Structured Settlements in Employment Cases: Tax Benefits

A structured settlement in an employment case lets you receive your settlement money as a stream of periodic payments funded by an annuity, rather than as a single taxable lump sum. Because most employment recoveries are ordinary taxable income, spreading the payments across multiple tax years keeps you out of the top marginal brackets and can save tens of thousands of dollars in federal and state tax. The arrangement is called “non-qualified” because employment claims don’t meet the personal-physical-injury requirement that makes personal injury structures fully tax-exempt.

Why Employment Settlements Are Taxable to Begin With

Under Internal Revenue Code Section 104(a)(2), only damages received “on account of personal physical injuries or physical sickness” are excluded from gross income. The Small Business Job Protection Act of 1996 added “physical” to the statute, ruling out purely emotional or mental injuries.¹ Wrongful termination, discrimination, harassment, retaliation, and wage claims almost never involve physical injury in the legal sense, so the proceeds are included in gross income. The Supreme Court confirmed this in Commissioner v. Schleier, 515 U.S. 323 (1995).²

Different pieces of the same settlement are taxed differently:

Back pay, front pay, and severance are treated as wages, subject to FICA and income tax withholding, and reported on Form W-2.¹
Emotional distress damages are taxable as ordinary income unless traceable to a physical injury, reported on Form 1099-MISC, and are not subject to federal employment taxes.¹
Recoveries under Title VII, the ADA, the ADEA, and similar statutes are not excludable under Section 104(a)(2).¹
Punitive damages are always taxable, with a narrow exception for certain wrongful death cases.¹

The taxability is exactly what makes structuring attractive. A large one-year payout pushes you into the highest brackets; splitting it across years often doesn’t.

How a Non-Qualified Structured Settlement Is Set Up

The mechanics involve more than two parties. Once you and the defendant agree to settle, the defendant transfers the periodic payment obligation, along with the cash to fund it, to an independent assignment company. You release the defendant from further liability. The assignment company then buys an annuity from a life insurance company, and the insurer sends the scheduled payments directly to you.³ The employer walks away with no ongoing administrative burden or investment risk.⁴

Timing is critical. The structure must be built into the original settlement agreement. If you have already received the money, or gained the right to receive it, you cannot go back and structure it.⁵ The settlement agreement itself has to specify the payment schedule, address attorney fees, and identify the governing law, and a separate “Non-Qualified Assignment and Release” formalizes the transfer among the parties, the assignment company, and the insurer.⁴

Payment design is flexible. You can choose fixed terms of 5, 10, or 20 years, lifetime payments, deferred lump sums at future dates, or hybrid arrangements combining an upfront cash payment with a later stream.⁶ The annuity payments must be substantially equal, occur at least annually, and begin within one year of settlement. If you die before the term ends, remaining payments generally pass to named beneficiaries and bypass probate.⁴

The Actual Tax Benefit

A non-qualified structure is not tax-exempt. Every dollar you eventually receive is still taxable. The benefit is timing: money inside the annuity grows tax-free until it’s paid, and you recognize income only in the year each installment arrives.⁴ Spreading the income out avoids the spike into the top brackets that a lump sum produces. In states with high income taxes, like California with its 13.3% top rate, the combined federal-and-state savings can be significant. The 2017 federal tax reform’s $10,000 cap on state and local tax deductions made the federal exposure worse for plaintiffs in high-tax states, sharpening the case for structuring.⁷

A concrete comparison illustrates the size of the effect. Take a $750,000 employment settlement. Received as a lump sum, the estimated tax bill is roughly $191,000, leaving about $559,000 after tax. Instead, take $100,000 upfront and place $650,000 into a 20-year annuity paying about $4,072 per month. The estimated total tax across the annuity’s life drops to about $45,700, the gross payout from the annuity totals roughly $1.077 million, and the tax savings versus the lump sum come to about $145,000.⁴

A second example: a $400,000 harassment claim taken as a lump sum at combined federal and California rates costs the plaintiff over $177,000 in tax. Structured as $40,000 per year over 10 years, the annual income sits in lower brackets and the effective tax rate falls considerably. The defendant’s actual cost is only $360,000 because of the time value of money embedded in the annuity.² That gap is why defendants often accept structured proposals at settlement numbers they would refuse in cash: the plaintiff’s after-tax result improves while the employer’s outlay drops.⁵

What Can and Can’t Be Structured

Not every part of an employment settlement can go into the annuity. Back pay and front pay currently cannot be structured because they are classified as wages subject to employment tax withholding and FICA.⁵ The IRS Office of Chief Counsel Memorandum PMTA-2009-035, dated October 22, 2008, lays out a four-step process for analyzing each component of an employment settlement, with one step devoted to determining whether a payment counts as “wages” for employment tax purposes.⁸ Wage components have to run through standard payroll reporting.

