Statement of John E. Chapoton, Partner, Vinson & Elkins, LLP
on behalf of the National Association of Settlement Purchasers
Testimony Before the Subcommittee on Oversight,
of the House Committee on Ways and Means
Hearing on Tax Treatment of Structured Settlements
March 18, 1999
Mr. Chairman and Members of the Subcommittee:
My name is John E. Chapoton and I appear before you today on behalf of the National Association of Settlement Purchasers (NASP). I am a partner with the law firm of Vinson & Elkins here in Washington. Accompanying me today is Tim Trankina, CEO of Peachtree Settlement Funding, a structured settlement purchasing company located in Atlanta, Georgia.
I was the Assistant Secretary of Treasury for Tax Policy from 1981 to 1984. I served in that capacity at the time the tax provisions under discussion today were enacted. I testified before the Ways and Means Subcommittee on Select Revenue Measures about these provisions, and was actively involved in the development of the legislation.
I want to discuss the tax issues presented by the 1982 legislation and by the proposal before you today. From my reading of the record from 1982, and my memory of that process, I believe there are some misconceptions concerning the original tax issues that need to be clarified. I believe they bear on the task before you.
Background
A structured settlement is a financial arrangement that resolves a personal injury or wrongful death claim with an agreement to make payments over time instead of in one lump sum. This vehicle is often very useful in settling litigation or potential litigation. Structured settlements are used for everything from slip and fall cases to serious, lifelong injuries. They are not, and never have been, limited to catastrophic injuries, however. The perception that structured settlements typically involve lifelong disabilities is simply wrong.
Generally, under a structured settlement the beneficiary or claimant is paid over a period of years in a series of installments with inflexible payment terms. Most typically, the settlement takes the form of monthly payments, periodic lump sums, or a combination of both. It is estimated that in excess of 50,000 structured settlements are arranged each year, generating premiums to annuity companies that may be approaching $10 billion annually. These arrangements are often utilized because of the highly favorable tax treatment granted to both claimants and insurers, and because the arrangement lowers the cost to insurers of compensating personal injury victims.
According to one of the largest brokers of structured settlements, more than fifty percent (50%) of structured settlements involve premiums of less than $50,000. Fewer than thirteen percent (13%) involve settlements of greater than $250,000. Whatever the original conception of structured settlements and the purpose of the tax rules facilitating them, these figures clearly belie any assertion that they are today used principally for catastrophic injuries.
Under the terms of a structured settlement that qualifies for preferable tax treatment, the claimant is prohibited from possessing the right to accelerate, delay, increase or decrease future payments from the structured settlement company. If a claimant's life circumstances change creating a need for additional funds from the settlement, the only way the claimant may gain access to additional funds is to sell a portion, or all, of his or her settlement. This need has given rise to a secondary market where companies will purchase a portion of the individual's settlement for a lump sum payment. That lump sum reflects the discounted present value of the payments being purchased, using discount rates that presently average sixteen to eighteen percent (16%-18%). These discount rates reflect the cost of capital, the inherent risk involved, and a profit for the companies.
The National Association of Settlement Purchasers (NASP) is a non-profit trade association composed of companies that purchase structured settlement and other deferred payment obligations. Formed in July 1996, NASP and its member companies support rational regulation to protect the rights of consumers seeking to sell structured settlement payment rights. NASP has adopted a code of ethics, which includes consumer protection and suitability standards, and has created a fraud alert system. NASP is dedicated to providing claimants and their representatives with an efficient, legal and ethical means by which to obtain liquidity from inflexible structured settlement payments. NASP is actively working in a number of states to pass comprehensive legislation that protects the interests of personal injury victims both at the time of settlement, and subsequently should the individual choose to liquidate a portion of his or her structured settlement payments.
Growth in the Use of Structured Settlements
Historically, personal injury lawsuits were settled with an up-front, lump-sum payment to the claimant in exchange for a release of liability delivered to the defendant. The amount received by the plaintiff was exempt from taxation under Code section 104, which was originally enacted in 1919. Beginning in the 1970s IRS began issuing private rulings which permitted claimants to receive payments in settlement of personal injury claims over time on the same tax-free basis as lump sum settlements. This lead to an effort in the early 1980s to streamline and codify this IRS ruling position. The result was enactment of the Periodic Payment Settlement Act of 1982 (the "1982 Act").
The 1982 Act did two things. First, it codified through amendments to section 104 the IRS ruling position that the full amount of settlements received over time retained their tax-free character when received by claimants. Second, and most importantly today, it enacted a new section 130 which set up favorable tax procedures that allowed defendants and their insurers to assign their liability to structured settlement companies in exchange for the purchase by the structured settlement company of an annuity to fund the liability. Technical rules specified how these assignments of liability had to take place in order to receive the favorable tax benefits.
