Mr. Chairman, Mr. Coyne, and Members of this Subcommittee, it is a pleasure to speak with you today about the current-law tax treatment of structured settlement arrangements and legislative proposals to impose an excise tax on the purchase of structured settlement payment streams.

As you know, the Administration has proposed in its fiscal year 2000 budget to impose an excise tax on structured settlement factoring transactions. The Administration believes that the proposed tax, which is intended to act as a deterrent to factoring transactions, is necessary to preserve the integrity of the structured settlement tax regime and the underlying policy objective of protecting and providing for the long-term financial needs of injured persons. Our budget proposal is very similar to H.R. 263, the "Structured Settlement Protection Act of 1999," as introduced by Messrs. Shaw and Stark and other Members of the Subcommittee and full Committee.

Following is an overview of the tax treatment of structured settlements under current law, a discussion of the rationale for these favorable rules, an analysis of the potential impact of a factoring transaction, and an explanation of how the proposed excise tax would operate in support of the legislative purpose underlying current law.

Since 1983, section 130 and other provisions of the Internal Revenue Code have contained a series of special tax rules intended to facilitate the use of structured settlements to resolve physical injury damage claims.

Structured settlements that qualify for this favorable tax treatment typically have the following characteristics: A tortfeasor who is required (whether by suit or agreement) to pay damages to a physically injured person enters into a structured settlement agreement with the injured person and a structured settlement company ("SSC"), under which terms the SSC is to pay the injured person specified amounts for a number of years or for the life of the injured person. Pursuant to the agreement, the tortfeasor pays a lump sum to a structured settlement company ("SSC"), which assumes the tortfeasor's liability to the injured person. The SSC purchases an annuity contract to fund the liability, and uses the annuity payments received under the annuity contract to pay the amounts due to the injured person.

The tax results of the structured settlement arrangement are as follows: The tortfeasor is permitted immediately to deduct the lump sum paid to the SSC, but the SSC does not include in income the amount received from the tortfeasor to the extent that such funds are used to purchase the annuity contract. The earnings on the annuity contract are taxed to the SSC according to the favorable rules generally applicable only to individual annuityholders. These rules generally defer taxation of income under the annuity contract until such time that the SSC actually receives annuity payments, at which time the SSC is eligible for a corresponding offsetting deduction for the amounts paid to the injured person. Furthermore, the injured person is not taxed on any amounts received from the SSC, even though significant portions of such payments are funded through the SSC's investment earnings. Taken together, these rules effectively provide that the earnings on funds set aside for the injured person are never subject to tax.

Prior to 1983, the Treasury Department and Internal Revenue Service had taken an administrative position similarly exempting the injured person from tax on the earnings on certain funds set aside on his or her behalf. See, e.g., Rev. Rul. 79-313, 1979-2 C.B. 75. The legislative history to the rules enacted in 1983 explains that the statutory changes were intended, at least in part, to provide statutory certainty that the injured person was not subject to tax on the earnings from qualified structured settlements. In addition, the legislation removed potential tax impediments with respect to SSCs. See H. Rpt. No. 97-832, 97th Cong., 2d Sess. 4 (1982); S. Rpt. No. 97-646, 97th Cong., 2d Sess. 4 (1982). 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 taxpayer is not in constructive receipt of or does not have the current economic benefit of the sum required to produce the periodic payments."

Although the non-tax policy considerations underlying the favorable statutory clarifications are not discussed in these reports, Senator Max Baucus (D-Mont.) described these considerations in introducing the legislation that led to the favorable tax rules. Senator Baucus explained that the recipients of structured settlements are less likely than recipients of lump sum awards to consume their awards too quickly and require public assistance:

• In the past these awards have typically been paid by defendants to successful plaintiffs in the form of a single payment settlement. This approach has proven unsatisfactory, however, in many cases because it assumes that injured parties will wisely manage large sums of money so as to provide for their lifetime needs. In fact, many of these successful litigants, particularly minors, have dissipated their awards in a few years and are then without means of support.
  

• Periodic payments settlements, on the other hand, provide plaintiffs with a steady income over a long period of time and insulate them from pressures to squander their awards....
  

  [Congressional Record (daily ed.) 12/10/81, at S15005.]

