Structured Settlements and Taxes

Tax laws governing structured settlements were enacted to encourage the use of structured settlements in personal injury cases because they benefit the injured party as well as federal and state governments. The long-term financial security they provide to settlement holders reduces the burden on public assistance programs.

Although lawmakers prefer people hold on to their structured settlements, there are no negative tax consequences to selling settlement payments.

When Are Settlements Tax-Free?

Because structured settlements for compensatory damages are tax-exempt, so too are proceeds from selling future payments.

Structured settlement payments and revenue from selling these payments are also exempt from state taxes and taxes on dividends and capital gains.

That’s because settlement money isn’t considered traditional income by the government. Instead it’s compensatory, meaning it’s meant to compensate for a loss, such as wages lost because of a serious accident.

This is covered in Section 130 and Section 104(a) of the Internal Revenue Code. The law states that any damages received by suit or agreement for personal injury, physical sickness and workers’ compensation are tax-free.

However, punitive damages — money awarded to the injured party as punishment for the responsible party’s actions — are taxed as income, and interest earned on the settlement is taxed as “interest income.”

Structured settlements are meant to provide regular income to the injured party by spreading payments over several years instead distributing the money as a single lump sum, which could be misspent. The periodic payments help injured people pay living costs without the need for public assistance — another reason government doesn’t tax this money.

Periodic Payment Settlement Act

Congress passed the Periodic Payment Settlement Act of 1982 to encourage the use of structured settlements in physical injury and wrongful death cases. In 1997, Congress extended those tax-free benefits to workers’ compensation cases involving employees injured on the job. These tax advantages are incorporated into the Internal Revenue Code.

Tax-exempt structured settlements are awarded in the following cases:

• Personal injury
• Physical sickness
• Medical malpractice
• Wrongful death
• Workers’ compensation

Injured parties will never pay taxes on structured settlement money awarded in these cases, regardless of whether they receive the money in a series of payments or sell their payments for a lump sum.

Structured Settlement Tax Advantages

Structured settlements and lump-sum payouts for compensatory damages in personal injury cases are tax exempt. So there is no distinct tax advantage to the type of settlement payout you receive. The tax advantages of structured settlements are generally considered in terms of their benefits over time.

For example, if you receive your settlement as a single payment and invest the money in the stock market, you will owe taxes on the dividends and interest earned. This money will be taxed at your current tax bracket.

The same goes for the lump sum you would receive if you chose to sell your structured settlement payments today and invested that money in stocks, real estate or another investment type. Cashing out your settlement and reallocating that money to nonexempt investment vehicles would result in you owing taxes on dividends, interest, income or capital gains.

In other words, the money from your settlement is only excluded from your tax obligation as long as it is held in and paid out from the annuity or Treasury bond that was funded by the defendant at the time of the settlement agreement.

When Are Settlements Taxable?

In 1996, a change to the tax code established that injuries must be physical in nature for settlements to receive tax-exempt status, according to the American Bar Association. This means awards stemming from discrimination, mental anguish and injury to a personal reputation can be taxed by the IRS.

Likewise, the 1996 amendment determined that injuries must be physical or visible for the settlement to be excluded from gross income, so emotional distress recoveries that “do not originate from a personal physical injury or physical sickness” must be included in your income and taxed accordingly. The law allows you to deduct amounts paid for medical expenses related to the emotional distress that were not previously deducted.

The same rule applies to sexual harassment cases, though some taxpayers have argued that their damages are physical and should be tax-free.

Punitive damages are always taxed and should be reported as “other income,” according to the IRS.

Even if you are completely disabled in a medical malpractice case, punitive damages are taxed. For example, if someone who was disabled by a faulty piece of equipment is awarded $100,000 in compensatory damages and $1 million in punitive damages, the $100,000 is tax-free, but the $1 million is taxable.