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How
the Victims of Terrorism Tax Relief Act of 2001 Impacts Structured Settlements I. Background A. Enactment - On January 23, 2002, President George W. Bush signed into law the Victims of Terrorism Tax Relief Act of 2001. Enacted in response to the terrorist attacks of September 11, 2001, this legislation includes a section entitled "Treatment of Certain Structured Settlement Payments" which adds new Section 5891 "Structured Settlement Factoring Transactions" to Subtitle E of the Internal Revenue Code. B.
Political Compromise - The enactment of IRC Section 5891 resulted from a
political compromise negotiated by the National Structured Settlement Trade
Association (NSSTA), representing the traditional structured settlement
industry, and the National Association of Settlement Purchasers (NASP),
representing the factoring companies.
Their political compromise also includes agreement to support the Model
State Structured Settlement Protection Act.
Both IRC Section 5891 and the Model State Structured Settlement Protection
Act have received strong support from lobbying organizations representing
disabled individuals, plaintiff attorneys and the insurance industry. II. Summary of IRC Section 5891 A.
Excise Tax - IRC Section 5891(a) imposes a 40-percent excise tax
on any person who acquires structured settlement payment rights in a factoring
transaction. B.
Exception - IRC Section 5891(b)
grants an exception to the excise tax if the transfer is approved in advance in
a qualified order under an applicable State statute by an applicable State
court or responsible administrative authority.
A qualified order must include findings that the transfer: 1. Does not contravene any Federal or State statute or the order of any court or responsible administrative authority; and 2. Is in the best interest of the payee, taking into account the welfare and support of the payee's dependents. C.
Definitions - IRC Section 5891 includes the first definition of "Structured
Settlement" in the Internal Revenue Code. Definitions are provided in sections
5891 (b) and (c) for the following terms: 1. Approved Transaction 2. Qualified Order 3. Applicable State Statute 4. Applicable State Court 5. Structured Settlement 6. Structured Settlement Payment Rights 7. Structured Settlement Factoring Transaction 8. Factoring Discount 9. Responsible Administrative Authority 10. State D.
Structured Settlement Taxation - IRC section 5891 (d) (1)
confirms that a structured settlement factoring transaction does not affect the
application of IRC sections 72, 104(a) (1) and (2), 130 and 461(h) provided the
requirements for those sections were satisfied when the structured settlement
was consummated. In the event of a
structured settlement factoring transaction, section 5891 (d)(2) exempts the
person making the periodic payments from withholding tax on those payments. E. Effective Dates – 1. Structured Settlement Taxation - Section 5891 (d) (1), which clarifies the application of IRC sections 72, 104(a) (1) and (2), 130 and 461(h), applies to all structured settlement factoring transactions regardless of when the factoring transactions occur. 2. Other Amendments - The other amendments in IRC section 5891 were effective February 22, 2002. 3. Transition Rule - A transition rule applies to certain structured settlement factoring transactions completed without a qualified order between February 22, 2002 and July 1, 2002 provided two conditions are met. First, the structured settlement payee must be domiciled in a state that has not enacted an applicable state statute. Second, the person acquiring the structured settlement payment rights must make specific disclosures in advance to the structured settlement payee. III. Analysis of IRC Section 5891 A. Claimants 1. Transfer Rules - Claimants and their attorneys now have definitions, procedures, guidelines and some protection under the Internal Revenue Code to help them transfer structured settlement payment rights for consideration following settlement. 2. Previous Transfers - Claimants who have previously transferred structured settlement payment rights now have some tax clarification and assurance. 3. Prospective Transfers - Claimants currently possessing structured settlement payment rights have received guidance on how, and under what circumstances, they can transfer those payment rights. 4. Future Structured Settlements - Claimants in future structured settlements should: a) consider whether and how best to facilitate future transfers of structured settlement payment rights; b) reevaluate existing structured settlement products to achieve sound financial and insurance plans; c) reevaluate structured settlement documentation provisions such as anti-assignment and applicable state law clauses. B.
