Constructive Receipt
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Sometimes your clients surprise you. Speaking recently with a longtime client about last month’s edition I was stunned when he told me straight out that he was fairly sure that most of the attorneys he deals with had little appreciation of the importance of constructive receipt in the settling of tort claims.
Not good. In fact, failing to recognize and guard against inadvertent constructive receipt can be outright dangerous. Constructive receipt is a criterion used by the Internal Revenue Service to determine when income has been received by a taxpayer (whether dividends, interest, settlement proceeds, etc.). Accepting a direct payment would be actual receipt; having payment sent elsewhere but retaining an unencumbered right to claim it is constructive receipt. You may not have the money yet yourself, but if it’s yours to claim, it’s income to you for tax purposes.
In structured settlements, constructive receipt is the “kiss of death”. Once money has been received by the claimant – whether actually or constructively – it triggers their one-time 100% tax exclusion under Internal Revenue Code Section 104 and terminates the opportunity to maximize that tax break over time via a structure.
So why, you may ask, is this such a big deal? It’s not a big deal if the claimant understands what’s at risk and if they have expressly authorized their attorney to receive the funds and thus void the lifetime tax break. If the attorney takes funds into their client trust account without the client having been informed of the consequences they could have a big problem: for tax purposes, constructive receipt is irreversible.
Some may ask, “So what if the claimant does not structure their settlement? They still get their money.” Yes indeed the claimant still gets their money - but a lot less of it. And, in my experience, most claimants want to keep as much of it as possible.
A properly established structured settlement will routinely produce as much as 40 percent greater net income than a cash settlement similarly invested. For example a taxpayer in the 28% federal income tax bracket who invests $ 50,000 at 5% will produce a net annual return of $ 1,800 versus a full $ 2,500 if they do not have to pay any income taxes. Over 20 years the accumulated net return on investment will total $ 36,000 versus a tax free $ 50,000 - a 39% decrease. This simple example contemplates federal income taxes only. Add state and local income taxes to the equation and things get even uglier.
Back to the question of claimants not structuring their settlement. It is a fact that, no matter how great the benefit, some claimants simply want cash and there is nothing the attorney can do about it. It’s the client’s money and they can decide for themselves how they want to receive it.
No problem for the attorney – until the client exhausts the funds. Suddenly the amount they “settled” for seems paltry relative to their injuries and their high opinion of their attorney at the time of settlement, has been replaced by a certainty that their attorney did a rotten job. Their calls gradually go unanswered until they call another attorney. Clearly - since the client is unsophisticated and the funds evaporated in two years – this was a case that “should have” been structured. Not only would the structure have helped reduce their dissipation risk, but the tax benefits would have increased the client’s net income substantially. Surely, the Section 104 lifetime income tax break had been discussed with them prior to receipt, right? Uh oh…
Most claimants are unfamiliar with tax rules at settlement and are relying on their attorneys to help them achieve the best possible financial outcome. Although many attorneys may not appreciate the importance of avoiding constructive receipt, they are ethically bound to inform their client of the issue. Rule 1.4(b) of the American Bar Association Model Rules of Professional Conduct states the attorney’s obligation: “A lawyer shall explain a matter to the extent reasonably necessary to permit the client to make informed decisions regarding the representation”. If there are two methods of settlement available and the claimant agrees to compromise the claim knowing about only one method, can it really be said that they made an informed decision?
And this is the window through which a bitter (and now broke) former client can earn a second recovery - not from the original tortfeasor, but from their original attorney. Sadly, such claims are now made and quietly collected on, even earning a clever name: “destructive receipt” claims*.
Cautious attorneys not only inform of the pros and cons of bona fide structured settlements but recommend them to their clients. More importantly, these attorneys document that they so informed their client**.
Why would careful practitioners inform some claimants and not others? In many cases it comes down to routine and added time/hassle. Either they don’t appreciate the risks of not informing clients or they have simply made a business decision to skip the drill and take the risk. Given that the first widely reported destructive receipt case cost the trial attorney and guardian ad litem a collective $4.1 million to settle, that could turn out to be an expensive decision.***
Do you have a claimant who needs informing about their settlement planning options? Call Frank C. Kilcoyne, CSSC at 800-544-5533, I am here to help.
* See “Destructive Receipt”, Henry L. Strong, “The Advocate”, Kentucky Academy of Trial Attorneys, Fall 2006
**Most often through use of a so-called “Grillo Waiver”.
*** See Grillo v. Pettiete et al as reported in Lawyer’s Weekly USA, August 6, 2001
