Achieving a settlement and then deploying it to meet a plaintiff’s needs has become a confusion of processes and rules. The difficult part should have been defining the elements of loss and the award amounts. Instead, the difficult parts have become the valuation of the Award and its subsequent deployment.

Let’s deal with basics! The recovery of a loss is, in most cases, not a taxable event. If a plaintiff placed a cash recovery with an institution that merely paid that amount back over time, the amounts received by the plaintiff would not be taxable. Only when interest is introduced does the possibility of a taxable event come into play.

Insurers, seeking to match the timing of the loss with payments to claimants and to reduce their costs, came up with periodic payments using annuities as the funding vehicle. Under Code Sec. 130 periodic payments are treated as the pay-out of the loss over time, and, if properly set up, those payments are free of any Federal Tax.

This has shifted focus to the setup of settlement payment (form) over the purpose of the periodic payment (substance).

If the parties are to avail themselves of the provisions of Sec. 130, they must use certain vehicles with numerous restrictions and under specifically defined rules, or the interest income might become taxable. The rationale for these rules seems to be that plaintiff must be prevented from earning more than programmed at the time of settlement, or there might be some gain that the IRS did not tax. In essence the rule seems to be that "if we can’t get ours, you can’t get yours".

That still doesn’t change the basic principle, recovery on the original loss is not a taxable event (Sec. 104). The discounted value is generally employed to provide a value for an Award or settlement, and the individual plaintiff has little or no recourse but to accept the discounting, it seems difficult to view the event as a compromise of a claim. Therefore, the total Award should be available for use independent from the provisions of Sec. 130. There would need to be both a causal and temporal connection between the Award or settlement, and the vehicle used for providing periodic payments to the plaintiff. That could be satisfied by assignment prior to distribution of funds. The plaintiff should then be free to choose annuities as proffered by the brokers and/or trust vehicles that hold investment grade otherwise taxable obligations.

The determination of the amount of the loss would be the undiscounted amount of the Award or settlement. For the most part, it is what a jury votes upon and a Judge confirms, or what the parties agree upon in a settlement. (For validation, there should be a direct correlation between the total Award or future payment amounts under a periodic payment scheme and the net Award or settlement.) That amount would be adjusted for any front-end (lump sum) payments to be made to the plaintiff for any losses.

Whatever the vehicle, It can be argued that, until the full Award is recovered, there can be no taxable event. Under other provisions of the Code, repayment of annuity principal is amortized over the life of the annuity and deducted from the gross payments to produce annual taxable income. The total Award or settlement could be similarly treated with earnings in excess of an amortized portion of the total Award or settlement being taxed. Amortization would be over the period certain that payments were to be made. Earnings in excess of that amount would then be taxable. As an alternative, taxes could be deferred until the total Award was met.

If this concept is accepted, the criteria for choosing the vehicle to use become expected return on invested funds and flexibility in distribution of funds versus guaranteed payment streams. Tax is not involved since it would only apply to amounts in excess of the Award.

As a practical matter, alternate taxable investment grade vehicles (Moody’s aaa, baa etc) yield approximately 2% more than annuities at any given time, and there is no lock-in to a given return or yield.

We have built a model that takes some portion or all of a Net Award and invests it to get Moody’s aaa, baa or mortgage annual yields. Pay-out follows either the Award work-up or some alternative. Provision is made for calculating and paying taxable income in excess of the Award, and costs for administering the fund and preparing annual taxes.

If the period over which payments are to be made exceeds 25 years,

• Payments under the proposal would match those under annuities.
• Administrative costs, taxes and tax preparation costs would be paid.
• Initial pay-in could be reduced by 20% or more, and
• A substantial residual would still remain at the end of the period certain or expected life.

All of that while retaining full pay-out flexibility.