemed to be constructive receipt. To receive the future payments tax-free, the claimant may not have actual or constructive receipt of the funding asset or the funds used to purchase it.
The annuity or Treasury obligation will neither be purchased or owned by the claimant. It is an error to state that the claimant will purchase an annuity, if that is not to be the case. It is certainly fatal to the preservation of tax benefits to have the annuity premium paid to the claimant attorney’s trust account. The claimant’s attorney is an agent of the claimant, and any money to fund future payments will be constructively received by the claimant if paid to the attorney.
Most structured settlements today involve two transactions: 1) the settlement agreement and release and 2) the assignment of the future payment obligation. The settlement agreement extinguishes the tort liability of the defendant in consideration usually of a payment or several payments of money. If the settlement agreement and release includes a promise of future payments, those are typically assigned by the original defendant or liability insurer to a third-party assignee by paying the assignee a single lump sum at the time of settlement. The assignee, in turn, purchases the asset that will fund the future payments to the claimant or other payee designated in the settlement terms. If the future payments are excluded under section 104, due to a personal physical injury, physical sickness or workers’ compensation claim, the transfer of the obligation can be a “qualified assignment” under section 130. This is a tax-neutral transaction, since the assignee does not report the consideration paid to it if an annuity or Treasury obligation will be purchased within 60 days and if the output of that funding asset essentially matches the future payment liability. The assignee does not get a tax deduction when those payments are made.
If the payments are taxable, the assignment is nonqualified. This is accomplished most often by a reinsurance assumption agreement between the defendant’s liability insurer and the reinsurance company. Using a reinsurance agreement instead of an annuity avoids the baggage of an excise tax that can accompany an annuity under section 72 when the annuity is owned by other than a natural person or when the payments will not begin within a year and otherwise do not follow a narrowly prescribed formula for avoiding the tax. Another method of avoiding the section 72 excise tax is to have the assignee located in an offshore “tax haven,” with a secondary guarantee from a U.S. entity to make the promised payments.
Document Cost of Future Payments
It is permissible and encouraged to specify in the settlement agreement the amount that will be paid for the purchase of an annuity or other funding asset, whether the defendant or its insurer will purchase and own the asset or whether the money will be paid to a third party assignment company as consideration for the third party assuming the liability created in the settlement terms to make the periodic payments. Just do not confuse the annuity purchase price and assignment fee being paid on behalf of the claimant with the consideration being paid to the claimant. Also, if the claimant acknowledges receipt of promised future payments before they are due, as in the preceding incorrect example, the obligor might be off the hook to make them.
Document Nature of the Injury
Another common mistake is the failure to document the fact that it was a personal physical injury or physical sickness that gave rise to the claim. The 1996 amendment to section 104 added the word “physical” twice to the requirement for the damages to be excluded from gross income. The settlement documents should track the language of the statute to avoid unnecessary attention from the IRS.
Incorrect: “All sums set forth in this agreement constitute damages on account of personal injuries or sickness within the meaning of section 104(a)(2) of the Internal Revenue Code of 1986, as amended.”
This is a vestige of a standard form document that was in use prior to the 1996 revision to section 104, which no one evidently has seen fit to update.
Correct: “All sums set forth in this agreement constitute damages (other than punitive) on account of personal physical injuries or physical sickness within the meaning of section 104(a)(2) of the Internal Revenue Code of 1986, as amended.”
In the event the original petition, any subsequent pleading or even discussions between parties mentioned punitive damages, it is crucial to address them in the settlement documents. Here is some suggested language:
Correct: “No payment or part of any payment shall be for punitive damages. While punitive damages were alleged in the Complaint, they were not proven, and it is in the mutual best interest of the parties that punitive damages are not part of this settlement.”
