Structured settlements and selling future payments

A structured settlement is a legal settlement, usually for a personal injury, wrongful death or workers' compensation claim, paid as a stream of scheduled payments instead of one lump sum. A life insurance company issues an annuity that funds the payments. Selling future payments to a factoring company for a lump sum is legal, but it requires court approval in most places and usually costs the seller a large share of the payments' value.

The payment stream is, in effect, an immediate or deferred annuity with a schedule fixed by the settlement agreement. For the product basics see what is an annuity and how does it work? and Single premium immediate annuities (SPIAs): how they work.

How a structured settlement works

1. A claim settles. The parties agree that part or all of the money will be paid over time.
2. The defendant or its insurer arranges a "qualified assignment" to an assignment company, which buys an annuity from a life insurer. The annuity pays the claimant, called the payee.
3. The payee receives scheduled payments: monthly income, lump sums at fixed dates (for example, at age 25 or for college), or lifetime payments.
4. Payments may be level or increase at a stated rate. They may be guaranteed for a fixed period (period certain) or contingent on the payee being alive.

Payments from a settlement for physical injury or sickness are generally excluded from the recipient's gross income under Internal Revenue Code §104(a)(2), and that includes the investment growth built into the payments. That is a major selling point compared with investing a taxable lump sum. Tax treatment depends on the type of claim; punitive damages and some other awards are treated differently, so confirm with a tax professional.

Other reasons claimants choose structure: it protects a minor or a person with a disability from spending the money too quickly, it can help preserve eligibility for needs-based benefits when paired with a special needs trust (see life insurance for parents of a child with special needs), and it provides lifetime income. The drawbacks are inflexibility and the fact that the schedule generally cannot be changed.

Why people sell, and what it costs

Payees sometimes face emergencies or large expenses: medical bills, debt, housing, or a business opportunity. Factoring companies offer a lump sum now for some of the future payments. The buyer discounts the payments using a rate far higher than the rate the annuity earns, so the price is often well below the payments' present value. Federal tax law calls the gap between the total payments sold and the price paid the "factoring discount."

The effective annual discount rate can differ greatly from a quoted rate, because the buyer may add fees, legal costs and a spread. Compare offers by asking for the exact discount rate, total fees, and the total amount you give up. Before agreeing, consider alternatives: selling only a portion, borrowing against other assets, or waiting for a scheduled lump sum.

Hypothetical example

Say a payee is entitled to $1,000 a month for the next 15 years, which is $180,000 in total. A buyer offers $90,000 in cash today for all of those payments. The payee would give up $180,000 of scheduled payments to receive $90,000 now, a 50% discount on the face amount. This is an invented illustration, not a market price.

The legal protections

Federal tax: IRC §5891. Congress enacted section 5891 in 2001 as part of the Structured Settlement Protection Act. It imposes a 40% excise tax on the factoring discount, payable by whoever acquires structured settlement payment rights in a factoring transaction, according to the statute. The tax does not apply when the transfer is approved in advance in a "qualified order": a final court order finding that the transfer does not violate federal or state law or any court order, and that it is in the best interest of the payee, taking into account the welfare and support of the payee's dependents. Because of the tax, factoring companies seek court approval in nearly every transaction.

State transfer statutes. Most states have a structured settlement protection act that requires a court (or in some cases an administrative authority) to approve a transfer. Details vary by state, but they commonly include:

• written disclosure to the payee, ahead of signing, of the amounts, the discount rate, fees and what is being given up
• advice to get independent professional advice (legal, tax or financial), sometimes with a required statement that the payee received it
• a court hearing, usually in the payee's home state, with notice to the annuity issuer and other interested parties
• findings that the deal is fair and in the payee's best interest

Some states limit how often a payee may sell or add special rules for minors and people with disabilities. Read your own state's statute.

Steps if you receive an offer

1. Do not sign under pressure. Ask for the written disclosure and the discount rate.
2. Get quotes from more than one buyer. Compare lump sum, fees and total payments given up.
3. Talk with an independent attorney or fee-only planner who is not paid by the buyer.
4. Check whether the sale affects public benefits or your taxes.
5. Find your state's structured settlement transfer statute through the legislature's website or your state insurance department.
6. Attend the court hearing. If the deal does not seem right, tell the judge.

The insurer behind the payments

The annuity is backed by the issuing life insurer. If that insurer fails, your state's guaranty association may step in, subject to limits, and some states set special limits for structured settlement annuities. Check state life and health guaranty associations and state guaranty association coverage lookup. Selling payments does not change who owes them; the buyer simply receives them. People who are weighing a different sale, of a life insurance policy, should read life settlements: selling your life insurance policy.

Key takeaways

• A structured settlement is a series of scheduled payments funded by a life insurance annuity, typically from an injury or wrongful death claim.
• Selling future payments usually costs a large discount; compare offers and consider selling only part.
• Federal IRC §5891 imposes a 40% tax on the factoring discount unless a court approves the transfer in a qualified order.
• State protection acts commonly require disclosure, independent advice and judicial approval based on the payee's best interest.
• Get independent legal or financial advice before signing.