Tax Considerations Taxation of Claimant under Internal Revenue Code Section 104(a)(2). A major reason for the growth of structured settlements is that claimants receive very favorable federal income tax treatment. This favorable tax treatment is not available unless certain conditions are met. Section 104(a)(2) of the Internal Revenue Code provides that amounts received by claimants in injury and death claims are excludable from gross income and, thus, are not subject to federal income tax. Code Section 104(a)(2) provides: IN GENERAL. -...(G)ross income does not include the amount of any damages received (whether by suit or agreement and whether as lump sums or structured settlements) on account of personal injuries or physical sickness. On August 20, 1996, the Small Business Job Protection Act of 1996 became law. This law further clarified the taxation of the claimant under Section 104(a)(2). In essence, the law restricted 104(a)(2) to physical injury or sickness. This restriction, commonly known as the "Origin of the Claim Test," clarifies that in addition to being a "personal" injury to the claimant, an injury must truly be "physical" (as opposed to "emotional") to receive the favorable tax treatment afforded by 104(a)(2). This law also eliminated the exclusion for punitive damages on account of personal injuries or sickness, with the exception of punitive damages in a wrongful death action where state law provides that such damages are the exclusive remedy. You will have greater success using structured settlements if you understand this section of the Internal Revenue Code. Tax Law and Analysis:  The Origin of The Claim Test—A Closer Look at the Taxation of Damages The following Analysis is intended to help you evaluate the taxation of personal injury damages: Any receipt of funds by a taxpayer is presumed to be gross income unless the taxpayer can demonstrate the accession fits into one of the exclusions created by other sections of the Code. See Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955). Section 104(a)(2) permits a taxpayer to exclude from gross income any damages (other than punitive damages) received on account of personal physical injuries or physical sickness. The Supreme Court has stated Section 104(a)(2) and the accompanying regulations allow a taxpayer to exclude from gross income the proceeds of a settlement when two requirements are met: First, the taxpayer must prove the cause of action giving rise to the recovery is based upon tort or tort type rights; and Second, the taxpayer must demonstrate the tortfeasor paid the proceeds on account of personal injuries or sickness. Schleier, 515 U.S. at 337. If the taxpayer fails either requirement, Section 104(a)(2) will not allow exclusion of the disputed amounts from the taxpayer's gross income. Schleier, 515 U.S. at 333-334. By its express terms, punitive damages are not excludable from gross income under Section 104(a)(2). See, also, O'Gilvie v. United States, 519 U.S. 79, 84-90 (1996)(former versions of  Section 104(a)(2) did not exclude punitive damages from gross income). The legislative history of the 1996 amendment to Section 104(a)(2) provides explicitly:  If an action has its origin in a physical injury or physical sickness, then all damages (other than punitive damages) that flow therefrom are treated as damages received on account of personal physical injuries or physical sickness whether or not the recipient of the damages is the injured party. For example, damages (other than punitive damages) received by an individual on account of a claim of loss of consortium due to the physical injury or physical sickness of such individual's spouse are excludable from gross income.  H.R. Conf. Rep. No. 104-737, at 300 (1996), reprinted in 1996 U.S.C.C.A.N. 1474, 1793. Private Letter Ruling 200121031, 5/29/2001, IRC Sec(s). 104..."Because there exists a direct link between the physical injury suffered and the damages recovered, Taxpayer may exclude from gross income any economic damages compensating for such injury..." Tax Advantages of Structured Settlements Lump sums and structured settlements are both excludable from income under Code section 104(a)(2). However, if the claimant receives a lump sum, the claimant excludes that amount but may be taxed on any yield from the investment of the lump sum. On the other hand, if a casualty insurer invests the same lump sum and pays the investment yield to the claimant in the form of a structured settlement, no part of this investment yield is taxable to the claimant. Certain statutory and administrative requirements must be met in order for the claimant to receive a structured settlement tax-free. Statutory Requirements Two statutory requirements must be met in order for the claimant to receive a structured settlement tax-free. "Statutory" means that these two requirements appear on the face of Code Section 104(a)(2). First, this exclusion is not available unless the settlement or judgment is for "personal injuries or sickness." Second, to the extent that the claimant has taken a deduction in any prior year for medical expenses related to the injury, that portion of the settlement or judgment is not excludable and is treated as taxable income. Administrative Requirements Certain administrative requirements must also be met in order for the claimant to receive a structured settlement tax-free. "Administrative" means that these requirements do not appear on the face of the statute, but are imposed by the Internal Revenue Service. These administrative requirements were first published in 1979 as part of Revenue Rulings 79-220 and 79-313. Later, Congress passed the Periodic Payment Settlement Act of 1982. The legislative history of that act provided that the requirements originally set forth in Revenue Rulings 79-220 and 79-313 would be adopted as law (not as mere interpretations of the law). As experience with structured settlements increases, new administrative requirements continue to be published in the form of Revenue Rulings and Private Letter Rulings. Summary of Requirements For the claimant to receive a structured settlement tax-free, the casualty insurer and the claimant must comply with the requirements summarized here. Code section 104(a)(2) does not apply unless the settlement or judgment is for "injuries or sickness" that are both personal and physical." Source: Code section 104(a)(2) & Small Business Job Protection Act Code section 104(a)(2) does not apply to the extent that the claimant took a medical deduction in any prior year for expenses attributable to the injury. Source: Code Section 104(a)(2) The favorable tax treatment of Code section 104(a)(2) does not apply to punitive damages on account of personal injuries or sickness, with the exception of punitive damages in a wrongful death action where state law provides that such damages are the exclusive remedy. Source: Small Business Job Protection Act Claimant cannot have the right to control the investment of the lump sum that is used to produce the structured settlement. Source: Revenue Ruling 79-220 Claimant cannot have the right to receive a discounted present value of the structured settlement. Source: Revenue Ruling 79-220 Claimant cannot have the right to accelerate, defer, increase or decrease any structured settlement. Source: Revenue Ruling 79-313 Claimant cannot have rights against the structured settlement obligor that are greater than rights of the obligor's general creditors. Source: Revenue Rulings 79-220 and 79-313 If the obligor purchases and owns an annuity, the annuity is subject to the general creditors of the obligor. Source: Private Letter Ruling 8325054 If the obligor purchases and owns an annuity, the obligor must have all rights of ownership in the annuity, including without limitation the right to change the beneficiary. Source: Revenue Ruling 79-220