Since 1983, Congress has further expressed its support of structured settlement arrangements. In the Taxpayer Relief Act of 1997, Congress extended the section 130 exclusion to cover qualified assignments of liabilities arising under workmen's compensation acts. In deciding to extend such favorable tax treatment, "the Committee was persuaded that additional economic security would be provided to workmen's compensation claimants who receive periodic payments if the payments are made through a structured settlement arrangement, where the payor generally is subject to State insurance company regulation that is aimed at maintaining solvency of the company, in lieu of being made directly by self-insuring employers that may not be subject to comparable solvency-related regulation." See H. Rpt. No. 105-148, 105th Cong.,1st Sess. 410-11 (1997).

Many injured persons are willing to accept heavily discounted lump sum payments from certain "factoring companies" in exchange for their future payment streams from structured settlements. 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. The factoring transactions also effectively contravene the statutory requirement conditioning favorable tax treatment to the various parties to the arrangement on the injured person's inability to accelerate such payments.

The same policy considerations expressed in introducing the structured settlement tax legislation in 1981 remain relevant today. Dissipation of an award by an injured person who is unable to earn money because of his or her injury or illness may result in the need for welfare payments or other public assistance. By replacing structured settlements with a lump sum in the hands of the injured person, the factoring transaction facilitates potential dissipation.

Factoring transactions are prevalent today. According to recent press reports, one large factoring company has completed more than 15,000 structured settlement transactions with an approximate total value of $370 million. The company broadcast more than 90,000 television commercials in a period of less than two years. See Margaret Mannix, "Settling for Less," US News & World Report, p. 63 (January 25, 1999); Vanessa O'Connell, "Thriving Industry Buys Insurance Settlements from Injured Plaintiffs," The Wall Street Journal, p. A8 (February 25, 1998).

We understand that almost all structured settlement arrangements contain anti-assignment clauses that are intended to satisfy the section 130 statutory requirements. The fact that only companies able and willing to contravene these anti-assignment clauses can engage in factoring transactions allows such companies to pay heavily discounted amounts for payment rights. While one large factoring company reports an average discount rate of 16%, there have been reports of rates that in some cases have exceeded 75%. See US News & World Report, id. at 66; see also Gail Diane Cox, "Selling Out Structured Settlements: Abuses in Secondary Market Leads to Reform Legislation," The National Law Journal, p. B1 (August 18, 1997).

In sum, the Administration believes that the factoring transaction undermines the purpose of the special favorable tax rules applicable to structured settlements. In fact, the combination of the existing statutory requirements and the willingness of certain companies to ignore those requirements (but to exact heavy discounts in so doing) leaves injured persons potentially more vulnerable than before the enactment of the 1983 changes. The current state of affairs affords favorable tax treatment without ensuring that the legislatively-intended conditions for such treatment are satisfied -- thereby costing federal revenues without ensuring that the goal of long- term income protection for injured persons is achieved.

Both the President, in his fiscal year 2000 budget, and Representatives Shaw and Stark, in H.R. 263, have proposed the imposition of a substantial excise tax on the difference between the amount paid by the factoring company and the undiscounted value of the acquired payment stream. The excise tax would not be imposed where the purchase is pursuant to a court (or administrative) order finding that certain extraordinary and unanticipated needs of the original intended recipient render such a transaction desirable. H.R. 263 also would provide that factoring transactions would not retroactively affect the tax treatment of the original parties to the structured settlement transaction.

The imposition of a substantial excise tax should make it far less likely that factoring transactions will occur, because the transactions would become less profitable. To the extent that the market for such purchases is reduced or eliminated, far fewer injured persons would be approached or convinced to assign their future income rights, and the integrity of the structured settlement tax regime would be preserved. This will help ensure that the tax benefits conferred by section 130 accomplish their legislative purpose.

The Administration recognizes that the policy concern underlying the proposed tax -- the long-term financial protection of injured persons -- could also be addressed outside the Internal Revenue Code. However, such policy concern already underlies the favorable tax rules applicable to structured settlements. The proposed excise tax is intended to ensure the continued effectiveness of the existing tax rules in protecting the long-term financial security of injured persons. In addition, as of the close of calendar year 1998, we are aware of only three states -- Illinois, Connecticut and Kentucky -- that have passed laws requiring court approval of and fuller disclosure in connection with factoring transactions, and it is unclear whether and when other states might pass similar consumer protection laws.

In conclusion, Mr. Chairman and Mr. Coyne, and Members of this Subcommittee, the Administration looks forward to working with you and other Members of Congress in addressing this problem. We thank you for your interest in this issue, and for inviting us to participate in today's hearing.