Law Firm Suggests Replacement of Settlement Provision to Improve Tax Fairness

The attached memorandum suggests a change to the legislative regime governing structured settlements. The change is to repeal section 130 of the Internal Revenue Code of 1986, as amended, and substitute a rollover provision for amounts received in settlement of litigation involving physical personal injuries. That is, plaintiffs would have a limited period following receipt of those amounts within which to purchase an annuity that qualified for the annuity-income exclusion currently available to plaintiffs through section 104(a)(2) and 130. Such a change would increase fairness, equity and simplicity for taxpayers with no revenue effect.

Thank you for your consideration of this suggestion.

I. ENACTMENT OF SECTIONS 104(A)(2) AND 130 RELATING TO STRUCTURED SETTLEMENTS

A. Corporate assignee needed relief.

Sections 104(a)(2) and 130 were enacted at the request of¹ and on behalf a C corporation² that was acting as a delegee³ of the obligation of settling defendants or their insurers to make periodic payments to plaintiffs settling their litigation. As assignee, the corporation would receive the settlement proceeds from a defendant or insurer and use those settlement proceeds to purchase either annuities from life insurance companies or Treasury bonds to fund the periodic-payment obligations assumed by the corporation from the defendant or insurer. In order that the C Corporation not suffer tax on the settlement proceeds received as assignee, the taxpayer needed an exclusion from income for that amount.⁴ Section 130 provides that exclusion.

B. Introduction of the legislation.

Our initial draft of the legislation codifying both the plaintiff's exclusion from income of periodic payments and the assignee's exclusion from gross income was introduced as H.R. 4356, 97^th Cong, 1^st Sess. on July 31, 1981 by Representative Goldwater and entitled the Periodic Payment Settlement Act of 1981. H.R. 4356 was referred to the Committee on Ways and Means. Representative Rousselot was added as a co-sponsor on December 8, 1981. The same proposed legislative text was introduced in the Senate as S. 1934, 97^th Cong. 1^st Sess. on December 10, 1981 by Senator Baucus⁵ and referred to the Committee on Finance. Mr. Baucus made a floor statement that is reproduced in 127 CONG. REC. S15005-06 (daily ed. Dec. 10, 1981) (statement of Sen. Baucus). The identical bill was introduced in the House in the Second Session of the 97^th Congress as H.R. 5470, 97^th Cong., 2d Sess. (February 8, 1982) with the bill number that continued through enactment by Congressman Jacobs, joined by Congressmen Guarini, Duncan and Vander Jagt. Congressman Holland introduced an identical bill one month later as H.R. 5732, 97^th Cong., 2d Sess. on March 4, 1982.

C. Treasury negotiations.

D. House hearing and passage.

The opposition of both Treasury and the ACLI was overcome by changing the legislative language to limit the assignee's exclusion to amounts spent for the aggregate cost of any qualified funding asset. Thus, the exclusion only operates if the assignee buys an asset and then only to the extent of the asset purchase price. That eliminated any possibility of reserve tax accounting by assignees. That change also solved Treasury's second objection, which was that the exclusion might allow the assignee to defer the taxation of the assignment fee. Following the hearing, and at the request of TLC, the drafting was moved to the staff of the Ways and Means Committee and the final legislative text of the H.R. 5470 emerged addressing each of Treasury's concerns.

E. Non-germane Senate amendments, Senate passage and Conference.

Because H.R. 5470 appeared likely to pass and because the 97^th Congress was about to adjourn after its second session, the bill attracted amendments. Indian Tribal Governments sought to be treated as states to issue municipal bonds and receive other benefits, certain payments for foster care were to be excluded from income (section 131(c)) and the pre-emption by ERISA of the Hawaiian Prepaid Health Care Act was limited. The Indian Tribal Government amendment was vastly more complex than the changes to section 104(a)(2) and 130 and attracted objections in Florida. Nevertheless, the Revenue loss for H.R. 5470 as amended was still less than $5,000,000.00.

