IRS Rules That Periodic Payment Settlement Structure Defers Income to Taxable Year of Receipt

Scott E. Vincent
Vincent, Fontg & Hansen, L.L.C.
Kansas City
The Internal Revenue Service recently issued a ruling that provides a road map for structuring periodic payment settlements that will not trigger immediate income. Private Letter Ruling 200836019, released September 5, 2008, held that the taxpayer was not in constructive receipt of future periodic payments to be received pursuant to a settlement of damage claims relating to allegations of hostile employment practices.

Background

The taxpayer described in the ruling had asserted that she was subjected to a pattern of hostile employment practices during her employment, and she filed a complaint for damages including alleged lost overtime wages (“wage claim”) and from various non-physical injuries including emotional distress and mental anguish (“non-wage claim”). The taxpayer and the employer agreed to a settlement agreement and release that included a lump sum payment for the wage claim and a schedule of periodic payments for the non-wage claim. The settlement agreement and release and a related non-qualified assignment agreement included several key provisions noted in the ruling:

• The taxpayer agreed that she could not change the timing or amount of the periodic payments to accelerate, defer, increase or decrease the payments.

• The taxpayer agreed not to sell, mortgage, encumber or anticipate all or any portion of the periodic payments by assignment or otherwise.

• The employer reserved the right to enter into a “non-qualified assignment” designating an assignee to make the periodic payments to the taxpayer, and the taxpayer agreed that said assignee would then become the sole obligor with respect to the periodic payments, continuing the payments regardless of the subsequent bankruptcy or insolvency of the employer.

• The non-qualified assignment gave the taxpayer only unsecured general creditor rights against the assignee, with no third party beneficiary rights to any annuity contract purchased by the assignee and no assets of assignee set aside to secure the periodic payments.

The IRS also recited the following specific representations by the taxpayer:

1. The periodic payments represent compensation to the taxpayer for non-physical personal injuries and sickness she incurred during the course of her employment with employer.

2. The periodic payments represent payments made by employer to settle taxpayer’s non-wage claim and are not wages for federal income tax purposes.

3. Employer’s periodic payments in settlement of taxpayer’s non-wage claim will constitute a taxable recovery to the taxpayer pursuant to § 61 of the Internal Revenue Code and are not exempt from federal income tax under § 104(a)(2).

Analysis and Holding

Noting that the taxpayer in question was a “cash basis taxpayer,” the IRS addressed the following four concepts that could potentially (but did not) result in accelerating of the timing for the taxpayer’s reporting of income from the periodic payments: “actual receipt,” “cash equivalency,” “constructive receipt” and “economic benefit.”

Actual Receipt

The IRS stated that income is actually received when it is reduced to the taxpayer’s possession, dominion or disposition. Since the taxpayer in the ruling was receiving no property at the time of the settlement and related assignment and was receiving only an unfunded, unsecured contractual promise to pay, the IRS held that the taxpayer was not in actual receipt of cash or property pursuant to the settlement agreement and release or the related non-qualified assignment.

Cash Equivalency

The “cash equivalency” doctrine provides that a cash basis taxpayer is in receipt of income if the taxpayer receives a promise or contractual obligation that can be readily converted into cash by the taxpayer. In this case, the taxpayer was specifically barred from assigning, encumbering or otherwise transferring her right to receive the periodic payments in order to modify the schedule of periodic payments or accelerate, defer, increase, decrease, anticipate, sell, assign or encumber any payment. Further, the taxpayer’s rights to payment were unfunded and unsecured, even following the non-qualified assignment. Accordingly, the IRS held that the taxpayer did not receive cash equivalent rights to the periodic payments.

Constructive Receipt

Section 451 of the Internal Revenue Code and the related regulations set forth the constructive receipt doctrine, providing that gains, profits and income are to be included in gross income for the taxable year in which they are actually or constructively received by the taxpayer. The regulations further provide that income not actually reduced to a taxpayer’s possession is still constructively received in the taxable year during which it is credited to the taxpayer’s account, set apart for the taxpayer or otherwise made available so that the taxpayer may draw upon it during the taxable year. Importantly, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. The IRS further noted case law references establishing that a taxpayer will not be in constructive receipt of income merely because the taxpayer seeks deferral of payments as part of a negotiated settlement, but constructive receipt will apply if a taxpayer has a current right to receive all of the funds before a deferral mechanism is established.

The taxpayer in the ruling was not to have any right to draw on or otherwise accelerate her receipt of periodic payments under the non-qualified assignment, and the periodic payments could not be anticipated, sold, assigned or encumbered. The assignee’s payments were to be from its general assets, subject to claims of the assignee’s creditors. Further, the non-qualified assignment was to be entered into only after a settlement agreement and release were negotiated between the taxpayer and employer, so that the taxpayer would never have an unqualified right to receive immediate payment. Under these circumstances, the IRS held that the taxpayer would not be in constructive receipt of the periodic payments unless and until each payment is made in cash by the assignee. The IRS further noted that the assignee’s purchase of an annuity contract to fund its obligations under the non-qualified assignment did not amount to setting apart or crediting funds for the taxpayer’s benefit because she had no rights under the annuity contract.

Economic Benefit

The “economic benefit doctrine” provides that a cash basis taxpayer may be treated as having received income in a year prior to actual or constructive receipt when the taxpayer is assured the benefit of future payments. The IRS noted that the economic benefit doctrine is triggered when a payor unconditionally and irrevocably establishes a separate fund or trust of assets exclusively for the taxpayer’s benefit. The IRS determined that the arrangement outlined in the ruling did not set aside amounts to make the periodic payment or create a separate fund irrevocably and unconditionally for the taxpayer’s benefit. Further, the taxpayer had no rights against the assignee other than that of a general creditor. As a result, the IRS held that the economic benefit doctrine did not apply to the taxpayer relative to the periodic payments.

Conclusions

After significant analysis, the IRS held that the taxpayer will not be in actual or constructive receipt of the periodic settlement payments until the taxable year when she receives each applicable cash payment. This ruling provides an excellent framework for negotiation and settlement of claims under a structure that can indirectly provide the financial security of a third-party to make periodic payments without accelerating the taxability of the future periodic payments.