The reason why structured settlements receive tax beneficial treatment is due to the doctrines of constructive receipt and economic benefit. Basically, these doctrines prevent immediate taxation to the plaintiff, but the settlement must be structured carefully. In particular, the settlement must be in place before the plaintiff has the right to receive a lump sum payment (or current economic benefit)—otherwise, the lump sum payment will be taxable immediately, even if the payment were actually delayed until the next year.
Furthermore, it is important that the plaintiff not own the annuity. Normally, the defendant makes a single lump sum payment to a third party assignee (usually a life insurance company) who then becomes obligated to make payments to the plaintiff. The insurance company then purchases or funds an annuity that thereafter funds the plaintiff’s periodic payments. In this way, the plaintiff does not own the annuity.
The plaintiff pays income taxes only on the amount actually distributed to him each year. This is to his benefit because income tax rates are graduated as income rises. Accordingly, by stretching out the payments over time, the highest marginal tax rates are avoided. Potentially, this strategy could save the plaintiff large amounts in income tax. Saying the same thing differently, the federal income tax is a progressive tax system, meaning that as income is received in greater amounts it is also taxed at progressively higher rates. Structured settlements allow plaintiffs to receive a stream of smaller payments over time, so when those payments are actually received they will be taxed at a substantially lower rate than if the payment were a single lump sum.
