"Destructive" Receipt
If you handle tort claims and have any experience at all with structured settlements, you will recognize the play on words in this month’s newsletter title. It’s a twist on the key tax concept of “constructive receipt” which governs whether a settlement can be structured on a tax-free basis or not.
Getting this issue of “receipt” right is a big deal, bigger than most people suspect. It’s a big deal because it’s the key to whether or not a claimant will owe taxes on decades of future income.
Now, if the claimant blows it by making a bad decision for themselves, then that’s no one’s fault but their own. However, if no one ever told them about this option, or if their attorney mistakenly referred them to someone who purported to sell “tax-free structured settlements” that turn out later to be taxable post-settlement trusts, or if the defendant signed off on a deal without having their own expert examine the document for technical sufficiency, look out. Cases like this have already come to light and are bubbling to the surface with increasing frequency (1), ensnaring all manner of people who thought the cases were ancient history.
For most injured people, the decision to structure or not structure is the biggest tax decision they will ever make and likely one of the biggest financial decisions they will ever make. So, it’s important not to blow it – and it’s important for YOU not to have anything to do with a situation where someone else blows it for them.
As background, the concept of “constructive receipt” is a fundamental principal in tax law that seeks to determine when a person has effectively “received” income for tax purposes, even if they themselves didn’t literally receive the money. The simplest example of this would be an attorney receiving settlement funds into their client funds account but not yet paying it to the client. Although the claimant doesn’t have their hands on the money, the attorney works for them and must deliver the money to the claimant if asked. So…the tax man doesn’t care who’s holding your money, the second it becomes “yours”, that’s receipt in their book.
As mentioned above, competent claimants are legally free to decline a structure and pay taxes if they want to (provided they’ve been fully informed, etc.), but incompetent claimants are another situation entirely. When the claimant is incapacitated by reason of age or injury, now you have a fiduciary in there somewhere and a court that is going to take a keen interest in protecting and preserving that person’s recovery. Is a fiduciary free to waive the claimant’s I.R.C. Section 104 lifetime income tax exclusion? Perhaps…but only under very strict circumstances, carefully weighed and documented.
When you are dealing with a case where settlement proceeds must provide for the care of an impaired individual for the remainder of their days, then matters take a much more serious turn. Great care must be taken to protect the benefits of claimants such as these and (as outlined above), it is not only the plaintiff attorney’s and guardian’s job. The courts are keenly interested at settlement time and defendants can be dragged back into a bad outcome down the road.
Serious cases demand serious consideration of all available techniques to secure and maximize the claimant’s future buying power. Many excellent strategies are available through reputable structured settlement professionals, financial planners, and trust officers. There are of course “alternatives” promoted by others that...don’t turn out so well.
The importance of keeping one’s eye keenly focused on what’s best for the claimant is illustrated in a wrongful death case I recently reviewed. In this case, a husband acted as administrator of the estate of his wife, who had died as result of alleged medical malpractice. The husband sought approval of a compromise of the wrongful death action brought individually by him and on behalf of their children.
The Court had been advised that the father had a plan and had crafted it with several financial goals in mind. First, he sought to prevent the dissipation of his children's funds by placing the monies into irrevocable trusts until each child reached the age of 35. Second, he wanted to invest the funds in a fashion that would take advantage of potentially rising interest rates. And third, he planned to avoid income taxes by purchasing “tax-free” investments. The father proposed to accomplish these objectives by investing in a laddered portfolio of municipal bonds. (Sound familiar?)
While the Court was sympathetic to the father's objectives and concerns, its primary consideration was the preservation of funds for the use and benefit of the minor children when they reached majority; the desire to “reach” for higher returns was of secondary importance. The actual plan proposed by the father raised as many questions as it answered (For example: what’s the current rate? What happens if rates stay the same? What happens if rates go down?) and it offered no guaranteed payments of any kind. No guarantee of principle or interest payments and the provision regarding who would complete tax returns called into question the true extent of this plan’s “non-taxability”.
By comparison, the court found that a properly prepared structured settlement would provide both, guarantees of principle and interest and guarantees that those benefits would be excluded entirely from gross income as per I.R.C. 104(a)(2). Luckily, this court recognized the dangers of “destructive receipt” and took steps to protect these minors. The father was asked to reconsider and resubmit his plan paying more attention to risk, return, and the tax code.
Our work may seem routine, but what we do affects the quality of life of injured claimants for the rest of their lives. Whether intentional or by omission, permitting “destructive receipt” can wreak economic havoc on people who have enough problems to deal with.
Know a case crying out for preservation of benefits, maximum future buying power, and clean, correct transaction? Call Frank C. Kilcoyne, CSSC at 800-544-5533, I am here to help.
(1)
The infamous Grillo case serves as the largest destructive receipt claim reported to date and the only one with reliable hard dollar figures (improperly leaked to a reporter). However similar cases have been settled subject to confidentiality clauses and more are coming down the pike.
