Key Takeaways
- Most proceeds from the sale of future structured settlements payments aren’t taxable.
- There are some rare cases in which taxes will be due.
- In either case, there are some legal barriers to cross before you can sell your structured settlement payments.
Taxation of Structured Settlement Sales
Generally, if a structured settlement itself is not taxable, then selling the future payments is also not taxable. This is true as long as the contract provisions don’t change and the sale follows the law, which imposes several requirements on such sales, including oversight and approval by a judge.
Selling your structured settlements for a large lump sum could put you in a higher tax bracket if the circumstances of the settlement result in a taxable event. The sale may also result in losing tax-free growth from settlements with tax exclusion, or foregoing tax deferral benefits in settlements with taxable consequences.
Understanding which types of structured settlements are taxable and nontaxable will help you determine whether the sale of your settlement is ultimately to your advantage.
If you’re thinking about selling your structured settlement payments, it’s important to get advice from an attorney to handle potential legal issues and a financial or tax advisor to make sure your financial interests are protected.
Peggy James, CPAIndependent Accountant and Financial CoachPeggy James is a certified public accountant with a Master of Accounting. She has spent the past several years of her career focused on working in higher education finance roles. Peggy also has accounting and finance experience working in the corporate and nonprofit sectors.
When Are Structured Settlements Not Taxable?
Under the federal Periodic Payment Settlement Act, the IRS and state governments are barred from taxing most types of structured settlement income — whether it’s paid all at once or in installments. The Act, passed in 1982, ensures that structured settlements continued to provide financial security to those who received them. This law still exists to protect structured settlements today.
The government views these payments as a way of keeping injured people from relying on public assistance, thereby benefiting American taxpayers. Structured settlement holders, meanwhile, enjoy the benefit of not having to pay taxes on these payments.
The tax exclusion extends to interest, dividends and capital gains earned by funds in structured settlement accounts.
Read More: How Does a Structured Settlement Work?
Personal Injury and Wrongful Death Settlements
The government doesn’t consider settlements from personal injury lawsuits as income. In every case, any installment or lump-sum payments due to personal injury and wrongful death claims are exempt from federal, state and local taxes. The tax-exempt status includes capital gains or any interest earned throughout the duration of installment payments.
Consequently, any sales of structured settlement payments in these types of cases also are tax exempt, as long as the sale follows all applicable law including receiving the appropriate court approval.
Need To Sell Your Structured Settlement for Cash Immediately?
Workers’ Compensation Settlements
Insurance companies can also issue annuity contracts to fund settlement payments in workers’ compensation cases that involve physical injuries or illnesses suffered in the workplace.
Section 104 (a)(2) of the Internal Revenue Code mandates that damages from on-the-job physical injuries or illnesses cannot be considered income, so they are not subject to taxation.
Additionally, settlement recipients can sell their future payments with the tax-free advantages in place, as allowed by Section 130 of the IRC.
Some Settlements Are Taxable
The U.S. Supreme Court ruled in 1995 that some proceeds from lawsuit settlements would be subject to income taxes. Whether the settlement is directly related to physical injuries or illness determines whether it is taxable. Typically, settlement proceeds not related to physical injuries or illness receive the same tax treatment as ordinary income.
Discrimination and Emotional Stress
Settlement proceeds in cases involving lost wages for discrimination or emotional distress not caused by physical injury or illness need to be reported as taxable income. Proceeds are only nontaxable if the emotional stress was experienced due to malpractice.
Under IRC Section 104 (a)(2), compensation for discrimination cases related to age, race, religion, gender, or disability is also generally deemed taxable income.
Punitive Damages
The IRS states that any compensation for punitive damages — the kind designed to punish the wrongdoer, rather than to assist the victim — is subject to taxes. This holds even if the punitive damages are part of a personal injury settlement.
Taxable structured settlements are rare, and the payments are not often sold.
Although taxable structured settlements are rare, it’s best to confirm the status of your contract before attempting to sell your payments. Work with an experienced attorney to consider how taxes could affect your settlement.
Interested in Selling Annuity or Structured Settlement Payments?
Terrorism Law Applies Tax to Settlement Sales
In 2002, President George W. Bush signed the Victims of Terrorism Tax Relief Act of 2001 to provide relief to the victims of the Sept. 11 terrorist attacks. Among other provisions, the Act exempted certain disability payments made to any individual injured in a terrorist attack against the United States from income taxes.
At the same time, the Act essentially created a way for structured settlement holders to sell future payments, known as a factoring transaction. To protect sellers, the Act imposed a 40% excise tax on any profit from the purchase of most structured settlement payments imposed under Section 5891.
IRS Form 8876 is used to report and pay the 40% excise tax.
Exceptions to the tax requirement exist. To qualify for an exception, purchasers have to follow specific rules, which include obtaining court approval. State laws known as structured settlement protection acts govern the rules.
Once a sale is approved by a court, the lump-sum payment is given the same tax treatment as the periodic payments. That means, in most instances, they remain tax-free.
The intent of Congress and state lawmakers is to prevent factoring companies from taking advantage of settlement holders. Judges considering whether to approve sales of structured settlement payments must determine whether the sales are in the best interests of the people selling their payments.
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