The following section is for attorneys and tax professionals.

Taxation of damages for personal injuries

The victim does not have to pay taxes on his net share of the settlement, except for that portion of the money that constitutes punitive damages or interest. Generally speaking, compensation received as damages on account of personal injuries is not included in the victim's gross income and therefore is not taxable, per Internal Revenue Code section 104(a)(2):

§ 104. Compensation for injuries or sickness

(a) In general. Except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include—...

(2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness....

The exclusion in section 104(a)(2) applies whether the damages are received as a result of a lawsuit or settlement agreement, and whether they are received in a lump sum or periodic payments. The exclusion also extends to the portion of damages received as compensation for lost wages and lost income, even though the same would have been taxable if the plaintiff had earned them. (Burke, Therese A., 504 US 229 (Sup. Ct. 1992).)

However, when such compensation is received and invested, the gain (i.e., the interest or profit) on the same is taxable as ordinary income. (Rozpad, Joseph S., 154 F3d 1 (1st Cir. 1998); Greer, Yancy D., TC Memo 2000-25 (2000).) For example, if an accident victim settles his claim and receives $10,000, invests the $10,000 in a certificate of deposit, and makes $300 in interest after one year, that $300 is taxable even though the $10,000 is not. This same principle is applied to "delay damages" added to the jury verdict in a personal injury suit. Because such damages essentially compensate the plaintiff for the lost time value of money, they are not considered to be damages received on account of personal injury, and therefore are not excludable from gross income. (Francisco, Charles, 267 F3d 303.)

To learn the tax rates for 2009, see CCH Projects Key Tax Figures For 2009.

Congress determined that it would be in the best interest of accident victims if they received their compensation in the form of future periodic payments that had certain restrictions, rather than a single lump sum that could be spent immediately. To encourage victims to agree to do so, the lawmakers provided an incentive in the form of a "tax break." Specifically, Congress passed Public Law 97-473, which made the gain on a personal injury settlement excludable from income (i.e., tax free) if certain conditions are met. (See P.L. 97-473, Jan. 14, 1983 (97th Cong., 2d Sess.))

Tax rates for children

Dependent children are subject to special tax laws:

  • In 2009 the first $950 of a dependent child's (below the age of 19, or 24 if a full-time student) unearned income is tax-free.
  • The next $950 is taxed at the child's rate, which is typically 10%. So if a child earned $1,900 or less in unearned income in 2009 and did not have additional earned income, he would pay $95 at most in tax (10% on the second $950).
  • This tax rate goes up when the child's unearned income exceeds $1,900: at that point, his tax is computed at the parent's tax rate, which can be as high as 35 percent. This is referred to as the "kiddie tax."

IRC definition of structured settlement

The most concise summary of these conditions appears in the definition of "structured settlement" contained in Internal Revenue Code section 5891(c)(1):

The term "structured settlement" means an arrangement—

(A) which is established by—

(i) suit or agreement for the periodic payment of damages excludable from the gross income of the recipient under section 104 (a)(2), or

(ii) agreement for the periodic payment of compensation under any workers' compensation law excludable from the gross income of the recipient under section 104 (a)(1), and

(B) under which the periodic payments are—

(i) of the character described in subparagraphs (A) and (B) of section 130 (c)(2), and

(ii) payable by a person who is a party to the suit or agreement or to the workers' compensation claim or by a person who has assumed the liability for such periodic payments under a qualified assignment in accordance with section 130.

According to the above definition, the structured settlement of a personal injury claim must be an arrangement (a) established by a suit or agreement, (b) for the periodic payment of damages to an accident victim, (c) under which the payments are of the character described in IRC section 130(c)(2)(A) and 130(c)(2)(B), and (d) under which the payer is a party to the suit or agreement, or an assignee of the liability under a "qualified assignment."

Suit or agreement

A "suit" means a lawsuit. An "agreement" usually means a settlement agreement. A bodily injury claim is resolved by a suit, which leads to a court judgment, or a settlement agreement. Therefore the first requirement of IRC 5891(c)(1) is easily met.

Periodic payment of damages

The "periodic payment of damages" refers to the payments to be received in the future. This is generally understood to mean at least two payments. However, in one case, the IRS announced that one payment would meet the second requirement of IRC 5891(c)(1). Nevertheless, in the usual dog bite settlement, there are several or more payments.

Damages for bodily injuries and not punitive damages

"[E]xcludable from the gross income of the recipient under section 104 (a)(2)" means that the money is being paid on account of bodily injuries. Punitive damages do not qualify. The settlement agreement and everything else should therefore say that no part of the settlement is for punitive damages.

Amount and timing of payments

Section 5891(c)(1)(B) then refers to payments that meet the conditions of IRC section 130(c)(2)(A) and 130(c)(2)(B):

(A) such periodic payments are fixed and determinable as to amount and time of payment,

(B) such periodic payments cannot be accelerated, deferred, increased, or decreased by the recipient of such payments....

In a dog bite case, the victim's periodic payments typically are made through the purchase of a single-premium fixed annuity. An annuity is a contract by which a life insurer agrees to make payments at specific times in the future. These payments are "fixed and determinable" by the very nature of the annuity contract itself. A settlement that is funded by an annuity therefore meets this requirement.

