Integrating a Structured Settlement With a Special Needs Trust Through a Qualified Settlement Fund

1. Integrating a Structured Settlement With a Special Needs TrustThrough a Qualified Settlement Fund Richard B. Risk, Jr., Esq. Academy of Special Needs Planners Seminar, March 6, 2009 Rancho Bernardo Inn and Conference Center San Diego, CA

2. Thoughts On Legitimate Tax Avoidance By Supreme Court Justice Louis D. Brandeis "I live in Alexandria, Virginia. Near the Supreme Court chambers is a toll bridge across the Potomac. When in a rush, I pay the dollar toll and get home early. However, I usually drive a free bridge outside the downtown section of the city, and cross the Potomac on a free bridge. This bridge was placed outside the downtown Washington, D.C. area to serve a useful social service: getting drivers to drive the extra mile to help alleviate congestion during rush hour. If I went over the toll bridge and through the barrier without paying the toll, I would be committing tax evasion. If, however, I drive the extra mile and drive outside the city of Washington, I am using a legitimate, logical and suitable method of tax avoidance, and I am performing a useful social service by doing so. For my tax evasion, I should be punished. For my tax avoidance, I should be commended. The tragedy of life today is that so few people know that the free bridge even exists."

3. SNT+QSF+SS= • Special needs trust preserves Medicaid eligibility and allows settlement dollars to enhance the quality of life • Qualified settlement fund allows for immediate payment of settlement or judgment proceeds by defendant, while preserving all options for the injury victim and other claimants without defense involvement • Structured settlement provides tax-free growth and guaranteed payments

4. What is a Structured Settlement? Type of damages settlement whereby Defendant agrees to make periodic payments to injured Plaintiff over his or her life. Commonly, such settlement consists of an initial lump-sum payment with future periodic payments funded with an annuity. — Black’s Law Dictionary (6th Ed.)

5. What is a Structured Settlement? A settlement in which the defendant agrees to pay periodic sums to the plaintiff for a specified time. — Black’s Law Dictionary (7th Ed.)

6. What is a Structured Settlement? Structured settlements are an innovative method of compensating injury victims. Encouraged by the U.S. Congress since 1982, a structured settlement is a completely voluntary agreement between the injury victim and the defendant. Under a structured settlement, an injury victim doesn't receive compensation for his or her injuries in one lump sum. Rather, he will receive a stream of tax-free payments tailored to meet future medical expenses and basic living needs.A structured settlement may be agreed to privately (for example, in a pre-trial settlement) or it may be required by a court order, which often happens in judgments involving minors. — National Structured Settlements Trade Ass’n

7. What is a Structured Settlement? An arrangement (A) which is established by— (i) suit or agreement for the periodic payment of damages excludable from the gross income of the recipient under section 104(a)(2), or (ii) agreement for the periodic payment of compensation under any workers’ compensation law excludable from the gross income of the recipient under section 104(a)(1), and (B) under which the periodic payments are— (i) of the character described in subparagraphs (A) and (B) of section 130 (c)(2), and (ii) payable by a person who is a party to the suit or agreement or to the workers' compensation claim or by a person who has assumed the liability for such periodic payments under a qualified assignment in accordance with section 130. —26 USC § 5891

8. What is a Structured Settlement? Payments promised to be made by the released party to the releasing party that will not be made all at once. — Dick Risk

9. Transactions Creating Structure • Claim resolved by suit or agreement • Injury or simply an obligation • Taxable or non-taxable • Settlement agreement and release: • Claim converted to an obligation (debt) to make present and/or future payments • Assignment of obligation: • Original obligor is released when future payment liability transferred to third party

10. Code § 104 Code § 104(a) (excerpted) — In General: Except in the case of amounts attributable (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for prior taxable year, gross income does not include: (1) amounts received under workmen’s compensation acts as compensation for personal injuries or sickness; (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness. . . For purposes of paragraph (2), emotional distress shall not be treated as a physical injury or physical sickness. The preceding sentence shall not apply to an amount of damages not in excess of the amount paid for medical care (described in subparagraph (A) or (B) of section 213(d)(1)) attributable to emotional distress.