Annuity Owners and Issuers - Structured settlement annuity owners and
issuers, as well as state judges, can expect increased applications for
approvals of factoring transactions under state protection statutes. C. Structured Settlement Industry 1. Reinforced and Expanded Market - IRC Section 5891 reinforces and expands the structured settlement market. The new market includes structured settlement factoring transactions as well as structured settlements. The structured settlement aftermarket is a legal business. "Structured Settlement" and "Structured Settlement Factoring Transaction" are both defined in the Internal Revenue Code. 2. Product Opportunities - The traditional structured settlement industry has been slow to respond with product improvements and educational selling to address a customer need: greater flexibility to meet unanticipated future costs. IRC Section 5891 creates sufficient tax certainty to permit the design and sale of improved structured settlement products. 3. Negotiations and Sales - All structured settlement participants should consider the implications of permissible assignments under federal and state law. Persons who market structured settlements must learn how to sell a product whose payment rights are assignable under federal and state law. How will the new legislation and product alternatives impact negotiations and settlement documentation? Certain settlement agreement provisions, including anti-assignment and governing law clauses, now require close attention. 4. Pending Litigation - Annuity owners and issuers must reconsider pending litigation of structured settlement assignments. They must also respond to a growing number of applications for approval of transfers under state protection statutes. D. Defendants 1. Existing Structured Settlements – i. Tax Clarification – Defendants (including casualty insurers) who are periodic payment obligors on specific structured settlements, or otherwise qualify as "parties to a settlement" under IRC 5891 (d), have received tax clarification in the event of a factoring transaction. Provided the applicable requirements of IRC sections 72, 104(a)(1) and (2), 130 and 461(h) were satisfied when the structured settlement was consummated, these Internal Revenue Code sections remain applicable. In the event of a structured settlement factoring transaction, payers of the periodic payments are not required to withhold tax. ii. State Court Proceedings - As obligors in specific structured settlements, defendants and casualty insurers also qualify as "interested parties" under the Model State Structured Settlement Protection Act. As such, they are entitled to receive notice to applications and to participate in court proceedings seeking qualified orders for structured settlement factoring transactions. 2. Future
Structured Settlements i. Justification - For future cases, defendants should reconsider their use of structured settlements as well as their products, protocols and documentation. What is the strategic and operational justification for using structured settlements? Why, and under what conditions, should casualty insurers promote or agree to structured settlements? (a) Traditional Justification - The traditional justifications for casualty insurers to promote structured settlements have included saving claim costs and claim time. These traditional justifications are counterintuitive and unsubstantiated. The structured settlement industry lacks meaningful and articulated standards, metrics and best practices. 1) Cost Savings - Structured settlements typically are negotiated on a cash basis. Few plaintiff attorneys permit their clients to accept a structured settlement costing less than the cash alternative. Plaintiff attorneys increasingly are assisted by their own structured settlement consultants who have access to annuity rates. Annuity costs are discussed openly in most structured settlement negotiations. Justifications for cost savings frequently point to settlement costs that are less than preliminary reserve estimates. It is questionable whether such "savings" are attributable to the structured settlement or to good claim practices. 2) Time Savings - - Many structured settlement participants don't track their time. Structured settlements involve additional information, documentation and work processes not required in a lump sum settlement. The time inefficient process of completing structured settlement closing documentation creates a bottleneck for the entire claim management process. (b) Complexity and Risk - Balanced with these "benefits", are the complexity and risks of structured settlements that do not occur with lump sum settlements. Unanticipated liabilities and inefficient work processes result when defendants and casualty insurers fail to understand and properly manage the complexities and risks of their structured settlements. (c) Quid Pro Quo - Defendants, including casualty insurers, purchase 100 percent of all structured settlement funding products. They incur extra costs for structured settlements that increase general claim costs. When issues occur following settlement, including factoring transactions or insolvencies, they are at risk for additional costs. Beyond their concern for claimants' welfare, what quid pro quo do defendants and casualty insurers receive for promoting and agreeing to structured settlements? ii. "In House" Programs - Acknowledging these economics as well as the availability of relevant affiliated resources, many casualty insurers, and some self-insureds, have organized "in house" programs to capture and direct structured settlement claim dollars. These internal structured settlement programs frequently include partnerships with affiliated and/or external brokers and product providers. Internal structured settlement programs increasingly view claimants and their families as potential customers for financial and insurance products and services. The Financial Services Modernization Act has accelerated the development of internal structured settlement programs among casualty insurers. Few, if any, program specific or case specific performance metrics currently exist for structured settlements. iii. Factoring Transactions - Regardless of their strategic and operational perspective, defendants and casualty insurers should now reconsider how factoring transactions impact their structured settlement programs and case management strategies. Should they promote structured settlements? Should they facilitate structured settlement factoring transactions? Should they encourage and promote alternative structured settlement products? How should they respond to claimant demands for expanded structured settlement payment rights? Should they participate with claimants in seeking tax guidance on individual cases? iv. Product Alternatives – Defendants and the traditional structured settlement industry have responded slowly to address an apparent customer need: greater product flexibility to meet unanticipated future costs. IRC Section 5891 should encourage the structured settlement industry to design and sell improved products and to provide improved financial and insurance planning for claimants. Persons who market structured settlements must learn how to sell a product whose payment rights are transferable under federal and state law. How will the new legislation and product alternatives impact negotiations and settlement documentation? E.
