Qualified Settlement Funds and Section 468B (Portfolio 738)

Tax Management Portfolio, Qualified Settlement Funds and Section 468B, No. 738, describes the nature, uses, mechanics and pitfalls of using these funds for dispute resolution. They are authorized by Internal Revenue Code §468B. Since that section was added to the Code in 1986, and especially since the Treasury Department expanded the concept materially in regulations issued in 1993, these dispute resolution mechanisms have literally exploded in growth.

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Tax Management Portfolio, Qualified Settlement Funds and Section 468B, No. 738, describes the nature, uses, mechanics and pitfalls of using these funds for dispute resolution. They are authorized by Internal Revenue Code §468B. Since that section was added to the Code in 1986, and especially since the Treasury Department expanded the concept materially in regulations issued in 1993, these dispute resolution mechanisms have literally exploded in growth.

This Portfolio examines the uses of Qualified Settlement Funds, and their key tax benefits: (1) a deduction to the defendant upon contributing to the fund, even though the plaintiffs may not receive their distributions for months or years; and (2) the QSF being taxed as an entity only on its investment return, not on the contributions it receives from defendants.

Portfolio gives drafting and practice guidance, from the genesis to the termination of a QSF. It considers the perspective of both plaintiff and defense counsel, as well as the trust administration, accounting and compliance duties that maintaining a QSF requires.

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Robert W. Wood is a 1979 graduate of the University of Chicago Law School where he received the Florence James Adams Prize and a University of Chicago Scholarship. He practices law with Wood & Porter, a tax law firm in San Francisco, California (www.woodporter.com). Mr. Wood is a member of the bars of California, New York, Arizona, Montana, Wyoming, Texas, Washington, and the District of Columbia. He is also enrolled as a Solicitor in England and Wales. Mr. Wood is a Certified Specialist in Taxation by the California Board of Legal Specialization.

Mr. Wood is the author of more than 35 books, and has long been recognized as a leading authority and commentator. He is a leading expert on the taxation of damage awards and settlement payments, and is the author of the seminal treatise, Taxation of Damage Awards and Settlement Payments (Tax Institute, Third Edition 2008, available at www.taxinstitute.com). Mr. Wood is also the founder and Editor-in-Chief of The M&A Tax Report (CCH), a national monthly newsletter addressing tax techniques and trends affecting mergers and acquisitions. He is the author of the following BNA Tax Management Portfolios: 66 T.M., Real Estate Mortgages; 547 T.M., Home Office, Vacation Home, and Home Rental Deductions; 548 T.M., Hobby Losses; and 552 T.M., Tax Aspects of Settlements and Judgments. For a complete list of his publications, please visit www.woodporter.com.


Portfolio Description


Technical Advisors


Detailed Analysis

I. Overview

II. Establishing a QSF

A. Establishment Requirements

B. Approval Requirement

1. Consider Venue

2. Arbitration Order or Approval

3. Petition or Motion

4. Proposed Order

5. Selecting a Trustee and/or Administrator

a. Trustee

b. Administrator

6. When to Establish QSF: Consider Tax Issues

7. Time When QSF Is Established

a. Typical Timing

b. Relation-Back Election

c. Time Period of QSF's Existence

C. Resolve Claims Requirement

1. Allowed QSF Liabilities: Will a QSF Work for Your Situation?

2. Disallowed QSF Liabilities

3. Resolve or Satisfy Element

D. Single Claimant Controversy

1. What Constitutes Multiple Claimants?

2. Control and Commissions

3. Doctrine of Constructive Receipt

4. Economic Benefit Doctrine

5. Periodic Payments to Personal Physical Injury Claimants

a. Section 104(a)(2)

b. Section 130 Qualified Assignments of Periodic Payment Obligations

(1) Qualified Assignment

(2) Qualified Funding Asset

c. Revenue Procedure 93-34

6. Unanswered Questions

E. State Law Requirement

III. Drafting the Trust Agreement

A. Overview

B. Trust Agreement Elements

1. Title

2. Trust Property

3. Trust Purpose

4. Identification of Parties

a. Governmental Authority

b. Settlor

c. Beneficiaries

d. Administrator and Trustee

(1) Who Can Serve as Administrator?

(2) Administrator's Functions

(3) Trustee/Administrator or Trustee and Administrator?

(4) Who Can Serve as Trustee?

