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G
ou may have clients who are plaintiffs in a
wrongful death or survival lawsuit (based on
another’s death) or in a lawsuit stemming
from their own personal injuries. Those clients, and
their personal injury attorneys, often don’t realize the
importance of settling cases with future income and
estate tax liabilities in mind. But their understanding,
or at least their appreciation of the potential tax liabili-
ties’ significance, is critical so they can take this into
account when designing the settlement.
Depending on how a settlement is structured, plain-
tiffs in a wrongful death or survival lawsuit may be
saddled with unexpected income and estate tax liability.
Also, if a plaintiff in a personal injury lawsuit dies pre-
maturely, the untimely death can cause large amounts
of assets to enter his gross estate and become taxable,
sometimes resulting in surprisingly considerable estate
tax liability, even though the beneficiaries of the plain-
tiff’s estate may only be entitled to future payments. To
avoid surprises and reduce this tax liability, it’s impor-
tant for trusts and estates attorneys to be aware of clients’
pending litigations and advise them of the income and
estate tax implications of proceeds obtained from these
potential settlements.
1
Forward-thinking planning may
enable a plaintiff to access significant tax benefits by
carefully designing his settlement.
E`]\UTcZ2SObVAc`dWdOZ:Oe
States typically provide for personal injury causes of
action by the decedent’s beneficiaries, estates or both.
2SObVO\R2O[OUSa1O\0SBOfW\U
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eVS\aSbbZW\UOQOaS
Wrongful death laws create causes of action after
the death of an injured party for the benefit of certain
beneficiaries. For example, New Jersey provides “for the
exclusive benefit of the persons entitled to take any intes-
tate personal property of the decedent, and in the pro-
portions in which they are entitled to take the same ... ”
2
Survival laws allow certain causes of action to
become assets of a decedent’s probate estate. For
example, Connecticut provides that in any “action sur-
viving to or brought by an executor or administrator
for injuries resulting in death, whether instantaneous or
otherwise, such executor or administrator may recover
from the party legally at fault for such injuries … ”
3
The estate and income tax consequences of both
types of lawsuits must be considered, especially during
settlement negotiations.
Estate tax consequences. Proceeds from wrongful
death and survival lawsuits aren’t subject to estate
tax. Such actions only spring to life at the time of a
decedent’s death, too late for the decedent to have an
interest in them.
Since 1975, the Internal Revenue Service has taken
the position that neither wrongful death nor survival law
proceeds give rise to estate tax liability.
4
The estate tax
consequences of proceeds awarded based on wrongful
death and survival laws flow directly from the conclusion
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that neither wrongful death nor survival law
proceeds become part of a decedent’s gross estate.
Revenue rulings both before and after 1975 have
held that because a wrongful death cause of action
doesn’t exist before an injured party’s death, proceeds
from the action don’t enter the gross estate for estate
tax purposes.
5
The IRS explained the rationale of this
rule in 1954:
The decedent in his lifetime never had an interest
in the right of action or in the proceeds. He didn’t
create the right, it was created by statute and vested
in the persons designated in the statute. Inasmuch
as the decedent had no right of action or interest
in the proceeds at the time of his death, nothing
“passed” from the decedent to the beneficiaries.
Accordingly, the amounts recovered by the ben-
eficiaries wouldn’t be includible in the decedent’s
gross estate for Federal estate tax purposes.
6
The estate tax treatment of survival law proceeds
is now identical to that of wrongful death proceeds,
though this wasn’t always the case. The IRS holds that
under a survival law, the cause of action “survives the
victim’s death and passes to his personal representative
to be pursued as an asset of the probate estate.”
7
Prior
to 1975, the IRS argued that because the decedent has
the “power to designate who shall enjoy the proceeds it
must follow that she has some interest in the property.”
8
Arguably, the proceeds should therefore be included in
the decedent’s estate for estate tax purposes.
However, in 1975, after asserting the above argument
and losing in several cases,
9
the IRS acquiesced, agreeing
to follow the pro-taxpayer decisions. As such, the IRS no
longer includes the value of survival proceeds in a dece-
dent’s gross estate.
As will be discussed later, it’s impor-
tant to note that the 1975 revenue ruling specifically held
that damages arising before an injured party’s death (for
example, pain and suffering based on a personal injury
lawsuit) will be included in the decedent’s gross estate.
