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Taxation Information
The following is general information and should not be considered tax advice. Please consult your own tax professionals. Click Here to Download this info.
Structured settlement payments are typically tax free payments for the original annuitant, per 26 U.S. Code § 104, and carriers do not issue IRS Form 1099. But just because there is no 1099 does not mean that these assigned structured settlement payments (Secondary Market Annuities ) are tax-free. Income received that is in excess of the purchase price is subject to tax for the purchaser of a payment stream.
The income is typically considered ‘ordinary’ and recognized for tax purposes only when it is received, leaving unrealized income to defer, accrue, and compound. The portion of a payment that is reportable as income (and not principal) is ultimately determined by the taxpayer, but below are three methodologies you and your tax advisor may discuss.
Payment Table Methodology:
DCF Exchange obtained guidance from a well-recognized nationwide accounting firm, which we make available to our clients. This guidance states that the income portion of a payment is (1) the amount received minus (2) the price of purchase for that payment. That allows for substantial deferral as early payments have proportionally less taxable income, and later payments have more. This is shown on the Payments Table in the closing book.
The ‘Payments Table’ treats each individual payment in a series of payments as its own discounted cash flow event.
For example, using 100 monthly payments of $1000 starting in 1 month, the first payment will have very little interest and almost all principal. It requires $995.10 today to grow to $1000 in 1 month at a 6% annual rate. Because it only had 1 month to accrue and grow, you only recognize that $4.90 as interest income on that first payment. The second monthly payment will have a little more interest, and so on. By the end, the 100th payment has had 100 months to grow. It requires $615.34 today to grow to $1000 in 100 months at 6%, and therefore the last payment of $1000 has $384.66 of interest.
In sum, the ‘payments table’ is an approach that allows you to defer the recognition of income until later years.
Exclusion Ratio Methodology:
Some purchasers choose to compute taxes based on an “exclusion ratio” applied to the whole payment stream so as to obtain a consistent ratio of income vs. principal across all payments. This ratio is also shown on the Payments Table and while DCF has not obtained tax advice regarding this method, your tax advisors may choose to utilize this approach.
For example, a single lump sum that costs $50,000 and pays out $100K has a 50% exclusion ratio. Half of the payment, when received, would be taxable income. Likewise, 100 monthly payments of $1000 that costs $50,000, also has a 50% exclusion ratio. Half of each monthly payment would be recognized as interest when it is received.