Tax Issues - Neither Section 5891 nor the Technical Explanation
of the Legislation prepared by the Joint Committee on Taxation explain how to
grant claimants the right to transfer payment rights in periodic payments that
"cannot be accelerated, deferred, increased, or decreased by the
recipient." What language is required
in structured settlement documentation to both permit transfers and to protect
claimants against constructive receipt and present economic benefit? What types of acceleration clauses, and
other variable features, are now permissible in structured settlements? Until further tax clarification is provided,
parties negotiating structured settlements should proceed cautiously and seek
advice from tax professionals. F. State Legislation 1. Model Protection Statutes – 31 states have adopted structured settlement protection statutes, many based upon the Model State Structured Settlement Protection Act. Additional state structured settlement protection statutes can be anticipated including amendments to existing state statutes that do not comply with the requirements of IRC Section 5891. 2. Revised UCC Article 9 - – Revised UCC Article 9 Sections 9-406(d) as well as 9-408 (a) and (c) include overrides of contractual and statutory restrictions on assignments of payment intangibles. 39 states have enacted amendments to make these overrides inapplicable to structured settlements and workers compensation. 3. Uniform Periodic Payment of Judgments Act – IRC section 5891 also provides rules for recipients of periodic payment judgments who participate in factoring transactions. 37 states have enacted some form of periodic payment of judgment statute. Many of these statutes are poorly drafted. Several have been ruled unconstitutional. The Uniform Periodic Payment of Judgments Act represents a thoughtful legislative model. 4. Workers Compensation - IRC section 5891 interacts with other Internal Revenue Code sections impacting workers compensation including 104(a)(1) and 130. IRC section 5891 will impact, at least indirectly, some compromises of workers compensation cases. Post-award compromising of workers compensation cases is similar, in some respects, to factoring transactions. In both arrangements, claimants are transferring or releasing payment rights for cash or other products. Recipients of workers' compensation awards share many of the same financial and medicals issues as structured settlement recipients. Why shouldn't both categories of claimants have similar rules and procedures for liquidating or refinancing their payment rights? IV.
Conclusions - All parties to personal injury litigation should
reevaluate structured settlements in the context of new legislation including
both the Victims of Terrorism Tax Relief Act of 2001 and the state structured
settlement protection statutes. For claimants, this assessment should continue
to balance multiple considerations, including future financial liquidity, on a
case specific basis. For defendants, this assessment should consider program
strategy, legal risks, metrics, products, protocols, resources, work processes,
customer relationship management and settlement documentation. V. Additional Information A.
Structured Settlements and Periodic Payment Judgments -
A more detailed
analysis of structured settlement factoring transactions as well as the Victims
of Terrorism Tax Relief Act of 2001 will be featured in the next update of
"Structured Settlements and Periodic Payment Judgments" available May 2002 and
published by American Lawyer Media. Originally published in 1986, and updated
twice annually, Structured Settlements and Periodic Payments is the definitive
knowledge resource for the structured settlement industry. B. S2KM Limited - S2KM uses knowledge management to improve performance in the structured settlement industry. For more information, or to order "Structured Settlements and Periodic Payment Judgments", contact S2KM at info@S2KM.com or visit the S2KM website (www.S2KM.com). |