Income tax consequences. Internal Revenue Code
Section 104(a)(2) excludes from income, damages
received on account of personal physical injuries or
physical sickness. Thus, for income tax purposes, ben-
eficiaries who receive proceeds from a wrongful death
or survival lawsuit won’t need to pay income tax on
those proceeds if they were received “on account of” a
personal physical injury or physical sickness (that is, the
death resulted from some physical injury or sickness
caused by the defendant).
Proceeds from wrongful death and survival lawsuits
fall under different sections of the IRC. Wrongful death
proceeds are received tax-free as damages received on
account of personal physical injuries or physical sick-
ness. No case law exists on the federal income tax
consequences of survival law proceeds. However, it
seems reasonable to assume that they will be excluded
either in the same way as wrongful death proceeds, or
as would proceeds from a decedent entitled to dam-
ages originating before his death. Assuming a physical
injury or physical sickness, beneficiaries should receive
survival law proceeds tax-free under either theory.
Proceeds under wrongful death laws that create
causes of action for beneficiaries are received tax-free
as long the damages are received “on account of ” a per-
sonal physical injury or sickness.
Deceptively complex, the phrase “on account of”
has been frequently litigated. Congress inserted the
term “physical” twice into Section 104(a)(2) in 1996,
along with language specifically including gross income
damages received on account of emotional distress.
10
Legislative history and the IRS indicate that emotional
distress damages resulting from a physical injury or
physical sickness are received tax-free
11
and that physi-
cal injury or physical sickness damages resulting from
emotional distress are fully taxable.
12
In fact, as long as
the originating injury or sickness is physical, damages
“that flow therefrom” are treated as damages received
on account of personal physical injuries or physical sick-
ness whether or not the recipient of the damages is the
injured party.
13
Even spousal proceeds from a loss of
consortium claim can be excluded when received on
account of a personal physical injury or sickness of
one’s husband or wife.
14
Proceeds from a wrongful death lawsuit brought by
the decedent’s beneficiaries are received more directly
“on account of a personal injury or sickness” than pro-
ceeds from a loss of consortium claim, when a spouse is
making what amounts to an emotional distress claim on
account of the other spouse’s death. Unsurprisingly, the
IRS has repeatedly found that beneficiaries of wrongful
death proceeds are entitled to receive them tax-free,
whether received in a lump sum or via a structured
settlement stream of periodic payments.
15
The basis to exclude proceeds from a survival law
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Thus, in situations in which a decedent had an interest
in a claim for pain and suffering before dying a wrong-
ful death, or in a claim originating long before and unre-
lated to a decedent’s death, resulting damages will be
included in a decedent’s estate. This is true whether the
damages are or will be received in a lump sum payment
or in periodic payments over many years.
19
In the case of periodic payments, valuing the income
stream that must be included in a decedent’s gross estate
can become very complicated. Beneficiaries of decedent
lottery winners experience the same difficulty. Generally,
property is included in a decedent’s gross estate to the
extent of the property’s fair market value (FMV) on the
date of the decedent’s death, determined by the price a
willing buyer would pay a willing seller when neither are
compelled to buy or sell and when both have reasonable
knowledge of the facts.
20
The value of periodic payments is determined
under tables prescribed by the Treasury Secretary,
unless otherwise specified in regulations.
21
Regulations
issued in 1995 provide that a “restricted beneficial inter-
est,” that is, an annuity or income interest “subject to any
contingency, power, or other restriction,” won’t typically
be valued under the prescribed tables.
22
Such an interest
is to be valued based on all the facts and circumstances.
23
Court decisions before issuance of the regulations also
looked to whether a taxpayer seeking to depart from the
tables could substantiate a better method.
24
Whether lottery and structured settlement pay-
ments are considered to be restricted beneficial
interests becomes exceedingly important in mea-
suring estate tax liability. For example, a structured
settlement recipient’s estate argued to the U.S. Court
of Appeals for the Fifth Circuit, that the FMV of pay-
ments to which it was entitled equaled $1.2 million
based on the facts and circumstances, rather than
$2.4 million, as specified by the regulation tables. The
difference in FMV resulted in over $400,000 of addi-
tional estate tax liability.
25
Both lottery and structured settlement payments are
frequently non-assignable pursuant to their agreements,
though they’re sometimes “factored” anyway.