These concerns are necessitated by the 1996 amendment of the Tax Code, which made punitive damages taxable. The courts had been split on the taxation of punitive damages. The rationale for taxing them is that they are meant to punish the wrongdoer, not as compensation to the victim. Since punitive damages now can be paid “within the meaning” of I.R.C. § 104(a)(2), it is essential that punitive damages be addressed in the settlement document. See Barnes v. Commissioner, 36 T.C. Memo 97-25, which upheld the IRS’s making of an unfavorable allocation to the taxpayer to taxable damages because the settlement document was silent as to the treatment of punitive damages, which had been alleged. The IRS made it clear that such allegations did not need even to be in the pleadings, but could have been merely discussed during negotiations.
The IRS has also ignored settlement document provisions disclaiming punitive damages, even when the language is incorporated into a court order, when the facts indicated that the statement was nothing more than an accommodation to the claimant. If it is truly in the mutual interest of both parties that no portion of any payment is for punitive damages, and the stipulation is made at arm’s length, the argument likely will be more persuasive to the IRS than if the mutual benefit is not demonstrated. Liability insurance policies generally do not cover punitive damages, so it is reasonable that an insurer does not wish to admit paying them. Both parties should sign the agreement if it contains such a stipulation—this is more than a unilateral release by the claimant. Again, the final decision subject to appeal belongs to the IRS. The burden of proof is on the taxpayer.
Resist Unnecessary Restrictions
The plaintiff’s attorney should resist allowing the defense or the assignee of the future payment liability to impose unnecessary restrictions on those payments.
Several years ago the structured settlement industry adopted a Uniform Qualified Assignment and Release document that has served as a model for section 130 qualified assignments of nontaxable damages. That document form contains the following restriction in paragraph 3:
“None of the Periodic Payments may be accelerated, deferred, increased or decreased and may not be anticipated, sold, assigned or encumbered.”
This short sentence actually contains two sets of restrictions that serve two different purposes—one valid and the other overcome by events.
The restriction that payments may not be “accelerated, deferred, increased or decreased” serves a still-viable purpose of avoiding a triggering of the constructive receipt doctrine. If a payee has the right to change the timing or amount of any payment, that creates an incidence of ownership in the annuity or Treasury obligation that likely would be interpreted by the IRS as constructive receipt. Additionally, it would violate the conditions of section 130(c)(2)(a), which requires that periodic payments be “fixed and determinable as to amount and time of payment.” This would pose undesirable tax consequences to both the payee and the assignee, which owns the funding asset.
The usefulness of the second restriction, against payments being “anticipated, sold, assigned or encumbered,” has been overcome by the enactment on January 23, 2002, of H.R. 2884, the “Victims of Terrorism Tax Relief Act of 2001,” which added section 5891 to the Internal Revenue Code. This new section regulates “Structured Settlement Factoring Transactions” by imposing a 40 percent tax on the “factoring discount” unless the transaction is approved in advance by an “applicable state court.” (The terms of art shown here in quotes are defined in the new Tax Code section.)
A “structured settlement factoring transaction” is defined at 26 U.S.C. § 5891(c)(3)(A) as “a transfer of structured settlement payment rights (including portions of structured settlement payments) made for consideration by means of sale, assignment, pledge, or other form of encumbrance or alienation for consideration.” In other words, this new Tax Code provision specifically permits the type of transfer of payment rights that the industry’s standardized document prohibits, as long as the transaction is approved in advance by a state court of competent jurisdiction.
These restrictions were put in place originally for several reasons. First, the life insurance industry believed that its affiliated assignment companies ran the risk of having to pay taxes on the premium dollars paid to it for purchasing annuities and on the internal growth of the annuity if it no longer was considered a “qualified funding asset” under section 130(d). Second, if payees could manipulate the time and amount of their payments by selling the future rights to a factoring company, this might be perceived by Congress as a sham transaction, possibly jeopardizing the legitimate tax benefits it had created as a social policy to encourage structures and avoid injury victims later becoming wards of the state when lump sum damage payments were dissipated. Third, the injury victims were thought to be taken advantage of by some unscrupulous factoring companies that charged usurious discount rates and required extraordinary security measures such as advance agreement to confessions of judgment for breach of contract. In response, the life insurance industry assumed a protectionist role on behalf of the annuitants. Fourth, the life insurance companies ran the risk of having to make duplicate payments to both the factoring company and heirs of the deceased claimant who contended that the assignment of payments was invalid because it breached the settlement agreement.