Non-wage pieces of the same settlement can be structured even though they’re taxable. Emotional distress, compensatory damages for harassment or discrimination, and punitive damages all qualify.⁷ In practice, the settlement agreement separates the wage components, which get paid out immediately with withholding, from the non-wage components, which get placed into the annuity.⁹

Attorney Fees: The Above-the-Line Deduction

Attorney fees are their own tax problem in employment cases. Under Commissioner v. Banks, 543 U.S. 426 (2005), a plaintiff on a contingent fee has to include the full settlement in gross income, including the portion paid to the lawyer. The Court treated the contingent fee arrangement as an “anticipatory assignment” of income.¹⁰

Congress partially fixed the problem through the American Jobs Creation Act of 2004, which added IRC Section 62(a)(20). It allows an above-the-line deduction for attorney fees and court costs in cases involving unlawful discrimination, so the fees reduce adjusted gross income directly instead of being trapped as an itemized deduction subject to limitations. “Unlawful discrimination” under Section 62(e) is defined broadly, covering Title VII, the ADEA, the ADA, the Fair Labor Standards Act, ERISA, and a catch-all for any federal, state, or local law enforcing civil rights or regulating the employment relationship.¹¹

The statute applies whether the settlement is paid as a lump sum or in periodic payments, so structuring doesn’t cost you the deduction. In each year an installment arrives, you get the deduction against that year’s settlement income, capped at the amount of settlement income included in gross income for that year.¹¹ Attorneys can also structure their own contingent fees through parallel annuity arrangements to defer their tax liability.¹²

Practical Cautions Before You Sign

A structured payout is a guaranteed income stream backed by a life insurance company, which insulates you from spending down a lump sum too fast. A 2023 MetLife poll found that 81% of employment plaintiff attorneys were concerned about lump-sum depletion.⁵ Payments can be shaped to replace lost pension income, bridge a career transition, or cover future medical costs.⁶

Two cautions matter. First, poorly designed periodic payments can push you over income limits for Medicaid or Social Security Disability eligibility.⁶ Second, because the reliability of the whole arrangement depends on the insurer, check financial strength ratings from more than one agency and review them periodically, since ratings can change.¹³ The structure also has to be locked in as part of the original settlement agreement, so raise it with counsel before you sign anything.⁵

The IRS Authority the Structure Rests On

The tax treatment of employment structured settlements rests primarily on IRS Private Letter Ruling 200836019, issued June 2, 2008. It involved a taxpayer who settled a hostile work environment claim, involving mental anguish and emotional distress, through a non-qualified assignment. The IRS concluded that because the settlement agreement prohibited the taxpayer from accelerating, deferring, or modifying payments, the doctrines of constructive receipt, economic benefit, and cash equivalency did not apply. The taxpayer’s rights to future payments were not assignable or transferable, and the fact that the assignee bought an annuity to fund the obligation did not trigger current income because the taxpayer had no rights in the annuity contract itself.¹⁴

Tax commentators called the ruling a “remarkable victory” for the structured settlement industry. The IRS also cited Childs v. Commissioner, 103 T.C. 634 (1994), which held that an unfunded, unsecured promise to pay periodic amounts does not create immediate taxable income.⁹ One caveat: private letter rulings apply only to the taxpayer who requested them and cannot be cited as legal precedent.¹⁴ Together with Chief Counsel Memorandum PMTA-2009-035, though, these documents form the guidance practitioners rely on when structuring employment cases.⁸

1
IRS. Tax Implications of Settlements and Judgments
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USLAW Network. Creative Ways to Settle Employment Litigation Cases
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Patrick Farber. Employment Litigation Cases Whitepaper
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MetLife. Structuring an Employment Settlement: A Tax-Efficient Solution
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4 Structures. Employment Structured Settlements
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Amicus Planners. Structured Settlement Employment Cases
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Sage Settlements. Tax Benefits of Structured Settlements in Employment Cases
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Employment Law Group. Effective Use of Structured Settlements in Executive Compensation
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Wood LLP. Nonqualified Structured Settlements After PLR 200836019
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Justia. Commissioner v. Banks, 543 U.S. 426
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Cornell Law Institute. 26 U.S. Code Section 62 – Adjusted Gross Income Defined
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Attorney at Law Magazine. Structured Settlements for Taxable Damages Claims
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Annuity.org. Annuity Provider Ratings
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IRS. Private Letter Ruling 200836019