When the parties in a personal injury action reach a settlement, they commonly fund at least a portion of the plaintiff's settlement with a qualified annuity. If properly structured, these annuities take advantage of certain provisions in the tax code to provide a tax-free income stream to the plaintiff for a set period of time. Unfortunately for the plaintiffs in these actions, the same portion of the tax code that provides these preferential tax benefits also places limits on how the annuities may be purchased.
John Campbell, a Colorado Elder Law Answers member, posits that over the past 20 years, a narrow reading of these restrictions by attorneys and financial planners has created a system where the defendant in the action often has complete control over the annuity purchase, to the detriment of the plaintiff. In a presentation at the National Academy of Elder Law Attorneys' 2008 Advanced Elder Law Institute titled The Use of IRC Section 468B Qualified Settlement Funds, IRC Section 130 Qualified Assignments and Special Needs Trusts in Single Plaintiff Physical Injury Settlements, Campbell described a new way of looking at structured settlements that may provide much more flexibility to a plaintiff in a physical injury case.
In response to problems associated with lump-sum payments or periodic payments by defendants, the IRS changed the tax code to make it possible to pay for settlements through the use of qualified annuities which would provide the plaintiff with a tax-free income source and would allow defendants to move on.
The mechanics of this new system involved several amendments to the code. Campbell described how the Periodic Payment Act of 1982 amended Section 104(a)(2), which extended tax exempt status to periodic payments as well as lump sum, and added Section 130, which created qualified assignment that must be funded with a qualified funding asset. These new instruments became the backbone of the structured settlement industry.
In order for plaintiffs to receive the income tax benefits from a qualified assignment they must follow the rules set out in Section 130, meaning that, more often than not, defendants are responsible for purchasing the annuity.
Because of the problems and potential conflicts associated with having a defendant purchase the plaintiff's future income stream, plaintiffs in large class actions began to use Designated Settlement Funds (DSFs), authorized in IRC Section 468B, to hold settlement awards in escrow. DSFs allow a defendant to settle a lawsuit without having to purchase multiple annuities for all of the plaintiffs and also allow the fund to make the annuity purchases that comply with the rules in Section 130. While DSFs are traditionally used in multi-plaintiff suits, Campbell insisted that "there is no language in that statute that limits it to that. As a matter of fact, if you look at the statute, you will see language that indicates that it can be used for both multiple and single plaintiff actions."
After DSFs were authorized, the IRS eventually created regulations governing their use. These regulations, found at 26 C.F.R. 1.468B-1, created the Qualified Settlement Fund (QSF). Campbell said that "it is pretty clear, when you read all of the definitions, that a qualified settlement fund is intended to meet the statutory definition of a designated settlement fund".
Once a QSF is created and funded, it can then make a qualified assignment and purchase an annuity for the plaintiff. This removes the defendant from the process of purchasing the annuity and allows the plaintiff flexibility he may not otherwise have.
The periodic payments in a qualified assignment must be funded with a qualified funding asset, which is either a government bond or a commercial annuity issued by a private life insurance company. Campbell explained that the annuity "needs to be purchased with the settlement proceeds within 60 days of the qualified assignment, either before or after. This . . . can cause serious problems if you are trying to do Medicaid or SSI planning in connection with the settlement."
Campbell then discussed why he believes a QSF can be used to make a qualified assignment for a single plaintiff, not just for a multi-plaintiff lawsuit. Opponents of his idea point to the economic benefit doctrine, and saying that once the QSF is funded a plaintiff has a vested economic interest in the fund's assets, making it subject to income tax. But Campbell argues that Section 130 overrules the economic benefit doctrine and favors the use of QSF's to accomplish qualified assignments.
As for the "nuts and bolts" of actually using a QSF in this situation, first an attorney petitions the court to create the QSF trust and appoint an independent trustee. The petition must allow the court to continue to monitor the trust throughout its existence. Then the parties enter into a novation and the QSF assumes the defendant's full liability.
The court can then substitute the QSF as a party, removing the defendant. The trustee of the QSF now enters into a settlement with the plaintiff that is approved by the court and can purchase the annuity, which will pay out into a new supplemental needs trust established to hold the proceeds and protect them from SSI and Medicaid estate recovery.
Campbell emphasized that the lump sum that sits in the QSF before the qualified assignment takes place does not compromise SSI or Medicaid eligibility because "the QSF has that prohibition in it that says 'we can't do any money out except to purchase the qualified assignment. You are also going to see in those trusts provisions that are very clear that the plaintiff has no authority to compel distributions and may not exercise incidence of ownership over the assets while they are in the trust."
Campbell cautioned that planners should take into account all of the necessary state trust rules and SSI and Medicaid restrictions when drafting the supplemental needs trust to receive annuity payments. Some of these rules include structuring the payments so that the annuity can only pay into a trust before the beneficiary turns 65 and making sure the trust is not authorized to make prohibited purchases, like funeral expenses for the beneficiary. Campbell highlighted SSI's rule regarding the authority to act in regards to the beneficiary's assets, saying that "if you've got an adult plaintiff who is not incapacitated or incompetent and does not have a legal guardian, it has to be a court created trust" (as opposed to being created by a parent or grandparent).
The Deficit Reduction Act's Medicaid annuity rules also apply to qualified assignments, which creates problems when plaintiffs need an annuity to make large balloon payments for major medical expenditures and equipment purchases. Campbell said he thinks the DRA prohibition against these balloon payments does not apply when using a QSF to purchase an annuity because "the DRA is talking about the purchase of an annuity 'from assets of an annuitant who has applied for Medicaid' . . . the annuity that is used to fund that qualified assignment is not purchased by the plaintiff and second of all, we are not going to make the plaintiff the person who receives the payments under that annuity - we are going to name the special needs trust . . . this means the special needs trust becomes the annuitant."
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