Actual Receipt vs. Constructive Receipt of Structured Settlements: Which Is Better For Taxes?
For structured settlements, actual vs. constructive receipt is crucial for ensuring the appropriate tax treatment of settlement funds. These concepts help determine when a taxpayer is considered to have received income, impacting how and when the income is taxed. Let's delve into these concepts in a detailed manner.
Actual Receipt
Actual receipt occurs when a taxpayer physically receives the funds or has direct control over them. This means the taxpayer can use the funds at their discretion without any restrictions. In the context of a structured settlement, actual receipt would imply that the claimant has immediate access to the settlement funds and can use them however they see fit. Here are some key points about actual receipt:
Direct Payment: If the settlement amount is paid directly to the claimant in a lump sum, this constitutes actual receipt. The claimant has full control over the funds, and the entire amount is considered income in the year it is received.
Immediate Control: Even if the funds are placed in a trust or another account, if the claimant can access them immediately and without significant restrictions, it is treated as actual receipt.
Tax Implications: Income received through actual receipt is typically subject to taxation in the year it is received. For structured settlements, this could result in a significant tax burden if a large lump sum is received all at once.
Constructive Receipt
Constructive receipt is a more nuanced concept. It occurs when funds are made available to the taxpayer without substantial limitations or restrictions, even if the taxpayer hasn't physically received them yet. Essentially, if the taxpayer has control over the funds or the ability to use them, they are considered to have constructively received the income. Key points about constructive receipt include:
Availability of Funds: Constructive receipt occurs when the funds are made available to the taxpayer, and they could access them if they chose to. For example, if the funds are deposited into an account and the taxpayer has the right to withdraw them at any time, this constitutes constructive receipt.
Restrictions on Access: To avoid constructive receipt, the funds must be subject to substantial limitations or restrictions. For instance, if the taxpayer cannot access the funds until a certain future date or event, or if access to the funds requires fulfilling specific conditions, constructive receipt does not apply.
Tax Implications: Like actual receipt, constructive receipt generally results in the income being taxed in the year it becomes available to the taxpayer, regardless of whether they have physically accessed the funds.
Avoiding Actual and Constructive Receipt in Structured Settlements
To ensure that structured settlement payments remain tax-exempt under the Internal Revenue Code Section 104(a)(2), it is essential to avoid both actual and constructive receipt. This involves structuring the settlement in a way that the claimant does not have control over the lump sum used to fund the annuity. Here's how:
Purchase of an Annuity: The defendant (or their insurer) typically purchases an annuity from a life insurance company. The annuity is owned by the insurance company, not the claimant. The claimant receives periodic payments as specified in the settlement agreement.
No Control Over Funds: The claimant must not have any control over the annuity funds. They cannot direct the investment of the funds, choose the annuity provider, or alter the payment schedule. This ensures that the funds are not considered constructively received.
Fixed Payment Schedule: The payment schedule should be fixed and agreed upon in the settlement terms. The claimant should not have the ability to accelerate, defer, increase, or decrease the payments. This prevents any claim of constructive receipt.
Irrevocable Agreement: The structured settlement agreement must be irrevocable. Once the terms are set, they cannot be changed by the claimant. This reinforces the lack of control over the funds.
Qualified Assignment: To further ensure tax-exempt status, the structured settlement may involve a qualified assignment. Under a qualified assignment, the defendant transfers the obligation to make the periodic payments to a third-party assignee (usually the annuity issuer). This transfer must comply with specific requirements under the Internal Revenue Code to maintain tax advantages.
Practical Example
Consider a personal injury case where a claimant is awarded $500,000. Instead of receiving this amount as a lump sum, the settlement is structured as follows:
The defendant purchases an annuity from a reputable insurance company for $500,000.
The annuity is set to make monthly payments of $2,000 to the claimant for 20 years.
The claimant has no control over the annuity and cannot alter the payment schedule.
The agreement is irrevocable and specifies that the annuity payments will continue even if the claimant dies, with the remaining payments going to a designated beneficiary.
In this example, the claimant avoids actual and constructive receipt, ensuring that the periodic payments are tax-exempt. The structured settlement provides financial security and tax advantages, making it a beneficial arrangement for the claimant.
Conclusion
Understanding and navigating the concepts of actual and constructive receipt are vital for effectively managing structured settlements. By ensuring that the claimant does not have direct or indirect control over the settlement funds, the structured settlement can maintain its tax-exempt status and provide long-term financial stability. Structured settlements offer a reliable way to meet future financial needs while minimizing the tax burden, making them an attractive option for many claimants.