To meet this need, the structured settlement recipient may involve the sale (or, less commonly, the encumbrance) of all or part of certain future periodic payments for a lump sum.
[2] Growth in the United States was most likely attributable to the favorable federal income tax treatment for such settlements receive as a result of the 1982 amendment of the Internal Revenue Code to add 26 USC § 130.
[3][4] Beginning in the late 1980s, a few small financial institutions started to meet this demand and offer new flexibility for structured settlement payees.
The factoring company receives the entire structured settlement payment, when due from the annuity issuer, takes what is owed to it and "passes through" the balance to the payee.
In the beginning, the factoring industry had some relatively high discount rates due to heavy expenses caused by costly litigation battles and limited access to traditional investors.
One common mistake in calculating the discount rate is to use “elementary school math” where you take the funding/loan amount and divide it by the total price of all the payments being purchased.
The CFPB cautions that individuals should consider all options, including talking to trusted people or to a lawyer or financial counselor, before trading future payments for instant cash.
[10] The CFPB warning follows several high-profile news stories and lawsuits over the alleged abusive business practices by companies that purchase structured settlement payments.
Congress enacted law to provide special tax breaks for payments received by tort victims in structured settlements, and for the companies that funded them.
“Despite the best intentions of plaintiffs, lump sum settlement awards are often quickly dissipated because of excessive spending, poor financial management, or a combination of both.
“By enacting the PPSA, Congress expressed its support of structured settlements, and sought to shield victims and their families from pressures to prematurely dissipate their recoveries.”[14] Congress was willing to afford such tax advantages based on the belief that the loss in income taxes would be more than made up by lower expenditures on public assistance programs for those who suffered significant injuries.
A strict requirement for a structured settlement to qualify for this tax break was that the tort victim was barred from accessing their periodic payments before they came due.
According to Joseph M. Mikrut, “Congress conditioned the favorable rules on a requirement that the periodic payments cannot be accelerated, deferred, increased or decreased by the injured person.
Both the House Ways and Means and Senate Finance Committee Reports stated that the periodic payments as personal injury damages are still excludable from income only if the recipient is not in constructive receipt of or does not have the current economic benefit of the sum required to produce the periodic payments.”[15] “These factoring transactions directly undermine the policy objective underlying the structured settlement tax regime, that of protecting the long term financial needs of injured persons .
“[15] Mikrut was testifying in favor of imposing a punitive tax on factoring companies that engaged in pursuit of structured settlement payments.
Many annuity issuers were concerned that factoring transactions, which were not contemplated when Congress enacted section 130, might upset the tax treatment of qualified assignments.
In 2001, Congress passed HR 2884 Archived 2008-10-06 at the Wayback Machine, signed into law by the President in 2002 and effective July 1, 2002, codified at Internal Revenue Code § 5891.
Qualified state statutes must make certain baseline findings, including that the transfer is in the best interest of the seller, taking into account the welfare and support of any dependents.
Internal Revenue Code section 130 provides substantial tax incentives to insurance companies that establish “qualified” structured settlements.
Therefore, over time and as recipients’ personal situations change in ways unpredicted at the settlement table, demand for liquidity options rises.
5891 and most state laws require that a court find that a proposed settlement factoring transaction be in the best interest of the seller, taking into account the welfare and support of any dependents.
Some state laws may require that the judge look at factors such as the “purpose of the intended use of the funds,” the payee's mental and physical capacity, and the seller's potential need for future medical treatment.