H.R. 5470 and its amendments were referred to the Senate Committee on Finance on September 23, 1982. The Committee on Finance made those three amendments to H.R. 5470 and reported the bill to the full Senate. The Finance Committee report was submitted on October 1, 1982. The Report adds some minor language to the House-passed version of the legislative history. Under the Senate report, the annuity that serves as a funding asset must be issued by a life insurance company licensed under the laws of any state. In addition the funding-asset yield must not exceed the periodic payments, as follows:

F. Back to the House, Conference and enactment.

Congress adjourned but the House passed the Senate version on December 13, 1982 in a lame duck session with amendments to the Senate version relating to the foster-care change and other provision not including the structured-settlement portions of H.R. 5470. The Senate asked for a Conference on December 16, 1982. The Conferees acted favorably on December 21, 1982 and issued their Conference Report on December 21, 1982. The Conference Committee followed the House bill. Of course, the House had passed H.R. 5470 twice . . . once after referral from the committee on Ways and Means, and again after the Senate amendments preceding the Conference. The conference version is the second House version, as amended by the Senate. President Reagan signed the bill on January 14, 1983 on the last day of the pocket veto period, enrolled as P.L. 97-473, 96 Stat. 2605 (1983), without a name, although the law is often erroneously referred to as The Periodic Payment Settlement Act of 1982, or something similar.

II. POST-ENACTMENT AMENDMENTS TO SECTION 130

1. The physical-injury change.

Three years later, in a conforming amendment to reflect the limitation of the exclusion of section 104(a)(2) to physical personal injuries, section 130(c) was amended by section 1002(a) of P.L. 99-514, effective after 1986, to limit a qualified assignment to a case involving physical injury or sickness.

2. The secured-creditor amendment.

As the codification of structured settlements expanded their use, some insurance agents felt that permitting the plaintiff to become a secured creditor of the assignee would expand their sales. That is, the plaintiff should be able to foreclose on the annuity or Treasury bond in the event that an assignee defaulted. That amendment was made in 1988 by section 6079(b)(1)(A) and (B) of P.L. 100-647.

3. The workers-compensation amendment.

In 1997, P.L. No. 105-34 (Taxpayer Relief Act of 1997) amended section 130 to permit a worker's compensation liability to be assigned in a qualified assignment. The House Report explained the need for increase economic security for worker's compensation claimants, as follows:

A. The exclusion.

The exclusion language of section 130 is straightforward, containing only two defined terms, i.e., "qualified assignment" and "qualified funding asset," as follows:

Worth noting is that exclusion of section 130 exists because the client that sought the legislation was a C corporation not affiliated with a life insurer. Today, the vast majority of assignees are affiliates of a life insurer filing a consolidated return. Because those life insurers cannot own the annuities that they issue, an affiliated assignee is necessary to own the annuity. To some extent those assignees operate in low premium-tax jurisdictions, providing an additional advantage to plaintiffs. Section 130, however, adds considerable complexity to a structured settlement transaction. Some thought should be given to a statutory change that would permit the plaintiff buy an annuity with the proceeds of a settlement in much the same way that an individual retirement account withdrawal is rolled over.

B. The "qualified assignment" definition.

The qualified assignment definition contains six elements, three of which are unchanged from our draft legislation introduced in the House. Three of those were designed to satisfy prior private and published rulings focused on the constructive-receipt and economic-benefit doctrines. Those were (i) that the periodic payments could not be accelerated, deferred, increased or decreased by the plaintiff, (ii) that the assignee did not provide to the plaintiff rights greater than those of a general creditor (repealed by the secured-creditor amendment), and (iii) that the assignee did not have an obligation greater than that of the assignor. Several issues have emerged in practice from other elements of the definition.

First, the qualified assignment requires "any assignment of a liability." In practice, many defendants or their insurers try to skirt the requirement of a liability. That is, some defendants or property-casualty insurers seek to collapse the creation of the liability with the assignment of the liability to the assignee. Such a collapse is to be avoided if the definition is to be met. The defendant's or assignee's liability should exist and not be an integrated part of the transfer of liability. Nor should the transfer be required since such a requirement could be used to argue that the liability never existed. See Cabot v. U.S., 220 F. Supp. 261, 265 (D. Ma. 1963) aff'd per curiam, 326 F. 2d 753 (1^st Cir. 1964) ("one series of integrated steps all integrated in one document and accomplished without a discernible interval of time separating those steps for even a scintilla juris" found to be a single reorganization).

Second, there are many simple but nettlesome product-tax issues with the exclusion. Is the injury physical? Are taxable damages or interest being paid? Traditionally the ability to unwind the assignment is the remedy insisted upon by life companies to deal with those issues. What is needed is more guidance from the Service on the physical-non-physical distinction beyond the "observable harms (bruises, cuts, etc.)" position in Priv. Let. Rul. 200041022 (July 17, 2000).