Typical Structured Settlement Transaction
By definition, structured settlements are agreements entered into to settle actual or potential lawsuits. They may not be used after a jury has rendered a verdict. As a result, they are sometimes (approximately 25 percent of settlements) entered into without the claimant having the benefit of counsel. Often, a broker becomes involved in setting up these arrangements. Those brokers typically receive a four percent (4%) commission, which is the industry standard. A diagram illustrating the flow of funds in a structured settlement is attached.
Structured settlements are useful because they facilitate settlement of lawsuits. They allow defendants and their insurance companies to offer small settlements that look big because they are paid out over time. Most of us are familiar with the various sweepstakes awards that offer $10 million dollar prizes. It is only when you read the fine print that you discover that they are really offering $10 million over 20 years and that the real value, in present dollar terms, is far, far less. Structured settlements are often sold to claimants in the same way.
Unfortunately, many claimants who enter into structured settlement agreements do not receive this information before they settle their claim by agreeing to the long-term payout. Often the settlement is a take it or leave it offer -- settle now or take your chances with litigation, which in crowded court dockets may not take place for years. Faced with this Hobson's choice, many take the settlement. As a result, claimants often discover later that (i) the settlement is really not what they expected, or (ii) after a period of time the settlement no longer fits their needs. The average length of a structured settlement is 20 years. It is impossible for an individual to predict with accuracy what his or her needs will be over the next 20 years.
Inflexibility can be the most significant flaw of structured settlements. When financial needs change, a fixed payment schedule may no longer satisfy those needs. Structured settlement purchasers have stepped in to fill that legitimate consumer need. Settlement purchase companies provide a useful and vital service for individuals to deal with unforeseeable financial situations.
Although the majority of claimants work or have other sources of support, they often need the flexibility to pledge or assign their rights to meet unanticipated needs. Many claimants use the proceeds from payment sales to pay medical and educational expenses, make bill payments or arrange debt consolidation, cope with job loss or take advantage of an unexpected opportunity such as starting or expanding a business, purchase or make improvements to a home, or start or expand a family. Occasionally, sales of a portion of structured settlements are used to pay estate taxes due on the death of the claimant.
Structured Settlement Purchases
The structured settlement purchase market has developed in response to the needs of claimants who find that a fixed schedule of payments no longer meets their needs. They make the choice of altering the arrangement to better address their present circumstances. The attached diagram shows how a typical purchase is structured.
Settlement purchasers buy the right to receive a specified amount of structured settlement payments in exchange for a lump sum of cash. These purchases do not change the responsibilities of the structured settlement companies: the companies continue to make the same payments over the term of the settlement. They merely send their check to a different address. The amount, timing or duration of the payments do not change at all. According to statistics maintained by the NASP, 88 percent of settlement purchases are partial purchases. In such transactions, only a portion of the settlement is sold and the claimant retains the balance of the periodic payments.
Statistics from one of the largest NASP company members indicate that the average purchased payment amount is $20,406, representing a portion of up to seven years worth of payments. NASP statistics also reveal that the average seller of structured settlement payments is 33 years old, employed, and has an annual household income of nearly $25,000. Over 85 percent of structured settlement claimants are not disabled and are gainfully employed. Thirty-four percent of claimants use the money to buy a home, 31 percent to pay off existing debts or pay educational expenses, and 16 percent to open or expand an existing business. A NASP survey showed that 92 percent of claimants are "satisfied" or "very satisfied" with the refinancing they were able to accomplish with the help of the settlement purchasing industry.
Consumer Protection Concerns
NASP companies comply with a code of ethics that includes consumer protection and suitability standards. NASP members do not conduct transactions with minors, incompetents or their guardians except by court order. They do not conduct transactions with individuals dependent on future periodic payments for medical necessity or with those who are unemployed or unemployable who rely on their payments as the sole source of income. They do not buy payments from individuals with catastrophic or head injuries. All member companies encourage or require individuals to consult with their own legal counsel prior to entering into a funding transaction. Prospective sellers are given amply time and opportunity to secure alternative sources of capital or back out of a transaction.
NASP is committed to ensuring that the consumer receives adequate protection. NASP has worked in various states to advance legislation that requires state courts or court-like proceedings to approve settlement purchases. Such statutes would be greatly strengthened if language could be added to identify which beneficiaries are affected, which courts could approve lump-sum payments, and the standards the court would apply. NASP has prepared model legislation addressing these concerns and is working with several state legislatures to encourage enactment of this legislation.
