There are plenty of reasons that employees may bring a lawsuit to their employers – discrimination, sexual harassment, and wrongful termination, to name a few. When an employee wins his or her case, there are financial planning options that can help ensure the compensation received is as beneficial as possible. One important choice to make is whether to receive the money in a lump sum all at once or to instead break it up into smaller, guaranteed future payments over time with tax benefits.
The latter is typically known as a structured settlement, a term that sometimes gets a bad rap. But setting up periodic payments is not a one-size-fits-all approach, and it can have major tax benefits for the plaintiff.
Why do many employment cases settle?
Very few employment cases go to trial, and of the ones that do, only one percent eventually succeed in court. On the other hand, of the cases that settle, employees prevail about 87 percent of the time. Besides having the statistics in their favor, employees have other advantages of settling, mostly related to speed. By avoiding a long trial, plaintiffs will likely see their case conclude much faster, helping them to receive their financial recovery and move on sooner.
No matter the path to recovery, it’s critical for plaintiffs to have the right information about their planning options before settlement arrives. It’s easy to overlook or skip this step and go straight to receiving compensation from an employment litigation case; however, taking the time to plan will ensure that the plaintiff is not only prepared for the future income, but that he or she will receive it in a way that has the most positive impact possible.
Planning for taxes and finances
A structured settlement allows a plaintiff to defer some, or all, of their settlement funds. By establishing a structured settlement, he or she can create a predetermined schedule of future payments.
One popular option is to take part of the settlement as cash to cover immediate expenses and then the remainder in a series of tax-free payments to meet future needs. The setup is custom-tailored to the needs of the plaintiff and his or her family. Additionally, the plaintiff is responsible for paying taxes only on the structured settlement payments that he or she received that year – rather than the whole lump sum at once.
The structured settlement process was first established in 1982 when a bipartisan coalition of legislators in Congress came together to pass laws that amended the federal tax code. The Periodic Payment Settlement Act of 1982 (Public Law 97-473) formally recognized and encouraged the use of structured settlements for personal injury and wrongful death cases. Then in 2008, IRS Private Letter Ruling 200836019 ruled in favor of the use of structured settlements in non-qualified cases (meaning those recovering damages that are taxable) for recoveries from employment cases.
Following the Private Letter Ruling in 2008, the IRS Office of Chief Counsel issued a memo to help taxpayers understand how the IRS may determine the tax treatment of employment case settlement payments. It outlines a four-step process to determine the correct treatment of employment-related settlement payments. This process looks at whether the settlement from a claim is includable in gross income, whether it is considered wages for purposes of employment taxes, how it should be reported, attorney fees, and more.
A modern planning option
When structuring is the right option, settlements are typically placed into an annuity to provide the claimant with agreed-upon payments over years and about four to five percent growth. However, there is typically less growth on traditional structured settlement annuities than there used to be. Still, the security and tax implications of structuring are extremely valuable to many plaintiffs who receive a settlement. An investment-backed structure is a modern option that allows a plaintiff to get tax-deferred periodic payments with the potential for higher rates of return.
With a diverse investment plan, clients can grow their funds for years, reaping the benefits of both their settlement monies and the tax-free growth of the investment.
There is more risk associated with an investment-backed periodic payment obligation, but there is also more reward, making it a particularly viable option for younger clients who have discretionary settlement dollars and/or are afforded the time to take more of a risk.