11. Code § 130 (c) “Qualified assignment” means any assignment of liability of periodic payments as damages or workers’ compensation: (1) If assignee assumes liability from a person who is a party to the suit or agreement; and (2) If: (A) payments fixed and determinable as to time and amount (B) payments cannot be accelerated, deferred, increased or decreased by recipient (C) assignee’s obligation is no greater that assignor’s, and (D) payments are excludable under 104(a)(1) or (2) Recipient may have rights greater than general creditor (d) “Qualified funding asset” means annuity or obligation of U.S. Committee report: No constructive receipt or economic benefit

12. Reasons for Taking Control • Preserving the plaintiff’s damage recovery • Avoiding fraud and other abuses • Protecting privacy of personal financial data and medical history of plaintiff and attorney • Maximizing benefits with available funds • Allowing adequate time for proper planning • Providing immediate release for defendants • Avoiding a malpractice claim by own client

13. QSF Sequence of Events • Phase One: • Establishing QSF • Appoint administrator • Obtain federal tax ID number (EIN) • Settlement between claimants and original defendants • Receive funds from transferors • Phase Two: • Settlement between claimants and QSF • May include periodic payments • Court approval, if required* • Authorization to distribute* • Issue 1099s and file tax returns *Court may authorize distribution in Phase One, subject to settlement agreement, if no duty to protect releasing parties

14. Statutory Requirements toEstablish QSF • Internal Revenue Code (26 USC) § 468B • Treasury Regulations (26 CFR) § 1.468B-1(c) • Established pursuant to order by or approval of governmental authority, subject to continuing jurisdiction • To resolve or satisfy one or more contested or uncontested claims arising from an event or related series of events giving rise to at least one claim asserting liability... • Under CERCLA or arising out of tort, breach of contract, violation of law, or as designated by Commissioner of Internal Revenue, and • Fund, account or trust under state law or its assets are otherwise segregated from other assets of transferor

15. Selecting a Governmental Authority Must be “established pursuant to an order of, or is approved by, the United States, any state (including D.C.), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority.” 26 CFR § 1.468B-1(c)(1)

16. Handling OpposingParty Objections • Defendant or its insurer has no standing to object • Public policy gives privacy to individuals regarding their personal medical and financial status • File petition or motion ex parte in trial court or file in another court • Provide only QSF tax ID number • Make QSF substitute payee

17. Role of the Administrator • Submits to jurisdiction of court or agency • Agent for QSF, which is substitute defendant • Becomes a party to the proceedings • Trustee, if organized as trust • Must exercise independent judgment, even if retained by plaintiff • Acts to “resolve or satisfy” claims using QSF assets • May promise future payments and assign liability • Applies for EIN, sends 1099s and files tax returns

18. Funding Administration Costs • QSF might generate enough earnings to pay • Principal may be used to pay difference • Results in a cost to the beneficiaries • Structured settlement producer may pay all or part • Permitted under ABA Model Rules of Prof. Resp., 1.8(f) • Independent judgment • Client must consent • Plaintiff’s attorney may pay all or part

19. QSF Taxation Issues • Amount transferred is basis, not taxed • Earnings are taxed at highest federal rate (35%) • Earnings also taxed at applicable state rate • Expenses, costs, fees directly offset earnings • Taxation to payee depends on IRC § 104(a)(2) or other exclusion, i.e., return of property • May distribute excess to charity – IRC § 501(c)(3)

20. Constructive Receipt andEconomic Benefit Issues • Constructive receipt may be avoided • Economic benefit is the theory under which the liability insurance industry seeks to prevent a QSF from making section 130 “qualified assignment” when QSF was established for a single claimant • Whether CR or EB attaches does not affect the status of the QSF – just whether section 104(a)(2) damages may be structured and assigned • Defendant gets tax deduction under IRC § 461(h) regardless of whether funds are taxed to claimant or whether periodic payment liability may be assigned

21. Single-Claimant Tax Issues • Economic benefit argument is used most by opponents • Structures specifically “carved out” of economic benefit rule: • 1982 Act codifying Rev. Rul. 79-220 • TAMRA codifying right to security interest • 2001 Act codifying right to sell payments • PLR 9736032, which may not be cited as precedent, per IRC § 6110(k)(3), may be used to indicate how IRS interprets the Internal Revenue Code; see Hanover Bank v. Comm., 369 U.S. 672. 686-87 (1962) • Resources: • Article: “Debunking the QSF Single-Claimant Myth” • Article: “Understanding Constructive Receipt and Economic Benefit” • 23 Va. Tax Rev. 639 (2004)

22. Ethics Issues • QSF administrator self-dealing as structured settlement producer – possible constructive receipt issue • Attorney drafting documents to establish QSF to be filed by plaintiff also serving as QSF administrator • Payment of administrator by structured settlement agent • Undisclosed financial arrangements involving annuity commission • Resource: • SSP Standards of Professional Conduct for Settlement Planners • News Release from SSP on Adoption of Standards, 03-31-08

23. Summary • A QSF is an effective tool in preserving rights of claimants to make choices without the unwanted involvement of the defense • A structured settlement funding a special needs trust has significant advantages in: • Asset management and reduction of administrative costs • Providing significant tax benefits • Preservation of guaranteed annuity payments for other claimants