President's Fiscal Year 2000 Budget Proposal and H.R. 263, "The Structured Settlement Protection Act"
President Clinton's fiscal year 2000 budget contains a proposal that would impose an excise tax on any person acquiring a payment stream under a structured settlement arrangement. The amount of the excise tax would be 40 percent of the difference between (1) the amount paid by the acquirer to the injured person and (2) the undiscounted value of the acquired income stream. The excise tax would not be imposed if the acquisition were pursuant to a court order finding that the extraordinary and unanticipated needs of the original recipient of the payment stream render the acquisition desirable.
H.R. 263 (106th Cong., 1st Sess., introduced by Rep. Clay Shaw (R-FL) and others) provides for a 50 percent tax on the amount equal to the excess of (1) the aggregate undiscounted amount of structured settlement payments being acquired, over (2) the total amount actually paid by the acquirer to the seller.
Presumably these proposals are motivated by the valid concern that individuals who own structured settlements not deplete their assets. NASP members also are concerned about protecting the individual claimants. NASP views an informed consumer as the most appropriate way to prevent any abuses that could otherwise occur. Such legitimate concerns should not, however, permanently lock claimants into inflexible financial arrangements that might be completely inconsistent with a financial situation. Full disclosure of all the terms of a contemplated sale transaction, including discount rates, present values, fees and commissions, as well as representation by counsel, would go far to protecting individual claimants. Ironically, these same claimants do not now have the benefit of this full disclosure when they enter into structured settlements.
There is no question that one of the reasons motivating this Committee to adopt the Periodic Payment Settlement Act of 1982 was that structured settlements are useful in protecting people who cannot protect themselves. Although catastrophic injuries were clearly on everyone's mind when the 1982 Act was adopted, the legislation did not limit structured settlements to the catastrophically injured. In what is perhaps a classic example of the law of unintended consequences, the tax and economic benefits of structured settlements are so valuable that they are now used primarily for non-catastrophic cases. There has been a virtual explosion in their use since 1982. Estimates of annuity premiums received by life insurers from third party (non-affiliated) sources in the United States during the twenty year period shows an increase from $.005 billion in 1976 to $4.0 billion in 1996. When transfers to affiliates are included, this number increases to $10 billion. It defies reality to think that more than a small percentage of these represent people who should be locked into these settlements forever.
The policy considerations that support permitting structured settlements of personal injury claims do not justify preventing each and every claimant from selling all or a portion of his or her future payments. The notion that Congress should preclude claimants from revisiting a decision they may have made years before under entirely different circumstances -- after being made aware of all the expenses and other facts, and being properly advised as to the consequences -- cannot be defended. Circumstances change, and Congress should make it easy rather than difficult for these individuals to change their financial arrangements accordingly. The secondary market has quite appropriately evolved to fulfill this need.
The assumption that claimants are incapable of making reasoned financial decisions if provided full information is unsupportable. We offer as evidence the hundreds and thousands of satisfied customers of NASP members, many of whom have written to our companies attesting to their satisfaction. Virtually all of these individuals are competent to handle their own financial affairs and do so in all other contexts. NASP members, working together with claimants and their representatives, including counsel in many cases, provide various payment options to suit the needs of interested sellers, understanding the balance between demands for immediate cash and how much should be "held in reserve" for the future. Their decision is not always the correct one, but that cannot be prevented without taking away the individual's freedom to choose.
Discount Rates
It is often alleged that the discount rates used by structured settlement purchasing companies are too high, and thus financially disadvantaged claimants who sell their rights to a portion of their future payments. That is simply false. At present, the discount rate applied in the overwhelming majority of cases ranges from 16 to 18 percent, no higher than the interest rate charged on credit card balances. In fact, these rates have fallen steadily over the last two years. This reflects the fact that, as the secondary market has grown, more and more competition among settlement purchasing companies has developed. Often, claimants will shop among the companies to maximize the amount of money they receive, thus lowering the discount rate. In addition, one of the factors keeping rates high is the legal impediments raised by opponents of structured settlement purchases. If Congress can further streamline and make clear that sales are permitted under appropriate circumstances, it is a certainty that discount rates will drop substantially. Thus, consumers would be the ultimate beneficiaries from clarification of the tax and other rules that apply when settlements are purchased.
NASP believes that if Congress has concerns about discount rates it should address those concerns in a manner that does not have the effect of raising the cost of the transaction even higher. Imposition of an excise tax would only increase the cost to claimants who chose to engage in a sales transaction. For example, a claimant who desires to sell five years' worth of a settlement (approximately the current average length of payments sold according to NASP statistics) would be forced to sell in excess of eight years' worth in order to receive the same dollar amount if an excise tax became law.