The prohibition against accelerating, deferring, increasing or decreasing the payments is intended to ensure that the accident victim does not defeat the purpose of the legislation. The settlement agreement or the annuity contract itself must contain language that satisfies subdivisions (A) and (B).

Who can make the payments

The last condition has to do with the person or entity that actually will make the payments. The payments have to be made by one of the following: a party to the suit, a party to the settlement agreement, or a person or entity that has assumed the liability under a "qualified assignment."

The party to the suit is the dog owner. Usually he has homeowners or renters insurance. Therefore he will rely upon his liability insurer to make the payments. Note that the payments can be made to a party to the settlement agreement, which would include the homeowners or renters insurance company in the usual case, or a trust if a qualified settlement fund is used (for so-called "QSFs" see Code of Federal Regulations, section 1468(B)(1) (Qualified Settlement Funds)).

Typically, the defendant's liability insurer usually is not the ultimate payer. Liability insurance companies typically do not want long-term obligations on their books, and are not set up to make future payments of losses. There are legal restrictions as to how such companies are permitted to invest and make profits; they are not in the business of simply holding funds over many years for eventual payment to victims. Furthermore, from the victim's perspective, liability insurers go out of business from time to time, while life insurers (which are the annuity issuers) have a nearly perfect record of paying beneficiaries under structured settlement annuity contracts. So the victim would reasonably require more security than a liability insurer can provide. This is where the "qualified assignment" comes into the picture.

Qualified assignment

The last category of person or entity is one which has assumed the liability under a "qualified assignment." This can be any person or entity, but cannot be the victim, his attorney, his attorney's trust account, or anyone who is the alter ego of the victim, or is controlled by the victim. In the usual case, this third party usually is a holding company formed as a corporation and established, maintained and controlled by a life insurance company -- specifically, the company that issues the annuity that provides the future periodic payments. It would be unreasonable for the assignee to be a person, because he would have to be a trustee, he would need to be bonded, he certainly would charge yearly fees, and the funds could be lost if he dies or absconds with them. The assignee could be an institutional trustee, such as a bank, but they too charge fees. The life insurance companies that sell annuities for structured settlements have made it simple and economical to use their assignment companies, because no fees are charged, and the life insurers routinely issue guarantees that these companies will make all payments when due.

Section 5891(c)(1)(B)(ii) refers to "a qualified assignment in accordance with section 130." This refers to an assignment of the underlying obligation to make the future periodic payments. In other words, the holding company assumes the dog owner's tort liability and/or the homeowners or renters insurance company's liability to make the payments to the victim. This performs a neat accounting trick: the liability offsets the value of the annuity contract, so that there is no tax to be paid by the holding company. This becomes a "qualified funding asset" under Internal Revenue Code section 130:

§ 130. Certain personal injury liability assignments

(a) In general

Any amount received for agreeing to a qualified assignment shall not be included in gross income to the extent that such amount does not exceed the aggregate cost of any qualified funding assets.

(b) Treatment of qualified funding asset

In the case of any qualified funding asset—

(1) the basis of such asset shall be reduced by the amount excluded from gross income under subsection (a) by reason of the purchase of such asset, and

(2) any gain recognized on a disposition of such asset shall be treated as ordinary income.

(c) Qualified assignment

For purposes of this section, the term "qualified assignment" means any assignment of a liability to make periodic payments as damages (whether by suit or agreement), or as compensation under any workmen's compensation act, on account of personal injury or sickness (in a case involving physical injury or physical sickness)—

(1) if the assignee assumes such liability from a person who is a party to the suit or agreement, or the workmen's compensation claim, and

(2) if—

(A) such periodic payments are fixed and determinable as to amount and time of payment,

(B) such periodic payments cannot be accelerated, deferred, increased, or decreased by the recipient of such payments,

(C) the assignee's obligation on account of the personal injuries or sickness is no greater than the obligation of the person who assigned the liability, and

(D) such periodic payments are excludable from the gross income of the recipient under paragraph (1) or (2) of section 104 (a).

The determination for purposes of this chapter of when the recipient is treated as having received any payment with respect to which there has been a qualified assignment shall be made without regard to any provision of such assignment which grants the recipient rights as a creditor greater than those of a general creditor.

(d) Qualified funding asset

For purposes of this section, the term "qualified funding asset" means any annuity contract issued by a company licensed to do business as an insurance company under the laws of any State, or any obligation of the United States, if—

(1) such annuity contract or obligation is used by the assignee to fund periodic payments under any qualified assignment,

(2) the periods of the payments under the annuity contract or obligation are reasonably related to the periodic payments under the qualified assignment, and the amount of any such payment under the contract or obligation does not exceed the periodic payment to which it relates,

(3) such annuity contract or obligation is designated by the taxpayer (in such manner as the Secretary shall by regulations prescribe) as being taken into account under this section with respect to such qualified assignment, and

(4) such annuity contract or obligation is purchased by the taxpayer not more than 60 days before the date of the qualified assignment and not later than 60 days after the date of such assignment.

Qualified funding asset

The Internal Revenue Code section above set forth provides that any amount received for agreeing to assume damage liability shall be excluded from gross income if it is used to purchase an annuity contract issued by any State-licensed insurance company or a U.S. obligation to cover the liability. While it is possible to use U.S. obligations as "qualified funding assets," it is not as practical or advantageous as a special annuity. U.S. obligations such as Treasury bonds still require an assignee, and do not pay as well as annuity contracts.