Not surprisingly, all of these concerns were covered satisfactorily in section 5891 because the life insurance industry had a hand in drafting it. In fact, the structured settlement community, including the life insurance companies that sell structured settlement annuities, forged an agreement with the settlement purchasers, who had been their adversaries, and jointly recommended the text that was adopted by Congress as H.R. 2884 and enacted into law. Notwithstanding that all concerns of the life insurance companies have been ameliorated and the role of protectionist to the injury victims has been assigned to the state courts, some life insurance companies have been slow to agree to remove the restrictions in their prescribed document forms against payments being “anticipated, sold, assigned or encumbered.”
Do Not Cast Doubt That Injury Exists
One of the most potentially damaging errors in a settlement agreement for physical injury damages is to cast doubt on the existence of the injury. Consider the following language contained in a draft settlement agreement:
Incorrect: “[Claimant] does hereby declare and represent that the damages which she sustained as a result of her medical treatment are uncertain and indefinite.”
The following text achieves the same result for the defendant without harming the plaintiff:
Correct: “It is understood and agreed to by the parties that this settlement is a compromise of a doubtful and disputed claim, and the payments are not be be construed as an admission of liability on the part of the insured, by whom liability is expressly denied.”
If there is no personal physical injury or physical sickness, the damages are taxable. It is permissible to create a future payment promise, as a condition of settlement, and to assign the obligation—even when the recovery is taxable. The assignment of taxable payments would not be called a “qualified assignment,” which is the term used in section 130 when the recovery is excluded under section 104. Instead, it would be called simply an assignment. Future payments of taxable damages and attorney fees (which are always taxable, but in the year received) can be assigned through a reinsurance assumption agreement, if the assignor is an insurance company, or to an assignee located in an offshore “tax haven,” which will purchase a traditional structured settlement single premium, fixed annuity. But, care should be taken to ensure that nontaxable damages are not made taxable due to an error in the documents.
Stipulation of Cost Protects Claimant
As stated earlier, it is recommended that the cost of the annuity (including any applicable assignment fee) be stated in the settlement agreement. As long as the cost of funding future benefits, payable to a third party, is not confused with the consideration to be paid directly to the claimant, there is no problem in stating the cost. Contrary to the old dodge once used regularly by the defense that knowledge of the cost of the annuity will cause the claimant to lose tax-exempt status of the future payments, there are at least two private letter rulings by the IRS that dispel this myth:
“Disclosure by defendant of the existence, cost or present value of the annuity will not cause you to be in constructive receipt of the present value of the amount invested in the annuity.”
Priv. Rul. 83-33035 (1983).
“Knowledge of the existence, cost and present value of the annuity contract used to fund the settlement offer … will not cause the family to be in constructive receipt of the amount payable under the annuity contract or the amount invested in the annuity contract.”
Priv. Rul. 90-17011 (1970).
One excellent reason for including the cost of the annuity in the settlement agreement is that it verifies to the court, on behalf of the defense, the amount being spent by the defense for the benefit of the claimant. This is apropos when the settlement involves a minor or protected adult.
An even better reason to stipulate to the cost of the future benefits is that it creates privity of contract between the defendant or its insurer and the claimant. A true settlement agreement signed by all parties, and not just a unilateral release signed only by the plaintiff, is a contract. If the actual cost to the defendant or its insurer of the future benefits is anything other than the amount shown in the settlement agreement, there is a breach of contract.