The surest way to increase the amounts provided to the intended beneficiaries is to require adequate consumer protection in all phases of a structured settlement, including the original settlement and the subsequent transfer of payment rights. This would assure that beneficiaries are informed of the values and settlement options at the time of the original settlement so that they would be less likely to enter into settlements that do not meet their needs. Additionally, adequate protection in the form of a "consumer bill of rights" as adopted under the code of ethics by NASP members would help to weed out any unscrupulous refinance companies. Just as in the case of lotteries, consumer protection should include required cooperation between the companies making the settlement payments and any companies involved in transfer of payment rights.
Tax Effects of the Sale of Structured Settlement Payments
Finally let me turn to the Federal income tax issues presented by settlement purchases. Tax issues have been raised by proponents of the legislation before you today. In a nutshell, some assert or at least suggest that there are possible adverse tax consequences if structured settlement payments are sold.
Let me state, in no uncertain terms, that there is no tax issue. The sale of structured settlement payments by a claimant should have no adverse tax consequences to any party.
Section 130, which was enacted as part of the 1982 Act, codified IRS ruling practice dating back to the late 1970s. The IRS rulings permitted the use of structured settlements as a vehicle through which a claimant could receive payments over a period of years rather than in a lump sum without adverse tax consequences to either party, so long as the claimant was not considered to be in constructive receipt of those payments. The language appearing in the IRS rulings was copied into the statute, and the legislative history of section 130 reflects that purpose and intent.
The language in the statute prohibits the payments from being "accelerated, deferred, increased or decreased" by the recipient (claimant). Some have argued that this language bars the sale of structured settlement payments because a sale could be viewed as an acceleration. They argue that this language was intended to lock the claimants into their settlements and prohibit them from selling their payments, presumably because these are individuals who are incapable of making decisions on their own.
That is not what the language of section 130 does or was intended to do. First and foremost, there was no tax policy reason in 1982 (and there is none today) to encourage structured settlements of claims. As the hearing in 1982 makes clear, the tax policy concerns went the other way -- the effect of a structured settlement is to exclude interest income from the taxable income of claimants while granting a full deduction for that same amount to the structured settlement company. In spite of this tax slippage, it was decided (originally by IRS and later by Congress) to adopt tax rules that do not stand in the way of structured settlements.
The principal tax rule that might have impeded structured settlements was the doctrine of constructive receipt. If the claimant was deemed to have constructively received the promised future payments, he or she would owe tax on those sums immediately with no readily available cash to meet that tax obligation. Thus the IRS rulings, and later section 130 of the Code, used language designed to make clear that the terms of any structured settlement avoided constructive receipt when it was created. If constructive receipt was avoided at the outset, it will not reappear.
This language -- the claimant could not have the right to "accelerate, defer, increase, or decrease" the payments -- is the language of the constructive receipt doctrine. It has no meaning for or impact on a subsequent, independent transaction entered into by the claimant to borrow against or sell future payments. The notion that a sale by a claimant, many years after the fact, could cause the structured settlement company to lose its original benefit under section 130 (or could somehow cause constructive receipt to be revisited) is nonsensical. It cannot be a serious assertion under the tax law as it existed in 1982, or as it exists today.
It might be noted, almost parenthetically, that a sale of a stream of settlement payments would solve, not exacerbate, the tax policy issue that concerned Treasury in 1982. Thus the tax system (and Treasury and IRS) should have absolutely no interest in inhibiting sales of settlement payments.
If there is a policy concern about sales of structured settlement payments, therefore, it is solely a consumer protection concern. It is not a tax policy issue.
Consistent with this conclusion, it is interesting to note that the IRS has never raised this as an issue. There is no regulation, ruling, notice, or formal or informal pronouncement which indicates the IRS views the sale of settlement payments as raising tax issues under sections 104 or 130. There is no evidence that the IRS has ever raised this issue in any audit. Only one court case has dealt with this issue. The Third Circuit, in a bankruptcy decision, squarely addressed and rejected the argument that a subsequent assignment would cause a settlement company to retroactively lose the income exclusion provided by Section 130. The court went so far as to dismiss the argument as "novel."
Conclusion
Mr. Chairman, the settlement purchasing companies strongly support and actively seek consumer protection legislation to regulate structured settlements and secondary market transactions. Indeed, member companies have been actively working through NASP at the state level to pass such legislation to protect the interests of personal injury victims at the time of settlement and subsequently should they choose to sell a portion of their settlement. It is interesting to note that the Staff of the Joint Committee on Taxation in discussing the arguments for and against the Administration's proposal states "[a]rguably consumer protection and similar regulation is more properly the role of the States than of the Federal government." NASP would welcome adoption of standards to assure the adequate disclosure of present value, fees, and commissions, both at the time that structured settlements are established and at the time of secondary purchase.
I would be pleased to answer your questions.