We all hope to live healthy and productive lives, but sometimes fate can intervene in unexpected and unwelcome ways. When a person suffers a personal injury, the impact will often be both a shortened expected lifespan, and adversity in coping with new physical, mental and emotional challenges.
The premise underlying a personal injury legal claim is to make the injured individual whole again, understanding that money is at best a proxy for intact health. In large part this involves calculating the cost of future accommodations and rehabilitation, and rendering that back to a present value.
Having determined an appropriate figure, attention then turns to the form of payment, a decision very much guided by tax considerations.
Taxation of damage awards
Depending on the type of claim, damage payments may be taxable, non-taxable or a combination of the two. For example, commonly in employment disputes the bulk of the claim will relate to lost wages. As this would be compensation for loss of an otherwise taxable receipt, the substituted payment would itself be taxable.
A variety of types or ‘heads’ of damages may be claimed in a personal injury matter, with the key one generally being for loss of future earning capacity. On the face of it, that would seem to look a lot like that lost wages claim, but in fact — or rather, in law — there is a critical tax distinction between the two. Loss of earning capacity is considered the loss of a capital asset capable of producing income, not income itself.
Accordingly in our legal system, personal injury damages are generally non-taxable capital payments.
Origin of structured settlements
Structured settlements, or ‘structures’ as they are often called, extend the logic of a single damage payment to making a series of payments. If the purpose of the payment remains the same, the non-taxation should apply to either a lump sum or a series.
The basis for this tax treatment does not appear in the Income Tax Act directly, but is instead expressed through the Canada Revenue Agency’s administrative practice. Interpretation Bulletin 365R2 “Damages, Settlements and Similar Receipts” restricts the treatment to physical injuries. It applies where the damaging party acquires an annuity that is non-assignable, non-commutable, and non-transferrable to make payments for the agreed upon amount.
A key benefit of this approach is that it encourages the alleged offending party toward settlement. Commonly a lump sum award goes through a gross-up calculation to account for future taxes on investment growth. No such calculation (nor increased cost to the payor) would be required under a structure.
Court-ordered ‘structures’
A structure is an option available for a damage award, not necessarily a mandatory procedure. Still, when the claimant is under a disability a judge may be able to make such an order even if the claimant opposes, if the judge determines that it is nonetheless in the person’s best interests.
In a 2013 judgment, Melvin v. Ontario (Correctional Services), a judge considered whether to order a structured settlement. Thomas Melvin suffered brain injuries at the hands of two other inmates while incarcerated at an Ontario correctional facility in 1997. After four mediation attempts, the matter was eventually settled in 2012. As his litigation guardian, his mother had agreed to the amount of compensation, but subsequently opposed having it paid as a structured settlement.
In addition to submissions from the parties, a report was receive from the Public Guardian and Trustee. The judge allowed a small lump sum amount, but otherwise ordered a structure would be most appropriate for a number of reasons:
- Little or no prospects for Mr. Melvin’s future employment
- Predictable monthly income flows (with some indexing) without need for investment decision-making
- The guardian Mrs. Melvin had no specific investment expertise to counter the guarantee and predictability of a structured settlement
- Preservation of Ontario Disability Support Plan(ODSP) payments that would otherwise be at risk if the lump sum was owned, and/or when taxable income was earned
- Associated benefits from being a continuing ODSP recipient, including better health care coverage
Investing a lump sum payment
Not all injured persons will be so affected that a full structured settlement is necessary. In such cases, some or all of the funds will be paid in the form of a lump sum.
This is a classic situation where a comprehensive financial plan is called for, before making any commitments. The tough balancing act will be to preserve current and future supports, while producing sustainable income.
Initial investment inclination may be toward guaranteed income options such as annuities. Again though, tax considerations should be carefully factored-in, perhaps a combination of annuity income and drawdown of capital from an investment portfolio.