IRS Makes Structured Settlements More Secure

In recent years, structured settlements have been an attractive method by which to settle large civil damage suits. Certain recent changes in the tax laws, however, appear to make these structures even more secure (and thus more attractive) than before. Specifically, the amendments to Section 130 of the Internal Revenue Code (effective November 10, 1988) now seem to give a plaintiff the right to obtain a security interest in an annuity used to fund a structure, thereby offering the plaintiff even greater protection in the event the company responsible for his periodic payments becomes unable to pay.

In order to appreciate the significance of this change in the law, one must first understand how a typical structured settlement works. In the usual scenario, plaintiff settles his claim with the defendant’s liability carrier in exchange for an agreement to provide certain up-front cash and certain periodic payments in the future. Those future periodic payments represent the “structured” portion of the settlement.

Typically speaking, liability carriers do not want the obligation to make these periodic payments “carried on their books” for many years into the future. Therefore, they will usually assign their obligation to make these periodic payments to an Assignee. This Assignee may be a corporation related to the liability carrier, or it may be an entirely unrelated insurance company. In either event, the Assignee, in order to “fund” its obligation to the plaintiff, most often purchases an annuity from a life insurance company.

In such a situation, to whom is the plaintiff looking to “stand behind” his regular monthly payments, and how secure is the plaintiff’s position? Initially, plaintiff is looking to the Assignee to make those monthly payments since the obligation to do so has been assigned to the Assignee by the defendant’s liability carrier. (Normally, the liability carrier seeks, under the assignment, to be released from all responsibility once an assignment is made. If the plaintiff objects to this he may try to insist that the defendant’s carrier remain secondarily liable to “make good” on the periodic payments.) Thus, the plaintiff’s first concern should be to insure that he has a strong, solvent Assignee, since that is the first entity to which he is looking for the periodic payments. In this regard plaintiff’s counsel often insists that the Assignee have a strong financial rating from one of the recognized insurance company rating services such as A. M. Best and Co.

Recall, however, that in order to “fund” this obligation the Assignee usually purchases an annuity from a life insurance company. In that fashion, the Assignee makes certain that it has the cash on hand each month to make the periodic payment to the plaintiff. (In reality, most structured settlement arrangements provide that as a matter of convenience the life insurance company will mail the monthly annuity payment directly to the plaintiff even though the Assignee is the true owner/beneficiary of the annuity contract.)

If it is the Assignee who is initially responsible to make the monthly payments to the plaintiff (although they may be mailed to the plaintiff by the life insurance company), what happens if the Assignee goes bankrupt or otherwise becomes unable to make the periodic payment? Can the plaintiff look to the life insurance company for payment on the ground that the annuity it sold to the Assignee was really “earmarked” to fund the Assignee’s obligation to the plaintiff? Prior to the 1988 change in Section 130, the answer was clearly “no,” at least to the extent the plaintiff wanted to avoid “constructive receipt” problems and thus risk forfeiting the tax benefits of the structure. Since November 10, 1988 the answer appears to be “yes,” if the plaintiff has taken the appropriate steps to obtain and perfect a security interest in the annuity.

Before the tax change in 1988, the plaintiff was merely a general creditor of the Assignee. (If the plaintiff obtained some status greater than that of a general creditor, he was deemed to be in “constructive receipt” of the future payments, a circumstance which would effectively nullify the “tax free” advantages which are the sine qua non of structured settlements.) Thus, for instance, if the Assignee went bankrupt, the plaintiff “got in line” with all other unsecured creditors who were owed money by the Assignee, and he could not argue that he was in some preferred position because the Assignee had purchased an annuity to fund its obligation to him. Stated in more strict legalese, the plaintiff did not have a “security interest” in the annuity purchased by the Assignee and, therefore, he had no special rights to it.

Now, however, Section 130(c) of the Internal Revenue Code provides that the plaintiff can obtain a security interest in the annuity purchased by the Assignee. If such a security interest exists and the Assignee becomes unable to meet its obligation, then the plaintiff is in the more secure position of being able to look directly to the annuity for his future monthly payments. While Section 130 now makes it clear that a plaintiff may obtain a security interest in an annuity purchased by an Assignee, what is not clear is how the plaintiff may perfect such an interest. (Without perfection there is always the risk that the Assignee may take action which could prejudice the plaintiff. For example, the Assignee could grant a security interest in the annuity to another creditor which creditor does perfect its security interest, thus obtaining a claim to the annuity superior to that of the plaintiff.)

The perfection of security interests is a matter of state law. With regard to security interests in an annuity, the issues and problems that immediately come to one’s mind include the following:

  1. Are security interests in annuities governed by Article 9 of the Uniform Commercial Code?
  2. If so, what does the Code provide with regard to perfection?
  3. If not, what is state common law with regard to such security interests?

Research seems to suggest that, at least in Pennsylvania, a plaintiff can perfect his security interest in an annuity by possession of the contract. While Article 9 appears to exempt from its purview any contract of insurance (13 Pa.C.S. 9104(7)), case law indicates that only life insurance policies are excluded. See Ettinger v. Central Penn National Bank, 2 B.R. 385 (U.S.D.C. E.D.Pa. 1979), reversed on other grounds 634 F.2d 120 (3d Cir. 1980). Thus, it would seem that Article 9 applies to these annuities.

Common sense and commercial custom suggest that the only means of perfecting the security interest in the annuity is for the plaintiff to possess the contract itself. If applicable, Article 9 so provides. Similarly, common law provides for perfection of such security interests by possession.

Having noted all of the above, one might offer the following suggestions to plaintiff’s counsel who wish to obtain a security interest in any annuity purchased by the Assignee to fund its obligation to the plaintiff:

  1. Include in the settlement agreement and/or assignment a statement to the effect that the plaintiff is given a security interest in any annuity purchased by any party to fund its obligation to the plaintiff. With regard to an assignment, the following language might be employed:

“The parties to this assignment agree that plaintiff shall have a first security interest in any qualified funding asset acquired by Assignee to fund the periodic payments required to be made by Assignee, to plaintiff, pursuant to this assignment. Plaintiff’s rights in such qualified funding asset shall be limited to those of a secured party, only. Plaintiff, or his legal representative, shall have the right to possess the qualified funding asset only for purposes consistent with his rights as a secured party therein, including without limitation, perfection of plaintiff’s first security interest in the qualified funding asset.”

“This annuity contract, and the payments provided under it, are not assignable. Delivery to, and possession by, plaintiff, or a legal representative on his behalf, of this annuity contract are solely for purposes consistent with his rights as a secured party herein, including without limitation perfection of plaintiff’s first security interest in this annuity contract.”

In conclusion, the ability to obtain a security interest in the annuity used to fund a structured settlement now makes structures more secure than before, for plaintiffs. The authors wish to note that while the above information appears to be consistent with a literal reading of Section 130 (as well as related statutes and case law), there has been no official ruling by the IRS that a plaintiff holding a perfected security interest in an annuity is not in constructive receipt of the settlement proceeds. However, a request for such a letter ruling is now pending, and representatives for those groups requesting the ruling have stated they fully expect a favorable decision from the IRS.