26
Whether
the limit on transferability constitutes a “restriction”
for purposes of finding a “restricted beneficial interest”
(thus allowing a facts-and-circumstances analysis), FMV
has been frequently litigated. The IRS maintains that
the limitation on assignability doesn’t constitute a
“restriction” because the annuitant retains the right
cause of action is less clear. Survival laws create causes of
action that become assets of decedents’ probate estates.
An estate may exclude damages received for physical
injury or physical sickness under Section 104(a)(2). But,
do beneficiaries receive the damages from a decedent’s
estate on account of the decedent’s physical injury or
physical sickness? If so, the beneficiaries may exclude
survival law proceeds from their gross income under
Section 104(a)(2), as would the estate and as would the
decedent had he lived. However, Treasury regulations
hold that “damages” are amounts received “through
prosecution of a legal suit or action, or through a settle-
ment agreement entered into in lieu of prosecution.”
16
It may be questionable whether beneficiaries of survival
law proceeds receive “damages” under the regulatory
definition.
It seems more plausible that beneficiaries of sur-
vival law proceeds receive them in the same fashion
as do beneficiaries of a decedent with a pre-death cre-
ated cause of action (for example, pain and suffering
or a claim unrelated to decedent’s death).
>`SRSObV1`SObSR1OcaSa]T/QbW]\
What about proceeds from a decedent’s cause of action
created prior to the decedent’s death? The decedent may
have been a plaintiff in a personal injury lawsuit that set-
tled for a lump sum payment or payments over time or
even one that failed to settle during the decedent’s life.
Estate tax consequences. Proceeds from causes of
action originating before the decedent’s death, such as
pain and suffering, become part of the decedent’s gross
estate. Thus, they may give rise to estate tax liability.
Although wrongful death and survival law proceeds
aren’t taxable because a decedent never had an interest in
them, IRS rulings specifically caveat proceeds in which a
decedent had an interest during life.
17
For example, one revenue ruling in which the IRS
acquiesced to the identical estate tax treatment of
wrongful death and survival law proceeds explained:
[W]here it can be established that such proceeds
represent damages to which the decedent had
become entitled during his lifetime (such as for
pain and suffering and medical expenses) rather
than damages for his premature death, the value
of these amounts will be includible in the dece-
dent’s gross estate.
18
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4SObc`S(3abObS>ZO\\W\UBOfObW]\
to receive all payments.
27
Currently, there’s a split among the circuits.
28
The
Fifth and Sixth Circuits side with the IRS, finding
no “restriction” and therefore that the regulation tables
should be followed.
29
The Second and Ninth Circuits
side with taxpayers, interestingly, in cases based on
deaths before the addition to the regulations of the
“restricted beneficial interest” exception.
30
Those taxpay-
ers were allowed a facts-and-circumstances valuation
when the tables would produce a substantially unrealis-
tic or unreasonable result or when a more realistic and
reasonable valuation method exists.
31
Regardless of the valuation method, periodic pay-
ments can dramatically increase the size of a gross estate.
Income tax consequences. The operation of IRC Sec-
tion 691 can result in income tax liability to an estate
beneficiary. Section 691 includes in a beneficiary’s gross
income, payments received for tax purposes that a cash
method decedent didn’t, but would have, received for
tax purposes prior to death.
32
For example, a decedent’s
deferred compensation payments are included in a ben-
eficiary’s gross income.
33
For purposes of personal injury
awards and settlements, this means that beneficiaries
may incur income tax liability by receiving proceeds
from the decedent’s original cause of action. However,
payments that the decedent could have excluded from
gross income don’t constitute “income” to a benefi-
ciary either. Beneficiaries who receive proceeds from a
decedent’s cause of action originating prior to the dece-
dent’s death incur income tax liability only to the extent
that the decedent would have, if he had lived.
Beneficiaries of estates aren’t taxed upon receipt
of property. Thus, a lump sum settlement passed on
wouldn’t result in income tax to the beneficiary.
However, the same can’t be said of settlements
paid out over time. IRC Section 691 includes in a
beneficiary’s gross income “[t]he amount of all items
of gross income in respect of a decedent which are not
properly includible in respect of the taxable period in
which falls the date of his death or a prior period ... .”
34
As noted, for example, payments to a beneficiary
of a cash method decedent’s deferred compensation
are included in the gross income of the beneficiary.
