First used in the 1960s to settle a rash of cases resulting from the drug thalidomide, structured settlements became more common after 1982. That’s when the federal government formally recognized and encouraged their use in personal injury cases by passing legislation that made periodic payments, and any investment earnings from the underlying annuity, tax-free.
Structured settlements are commonly associated with the payment of personal injury damages because of their advantageous tax-free treatment, but some business purchases and buyouts can also benefit from structured settlements using annuity payments from an insurance company.
While payments from these non-personal injury cases are not tax-exempt, the recipient only owes taxes on the amount of money received each year.
To illustrate when structured settlements might work, suppose a buyer of a private business is unable to obtain financing from a bank. One option to finance the deal is an installment sale where the buyer puts up a percentage of the purchase price and the seller receives a promissory note for the balance. Payments are to be made monthly or quarterly.
The seller may be concerned about default. Although the loan is secured by company stock or assets and involves a personal guarantee, the seller must ultimately rely on the buyer’s ability to make the payments.
Another less risky option may be a structured settlement. Here, the buyer purchases an annuity from an insurance company, which makes monthly payments to the seller. The transaction reduces the seller’s risk of not getting paid because the payments are secured by the annuity. Plus, the tax consequences are likely to be more favorable than a 100 percent cash sale.
However, this technique only works if the buyer has the cash to purchase the annuity.
Another factor to consider in deciding whether to choose a structured settlement over a lump sum distribution is that a structured settlement — by it’s terms — only gives the recipient a right to receive money in accordance with the schedule set out in the settlement document. It doesn’t give the recipient or the payer any ownership interest in the funding asset, thus preventing creditors of either party from levying upon the structured settlement funds.
Time Value of Money
Cost savings can also make the use of structured settlements attractive. Because the underlying annuity or government obligation is purchased with today’s dollars, the out-of-pocket cost is less than the total amount of money that the structured settlement will pay out over time.
Of course, with any structured settlement offer, it’s obviously important to know the present value of the future payments so the offer can be compared with an immediate cash payment. Also, the present cost of a structured settlement depends on the amount of the future payments and their timing, so it’s always advisable to have an expert review the documentation and crunch the numbers.
Annuity payments are only one way to finance the sale of a closely held company, professional practice, or partnership interest. Our business valuation services can help structure a sale or merger that generates the best after-tax financial return.