The key tax advantage of a structured settlement is that the entire periodic payment stream, both the part that repays the settlement and the part that reflects growth over time, is excluded from federal income tax when the damages are for a physical injury. If you take the same money as a lump sum and invest it yourself, the lump sum is still excluded, but the investment returns are yours and are generally taxable.
Physical injury damages are excluded from income under IRC §104(a)(2), “whether as lump sums or as periodic payments.” A structure keeps the growth inside the excluded damages. A lump sum you invest earns taxable returns. Emotional distress without physical injury, and punitive damages, do not get this exclusion. Selling a structure triggers a 40% tax on the buyer unless a state court approves the sale.
What the tax code actually says
Section 104(a)(2) of the Internal Revenue Code lists what is not gross income. It includes “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.” The words “as periodic payments” are why a structure works: each payment is itself damages, so each payment is excluded in full.
The same section draws two limits. Punitive damages are carved out of the exclusion. And emotional distress “shall not be treated as a physical injury or physical sickness,” so a settlement for emotional distress alone is treated differently from one for a broken leg.
Section 130 deals with the other side of the deal. Most structures work through a “qualified assignment”: the defendant or its insurer hands the obligation to make the payments to an assignment company, which buys an annuity to fund them. Section 130(c) sets conditions for that assignment, including that the payments are “fixed and determinable as to amount and time of payment” and “cannot be accelerated, deferred, increased, or decreased by the recipient.” Those conditions are the reason a structure is rigid: flexibility would break the tax treatment.
Tax comparison: structure vs lump sum
| Component | Structured settlement | Lump sum you invest |
|---|---|---|
| The settlement money itself | Excluded, §104(a)(2) | Excluded, §104(a)(2) |
| Growth over time | Excluded, because it is part of each damages payment | Generally taxable as interest, dividends or gains |
| Punitive damages | Not covered by §104(a)(2) | Not covered by §104(a)(2) |
| Flexibility | Fixed schedule; §130(c) bars changing it | Full control |
| Selling future payments | 40% tax on the buyer unless court approved, §5891 | Not applicable |
A worked illustration
The figures below are an illustration, not a quote or a prediction, and they ignore fees and inflation. Suppose a settlement for a physical injury is worth $400,000 today.
| Step | Lump sum you invest | Structured settlement |
|---|---|---|
| Money received | $400,000 up front, excluded | Scheduled payments, each excluded |
| Year one growth at an assumed 4% | $16,000 of investment income, generally taxable | Growth is priced into the payments and stays excluded |
| What you report | The $16,000 of income on your return | No income from the scheduled damages payments |
| Control | Spend or invest as you choose | Payments cannot be accelerated or increased |
The longer the payments run and the larger the amount, the bigger the difference, because the investment income that a lump sum would earn keeps building up year after year. The trade off is control: a structure cannot be sped up if you need money for a house or a medical emergency, and changing your mind later means selling the payments at a discount.
Selling payments later: section 5891
Companies that buy structured settlement payments pay less than the payments are worth; the difference is the factoring discount. Section 5891(a) imposes on the buyer “a tax equal to 40 percent of the factoring discount” unless the transfer “is approved in advance in a qualified order.” A qualified order must find that the transfer does not break any federal or state law or court order and “is in the best interest of the payee, taking into account the welfare and support of the payee’s dependents.”
Where state law comes in
The qualified order has to be issued under an “applicable State statute” by a state court. Section 5891 defines that as a statute of the state where the payee lives or, if that state has none, the state where a party to the structure or the company issuing the annuity is based. That is why a sale of structured settlement payments goes before a state court judge, who applies that state’s own transfer rules as well as the federal best interest test. Our state guides cover the injury rules that come before any settlement.
Frequently asked questions
Are structured settlement payments taxable?
Why is investing a lump sum taxed differently?
What if my settlement is for emotional distress only?
What happens if I sell my structured settlement payments?
Sources
- 26 U.S.C. §104, compensation for injuries or sickness (Cornell LII)
- 26 U.S.C. §130, certain personal injury liability assignments (Cornell LII)
- 26 U.S.C. §5891, structured settlement factoring transactions (Cornell LII)