Third, the requirement that the assignment is from a party to the suit or its insurer has been extended to qualified settlement funds,¹⁴ but funds cannot hold workmen's compensation liabilities on a qualified basis. There is significant case history behind section 468B justifying that limitation from the Service's view, so a change to section 468B to permit workmen's compensation claims is not likely but would increase consistency across those settlement tools. The Special Master of the September 11^th Victims Compensation Fund of 2001 was also treated as a party to the settlement.¹⁵

Fourth, the fixed-and-determinable requirement for a qualified assignment has been stretched to include the use of variable amounts using the Standard & Poor's 500 Stock Index and/or a mutual fund portfolio up to 50% of the total annuity benefits.¹⁶ To stretch the concept further risks running afoul of the benefits-and-burdens test of ownership of the annuity. That is, if only the plaintiff will benefit from appreciation and suffer from depreciation, perhaps the plaintiff is the owner of the funding asset should be taxed to its income.

Fifth, the definition requires that the payments be excludable from the gross income of the recipient. Assignees designate plaintiffs to receive payments from the funding asset. If the plaintiff is the recipient, then this requirement seems to be met. But the assignee is the recipient because the payment is discharging the obligation of the assignee to make the periodic payment. This is a straightforward application of the Old Colony Trust¹⁷ doctrine. That doctrine includes in a taxpayer's income any payments made to third parties that discharge the taxpayer's obligation. Moreover, plaintiffs designate attorneys to whom plaintiffs owe money (except possibly in Michigan and Alabama)¹⁸ to receive periodic payments directly. Those too are payments received by the assignee under Old Colony Trust. That treatment is recognized in the Committee Reports, as follows:

The limitation to annuities and Treasury bonds seems to be working well. A term-certain annuity that is 90% reinsured is a QFA notwithstanding that (i) the affiliated reinsurer guarantees the obligations of the ceding company and of the non-insurance affiliated assignee that buys the annuity and (ii) another affiliate guarantees the obligation of the assignee.²⁰ Commutation of the annuity upon the death of the plaintiff during the period of period-certain payments is permitted for a qualified funding asset.²¹

D. The secured-creditor provision.²²

The benefit to a plaintiff of a security interest in the qualified funding asset proved to be illusory in practice for two reasons. First, all but one assignee currently doing business are holding solely annuities issued by affiliates of the assignee. Those assignees have virtually no debt in order to participate in the structured-settlement market. Thus, if that assignee defaults, then the affiliated annuity issuer is defaulting. The plaintiff is in the same position holding the post-foreclosure annuity as the plaintiff was in holding the pre-foreclosure promise of the assignee, although the post-foreclosure plaintiff is now a policyholder with a second-level priority in the federal insolvency proceeding (after administrative expenses). For example, in In Re Monarch Capital Corp., 130 B.R. 368 (D. Ma. 1991) the plaintiff was permitted to have priority in the insolvency of the assignee, over the objection of general-creditor banks. The proper result in that case would have been to give the plaintiff the same general-creditor priority as the banks. On the other hand, when the plaintiff is insolvent and his Trustee directs the annuity issuer to send payments to the estate, the issuer successfully refuses to do so, saying the assignee is the owner of the contract and not the plaintiff. In re Simon v. First Colony Life Insurance Company, 99 B.R. 781 (N.D. Oh. 1989).

Second, in insolvencies of the annuity issuers, state Courts have uniformly treated the general-creditor plaintiffs as policyholders of the defaulting insurers, making foreclosure unnecessary. As violative as that result is of the tax structure and of the documents implementing the tax structure, the sympathy factor seems to overwhelm the application of the law by the federal bankruptcy and state insolvency courts. The Executive Life Insurance Company insolvency also gave the plaintiffs category 5 priority in that state insolvency when, in fact, the plaintiffs were general creditors of the solvent assignee Executive Life of New York.

IV. SECTION 130 NECESSARY?

Most assignees are non-life affiliates of life companies. All satisfy the 5-year rule²³ so that the assignees can be part of a life non-life consolidated group for income tax purposes. Few seem to be engaged in the active conduct of a trade or business, however. Nevertheless, whether consolidated or not, the exclusion of section 130 operates to make the life company's tax treatment of the premium receipt the operative tax rules. Whether the premium is received by the issuer of the funding asset (annuity) from an assignee, a defendant or its insurer, the rules are well established. Discounted life-contingent annuity premium reserves flow from the Annual Statement (Life and Accident and Health) to the tax return pursuant by virtue of Code section 807(c)(1) and non-life, term certain annuities do so pursuant to Code section 807(c)(3).²⁴

Section 130 adds complexity to a structured-settlement transaction. An alternative should be considered to permit a rollover of amounts received in physical-personal-injury settlements into a qualified funding asset that could be owned by the plaintiff, subject to non-alienation rules to preserve the favorable treatment. Some consideration would be needed to a period during the rollover for the determination and payment of liens and Medicare set-asides. Simplifying the qualified-settlement-fund procedures of the regulations that accompany Code section 468B would enhance simplicity and provide a vehicle for the determination and payment of liens and set-asides. For example, funds could become a banking activity without requiring Court supervision.