In the case of Lyons v. Medical Malpractice Insurance Association, 730 N.Y.S.2d 345 (2001), the insurer for the defendant physician knowingly misrepresented the actual cost of the annuity that would fund future payments to the permanently incompetent injury victim. The value of the settlement had been overstated by some $265,000. This adversely affected the plaintiff’s ability to settle with the hospital defendant. It also resulted in an overcharge by the plaintiff’s attorney, who had a one-third contingent fee agreement with his client.
When this overstatement of the settlement’s true present value was discovered, the insurer was sued by the plaintiff, alleging fraud and other causes of action. The suit also named the structured settlement broker, the annuity issuer and its affiliated assignment company as defendants. The trial court dismissed these defendants on motion for summary judgment, as the defendants had claimed they owed no duty to anyone other than the insured physician. The defendants claimed there was no privity between them and the plaintiff. The appellate court overturned this ruling, holding instead that the inclusion of the settlement’s present value in the settlement agreement, as represented by the insurer to be true, created sufficient privity of contract. The issue of fraud and its consequential damages was remanded to the trial court.
The suit also named the plaintiff’s own attorney in the original settlement as a defendant. The plaintiff alleged that the original attorney was negligent in allowing the defendants to overstate the value of the settlement and, consequently, in overcharging the contingent attorney fee. Being the only defendant not dismissed by the trial court, the attorney was quick to settle, paying an amount to the plaintiff that was in seven figures.
The lesson of Lyons is that the plaintiff’s attorney should insist on including the purported settlement cost in the settlement agreement if there is any doubt that the cost was truthfully represented. Then, if there is later a reason for the plaintiff to sue for fraud because the represented cost to the defense of the settlement was discovered to be understated, the perpetrators might be held accountable if Lyons is persuasive.
Flawed Documents Void Tax Exclusion
If damages that would otherwise qualify for exclusion from the claimant’s gross income are made taxable due to an error, the claimant’s attorney likely will be the only person available for the claimant to sue when the error is detected and the IRS has allocated all or part of the recovery to taxable damages. The person who drafted the flawed document, if part of the defense team, will have been long released. This includes structured settlement brokers who are engaged by the defendant or its liability insurer to handle structured settlement transactions, often in exchange for a rebate of part of the commission on the annuity sale or some other consideration such as a commitment to use the annuity product of a life insurance company related to the liability insurer. When the claimant signs the release—usually after the claimant’s attorney has approved it as to form and content—the released parties include not just the torfeasor but the liability insurer and all of their agents.
Non-Attorney Held to Same Standard
It is well-settled in common law that someone like a structured settlement broker can fill in the blanks of standard documents that have been drafted by an attorney, if that person customarily deals with those documents on a regular basis. This constitutes engaging in the “practice of law,” but courts generally have held that this limited practice is authorized. Real estate agents who prepare sales contracts on behalf of their clients using form documents are the traditional example of a person engaged in the limited practice of law within a narrow area of specialization. However, the non-attorney practitioner is held to the same standard of care as a licensed attorney.
The plaintiff’s attorney should consider that the proposed settlement agreement prepared by the defense may have been drafted by a non-attorney. It may then have been reviewed by the defense counsel, whose area of specialization did not include structured settlement tax law. Regardless of the competence of whoever on the defense team drafted and reviewed the settlement agreement, no one on the defense team has a duty of loyalty to the claimant. If the plaintiff’s attorney does not feel comfortable reviewing the draft structured settlement agreement, it is highly recommended to engage the services of a specialist. That specialist might be either an attorney or a non-attorney whose narrow area of expertise is in the preparation and review of structured settlement documents. Just as a non-attorney drafter of the documents on the defense team is held to the standard of care of an attorney, so too is the non-attorney specialist engaged by the plaintiff’s counsel. That person has a duty of loyalty to the plaintiff and will not be released from liability for negligence when the settlement agreement is signed by the plaintiff.
The best defense against errors in the settlement agreement that might cause an adverse tax consequence or other unfavorable circumstance is not to rely on the defendant, its insurer, its structured settlement broker or any other agent to do the job for the plaintiff and the plaintiff’s attorney.