SMA’s are tax free awards to the original annuitant. Because of this, annuity carriers do not issue 1099′s to the recipients or to subsequent assignees.
Federal law and IRS guidelines per IRS 5891 outline how, in a properly structured transaction, a buyer becomes the assignee of an existing payment stream by means of qualified order, and the contractual right to the payments verifies that it is a valid transfer. This is the process we follow on all cases.
So while under current IRS regulations buyers will not received a 1099 for the income they receive, this does not mean it’s tax-free.
Even though the original payee does not receive a 1099, subsequent investors do have a cost basis in the payments and a gain, and therefore are responsible for income taxes.
The taxation of income from Secondary Market Annuities held in non-qualified accounts is up to the taxpayer and their tax adviser to declare. Generally annuities are considered ordinary income and the income vs principal is calculated using an exclusion ratio to determine (exclude) from income that amount of each payment that is return of principal. Refer to the following IRS rules for guidance and consult your tax adviser for specific questions.
How To Calculate The Exclusion Ratio:
Obviously, investors have a basis in an SMA investment, and a gain on that investment. The typical way to calculate the gain is to utilize an exclusion ratio for determining the principal and interest component of each payment.
Let’s look at an example of an exclusion ratio. Assume the investor paid $100,000 and will receive $200,000 over 100 payments of $2000 each. The exclusion ratio is 50%- Exactly 50% of each payment would be income, and 50% is return of principal. Consult your adviser, but generally, this income is “ordinary income” for IRS purposes.
There are other ways to reflect a payment stream where you use an amortization schedule, and one will be provided with your SMA purchase.
This method however treats the SMA like a loan (and you are the lender) and recognizes interest income predominately in early years, and principal in latter years. This may not be beneficial for you.
At this time, it’s our understanding you can use either the amortization method, or the exclusion ratio method, to calculate your taxes. But be sure to consult your own tax adviser.
SMA Amortization Schedules:
The software the Structured Settlement industry uses is called T-Val and is used for calculating present value and discounted notes, as well as amortization tables for loans. With each SMA purchase, you will receive an amortization schedule produced by TVal that shows the principal and interest portion of each payment under the amortization method.
The exclusion ratio is more intuitive than the amortization table. Feel free to view this article for more information on the exclusion ratio, in plain English and not tax-speak!
Other Tax Considerations:
In the case of factored lottery cases, taxes are withheld by the state lottery commission for state and federal taxes, and you will file for an applicable state and federal refund for the taxes withheld on that portion of your payment which is return of capital (basis).
SMA & Taxes Summary:
So even though investors do not receive a 1099 for the payments from the carriers based on current tax law, what happens in the future to tax law is anyone’s guess. Some may use an amortization schedule to calculate gains, and others use the exclusion ratio.
We at Annuity Straight Talk LLC do not offer tax advice, and this page is for general information only, so please be sure to consult your own tax adviser for more info.