Two constituencies would have an adverse interest is such simplification. First, Treasury's inside build-up position might be renewed. As long, however, as Congress continues its tax-policy decision reflected in section 104(a)(2), that interest would remain quiescent. Second, insurance agents and, to the extent those agents influence life-company positions, insurance companies, would object to expanding the exclusive distribution channels for settlement annuities that such simplification would create. Simplification is, I suppose, not simple.

² The client corporation was not taxed under Subchapter L.

³ The statute uses the term assignee, when, in fact, the role played by the taxpayer described in section 130 is one of "delegee" in contract law. See American Law Institute, Restatement of the Law, Second (Contracts), 1981, section 318. Note also the usage of the term in section 2-210 of the Uniform Commercial Code. The error is mine.

⁴ For example, if a case settled for $100,000 and the defendant had promised periodic payment costing that amount, then to burden the assignee with any tax upon receipt from the defendant of that sum would make the purchase of the annuity or Treasury bonds impossible in an amount sufficient to fund the obligations assumed.

⁵ Former Rep. Jim Corman arranged this bill introduction and all of the further legislative and administrative efforts. We first dealt with Rep. Corman while he was serving on the Ways and Means Committee. He had arranged a legislative settlement of our firm's litigation over the entitlement of motion-picture negatives to the investment tax credit. When he became available, he agreed to represent this legislation. Without him, none of the events described here would have occurred.

⁶ Priv. Ltr. Rul. 199942001 (Nov. 10, 1998).

⁷Miscellaneous Tax Legislation, Hearings on H.R. 5470 before the Subcomm. On Select Revenue Measures of the House Comm. On Ways and Means, 97^th Cong. (1982) (statement of John Chapoton, Ass. Sec. for Tax Policy, Dept. of the Treasury.

⁸Id. at 14.

⁹Id. at 113.

¹⁰Id. at 14.

¹¹ S. Rep. No. 97-646, 97^th Cong. 2d Sess. At 4 (1982).

¹²Id.

¹³ H.R. Rep. No. 105-220, 105th Cong. 2d Sess. (1997).

¹⁴ Rev. Proc. 93-34, 1993-2 C.B. 470.

¹⁵ Rev. Rul. 2003-115, 2003-2 C.B. 1052.

¹⁶ Priv. Ltr. Rul. 199942001 (Nov. 10, 1998); Priv. Ltr. Rul. 199943002 (Nov. 10, 1998)

¹⁷Old Colony Trust Co. et al. v. Comm'r, 279 U.S. 716, 49 S.Ct. 499, 73 L.Ed. 918 (1929).

¹⁸ In those state, and perhaps others, the client compensates a contingent-fee lawyer by assigning to the lawyer ownership of a percentage of the client's causes of action. Thus, upon settlement, the lawyer's share does not pass through the client's tax return.

¹⁹ H.R. Rep No. 97-832, 97^th Cong. 2d Sess. at 5 (Sept. 16, 1982).

²⁰ Affiliate guarantees of the assignee's obligations do not generally disqualify the annuity as a qualified funding asset, nor do they affect the reserve deduction by the issuer of the qualified funding asset. Priv. Ltr. Rul. 8831021 (May 6, 1988); Priv. Ltr. Rul. 8602016 (Oct. 9, 1985).

²¹ Priv. Ltr. Rul. 9812027 (Dec. 18, 1997).

²² The security interest can be perfected by notification, filing and possession. Priv. Ltr. Rul. 9253045 (Oct. 6, 1992); Priv. Ltr. Rul. 9407012 (Nov. 18, 1993); Priv. Ltr. Rul. 9437028 (June 17, 1994); Priv. Ltr. Rul. 9605003 (Oct. 30, 1995); Priv. Ltr. Rul. 9942001 (Nov. 10, 1998). Note that those ruling were issued before the Uniform Commercial Code addressed those annuity policies as general intangibles.

²³ Code section 1504(c).

²⁴ See Priv. Ltr. Ruls. 8831021, note 20 supra.