35
Proceeds from contingent claims, such as personal
injury causes of action, are also included as income in
respect of a decedent.
36
Fortunately for beneficiaries of decedents with causes
of action existing prior to death, Treasury regulations
hold that income in respect of a decedent isn’t received
when the proceeds would have been excluded from
the decedent’s gross income had he lived to receive
them.
37
Thus, if the decedent would have received the
damages on account of a personal physical injury,
excludable under Section 104(a)(2), the beneficiary
of such proceeds needn’t include them under Sec-
tion 691.
38
(See “Tax Consequences in a Nutshell,” this
page, for a summary of the taxability of various types of
proceeds.)
4`][9\]eZSRUSb]Ab`ObSUg
As is often the case with tax, too much knowledge can
leave one paralyzed. Below are three examples that
review the estate and income tax consequences of
certain settlements, as well as some accompanying sug-
gestions on how a practitioner might restructure the
settlement to best serve a client.
Example 1: Wro ng fu l De at h Pr oce ed s
John is killed in a car accident by a negligent driv-
er. John’s non-spouse beneficiary,
39
Janet, sues the
driver under a wrongful death law and settles for
$10 million.
Ta x c o n s e q u e n c e s : John never had an interest in the
proceeds, so for estate tax purposes they don’t enter his
gross estate. Therefore, the estate incurs no estate tax
liability. Because Janet will receive the damages on
account of a physical injury, she may exclude them
from her gross income. Therefore, she incurs no
income tax liability.
Structured settlement: Janet and the casualty insurer
could agree to a structured settlement of periodic pay-
ments to Janet. The insurer could assign liability to an
assignment company, which would purchase an annuity
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Damages won in certain lawsuits may be taxable
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As in Example 2, the beneficiary (Frank) incurs no
income tax liability under one of the two alternative the-
ories (the exclusion of Section 104(a)(2) or the exclusion
of Section 102 and no inclusion under Section 691).
Settlement negotiations: Jane’s attorney focused, at
least in part, on the interests of Frank, as Jane’s benefi-
ciary. Jane could likely have settled for a larger annual
payout limited to the span of her life, rather than for
a 32-year term. In fact, this would have resulted in no
estate tax liability, as no property or right to collect
would have existed beyond Jane’s life. However, foresee-
ing the possibility of Jane’s premature passing, her
attorney negotiated a settlement to secure an eco-
nomic benefit for Frank. Apart from the immediate
estate tax liability, Frank will benefit from the defer-
ral and interest component of the periodic payments,
which he will receive free of income tax.
If Frank possessed any claim as a result of Jane’s
physical injury, such as emotional distress, Jane’s attor-
ney would have been wise to include Frank as an original
plaintiff. Any portion of the settlement paid to Frank
wouldn’t be included in Jane’s gross estate for estate
tax purposes. Assuming that Jane received more than
she would use during life, and that the defendant was
only willing to pay a finite amount whether to one
or two plaintiffs, apportioning a reasonable amount
directly to the soon-to-be beneficiary would reduce
estate tax liability. In other personal injury tax contexts,
allocations are respected unless shown to be unreason-
able.
43
While the beneficiary of a near-death plaintiff
might be hesitant to accept settlement proceeds that the
plaintiff would otherwise receive, doing so may diminish
the subsequent tax burden.
Alternatively, a structured settlement between a defen-
dant and co-plaintiffs could name the more-injured
plaintiff as the primary beneficiary of the settlement
payments and the less- (emotionally) injured plaintiff as
a contingent beneficiary, only to receive payments upon
the first plaintiff’s death. Because both plaintiffs pos-
sessed claims against the defendant, the design of such a
settlement is arguably similar to the plaintiffs’ combined
purchase of jointly held property. Treasury regulations
hold that a decedent’s gross estate in such a situation
includes only the portion of property corresponding to
the decedent’s purchase.
44
The estate would argue that
the present value of payments made beyond the more-
injured plaintiff’s death represent liability value to the
less-injured plaintiff at the time of settlement.
to fund Janet’s stream of income. By doing so, Janet
could benefit from the investment portion of the annu-
ity without additional income tax liability, a significant
tax benefit.
40
Even if the wrongful death cause of action
had resulted from a nonphysical injury or sickness, thus
resulting in taxable proceeds, the use of a structured
settlement would defer income tax liability.
41
Example 2: Survival Law Proceeds
John is killed in a car accident by a negligent driver.
John’s representative sues the driver under a survival
law and settles for $10 million. The estate distributes
the entire settlement proceeds to Janet, a non-spouse
beneficiary.
Ta x c o n s e q u e n c e s : John never had an interest in the
proceeds, so they don’t enter his estate. Therefore, the
estate incurs no estate tax liability. Either because Janet
receives the damages on account of a physical injury,
or because inheritance is excludable and a beneficiary
needn’t include in her income amounts that the dece-
dent could have excluded, Janet may exclude the
damages from her gross income. Therefore, she incurs
no income tax liability.
Structured settlement: As was the case in Example 1,
the use of a structured settlement could provide addi-
tional value to the beneficiary.
Example 3: Decedent with a Claim Prior to Death
Jane, an unmarried woman, was shot and permanently
paralyzed by her neighbor. She sued the neighbor for bat-
tery and agreed to a non-assignable structured settlement
of $500,000 for 32 years. Two years later, in January 2011,
Jane died of a heart attack unrelated to the gunshot
injury. The estate distributed its entirety to Jane’s non-
spouse beneficiary, Frank, consisting only of the right to
receive 30 years of structured settlement payments.
Ta x c o n s e q u e n c e s : Jane had an interest in the
damages while still alive and thus they enter her
gross estate. Depending on the jurisdiction, her
estate will either value the right to receive 30 years of
$500,000 payments based on the Treasury regulation
tables or based on the facts and circumstances (account-
ing for non-assignability). Under the regulations, the
payment’s value is $10,606,050.
42
Assuming, generously, that Jane used none of her
unified credit during her life, the first $5 million of value
isn’t subject to the estate tax. The remaining amount,
$5,606,050, results in estate tax liability of $1,962,117.50.
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B3
Were the settlement already completed, the attorney
might advise the plaintiff that in each year succeeding
the settlement she make gifts of any unneeded funds
to her intended beneficiaries in amounts not exceeding
$13,000 per donee.
45
The lifetime unified credit is only
reduced by gifts in excess of the $13,000 annual exclu-
sion. For example, with actual needs of $200,000 per
year for her care, Jane could gift away up to $300,000
per year without incurring gift tax, thus reducing her
later gross estate. Of course, a short life would render
this plan less effective. Moreover, she would only wish
to effect this plan with intended beneficiaries. Because
the annual exclusion is small, Jane would need many
intended beneficiaries for the plan to substantially
reduce her gross estate. Still, a gift of $13,000 in the year
of settlement might grow to $30,000 by the time of her
death. Thus, gifting early would likely save more than
the gift amount multiplied by the estate tax rate.
Unfortunately, even if a plaintiff takes these steps,
there may be significant estate tax liability without
any estate liquidity. This will result when the estate’s
only significant asset is a stream of periodic payments.
In that case, the request of an extension may be appro-
priate based on a showing of “reasonable cause.”
46
Alternatively, a plaintiff may wish to purchase a life
insurance policy to provide liquidity.
47
To avoid the
gross estate from including such proceeds for estate tax
purposes, a plaintiff could contribute the policy to an
irrevocable life insurance trust.
48
Without such liquidity,
or an extension, the representative of the estate may be
forced to sell a portion of the future stream of income at
a significant discount. (See “Practice Tips,” this page.)
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The above strategies are but a few arrows in the quiver
of a competent trusts and estates attorney. Other alter-
natives exist that may mitigate estate tax liability such
as grantor retained annuity trusts and intentionally
defective grantor trusts. The first is designed to transfer
value to a beneficiary equal to the difference between the
IRS’ assumed rate of interest and the actual rate of inter-
est obtained. The second invites gift tax of transferred
assets at today’s value, rather than estate tax at the likely
higher value upon the grantor’s death. In addition, it
allows the trust to directly receive income derived from
the assets and the grantor to remain responsible for the
income taxes associated with the trust.
—The views expressed herein are those of the author
and do not reflect Treasury policy. The author would like to
thank Melissa Hung, an associate at Springs & Associates
in San Francisco, for her edits and advice on the estate tax
aspects of this article. Thanks also to Noël Cunningham,
Professor of Law at NYU School of Law, and Catherine
Hughes, a federal government estate and gift tax attorney,
for their comments.
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