(5) Transferor as Trustee

(6) Beneficiary as Trustee

(7) Attorney as Trustee

e. Successor Administrators and Trustees

f. Co-Trustees

C. Trustee Duties and Powers

1. Trustee Duties Pursuant to Statutory and Common Law

2. Trustee Duties Specific to QSF Trust Agreement

a. Distribution of Trust Property

b. Termination of Trust

c. Maintenance of QSF Qualification

d. Tax Preparation, Reporting, Withholding, and Related Duties

3. Trustee Powers Under Statutory and Common Law

a. General Trustee Powers

b. Specific Trustee Powers

c. Administrator Powers

D. Compensation, Immunity, and Indemnification

1. Compensation

2. Immunity and Indemnification

IV. Administration of a QSF

A. Initial Administrative Duties

1. Obtain an EIN

2. Establish Bank Account

B. Transfers to a QSF

1. Release of Transferor

a. Timing of Release

b. Administrative Responsibilities Related to Release

2. Dismissal with Prejudice

C. Assets Held by the QSF

D. Tax Filing, Payments, Reporting, and Withholding

V. Defendant Transfers and Deductions

A. Overview

B. Deductibility of Defendants' Settlement Payments

1. General Business Expense Requirements

2. Even Rare Expenses May Qualify as Ordinary and Necessary

3. No Deduction for Capital Expenditures

4. Origin of Claim Analysis

a. Examples of Settlements as Deductible Business Expenses

(1) Financial Reporting

(2) Claims Paid by Individual for Suit Against Business

(3) Products Liability Suit

b. Settlements Constituting Capital Expenditures

c. Origin of Claim Analysis with Legal Fees

(1) Allocations Between Deductible and Capital

(2) Allocations Between Business and Personal

d. Reasonableness of Expenses

e. Trade or Business Nexus

(1) Directly Connected

(2) Required Nexus

(3) Payor Identity

f. Nexus to Income-Producing Activity

5. Timing of Deductions in General

6. Economic Performance in Absence of QSF

a. Tort Liabilities and Workers Compensation

b. Other Deductions for Liability Under § 461(h)

C. Deductions in Presence of QSF

1. Liabilities Allowing Economic Performance upon Transfer

2. Timing of Deductions with QSF

3. Transfers to QSF Where Economic Performance Has Not Occurred

a. Liabilities Not Allowing Economic Performance upon Transfer

b. Refund or Reversionary Rights

c. Transfer of Debt, Service, Property, and Future Payment Obligations

d. Insurance Amounts Received from Insurance Claims

D. Property Transfers to a QSF

1. Sale or Exchange Status

2. Basis of Property Transferred to QSF

3. Taxation Rates for Transferors

4. Limitations on Transferor's Recognition of Gain or Loss

5. No Gain or Loss Realization for Transfer of Section 1.461-4(g) Obligations

6. Debt Is Not Property

7. Nonrecognition for Corporation's Exchange of Stock for Debt

8. Anti-Abuse Rule Regarding Loss Realization

9. Qualified Appraisal

10. Anti-Abuse and Qualified Appraisal Rules Compared

11. No Deduction on Transfer of Amounts in Settlement of Insurance Claims

VI. Determining QSF Income and Deductions

A. QSF Modified Gross Income

1. QSF Taxed on Modified Gross Income

2. Definition of Gross Income

3. Exclusion from Modified Gross Income

4. United States v. Brown

5. Letter Rulings Regarding Modified Gross Income

6. Exclusion for Income of U.S. Government, States, Municipalities, and Possessions

7. Time During Which a QSF Can Earn Modified Gross Income

B. Transfers to and Distributions from a QSF

1. Tax on Sales and Exchanges

2. Basis of Property Distributed

3. Treatment of Transfers to a QSF

a. Transferor's Realization of Gain or Loss

b. Limitations on Transferor's Gain or Loss

c. Examples of Sales or Exchanges upon Transfer to a QSF

C. QSF Deductions

1. Deductions from QSF's Modified Gross Income

2. Deduction for Administrative Costs and Other Incidental Expenses

3. Deduction for Certain Specified Losses

4. Deduction for Net Operating Losses

D. Alternatives to Taxation Methodology

1. QSFs Established After August 16, 1986, but Before February 15, 1992

2. QSF Established After February 14, 1992, but Before January 1, 1993

3. Election to Apply QSF Rules for Post-August 16, 1986 QSFs

4. Grantor Trust Election for QSFs Established After February 3, 2006

a. Only Single Transferors May Make Grantor Trust Election

b. Special Rule for Pre-February QSFs Established by U.S. Government

VII. Distributions and Structured Settlements

A. Distributions

1. Cash Distributions

2. Property Distributions from QSF

a. Basis of Property Transferred to QSF

b. Sale or Exchange Status

c. Treatment of Property Distributions to Transferor

d. Treatment of Property to Claimants

B. Release of a QSF

1. Importance

2. Mechanics

3. Distributions to Charitable Organizations

C. Structured Settlement Distributions

1. Section 104(a)(2)

2. Third-Party Assignees

3. Section 130 Qualified Assignments of Periodic Payment Obligations

4. Qualified Assignments and Qualified Funding Assets

a. Qualified Assignment Elements

b. Qualified Funding Asset Elements

c. Revenue Procedure 93-34

D. Structuring Attorney Fees

1. QSF May Pay Attorney Fees

2. QSF May Facilitate Structured Fee Payments

3. Structure Attorney Fees Carefully

E. Taxable Non-Qualified Structures

1. Non-Qualified Assignment Basics

2. Receipt of Income by Claimant

3. Non-Qualified Assignment by QSF

VIII. Tax Filing, Payments, and Penalties

A. QSF Filing Requirements

1. Administrator Responsible for Income Tax Return

a. Relation-Back Election

b. Grantor Trust Election Exception

2. Filing Deadlines

3. Depository Taxes

4. Other Forms to File

5. Payment Due Dates

a. Ways to Extend Time for Payment

b. File Form 1138 When NOL Carryback Expected

c. Form 1139 Can Extend Payment Deadline

6. Estimated Tax Payments

7. Reporting and Withholding

B. Penalties and Interest

1. Failure to File

2. Failure to Pay

3. Failure to Pay Estimated Tax

4. Other Penalties

a. Trust Fund Recovery Penalty

b. Accuracy and Fraudulent Underpayment Penalties

c. Reporting-Related Penalties

5. Interest

a. Debit Interest

b. Credit Interest

C. When QSF Filing Requirements Apply

1. Filing Requirements During QSF's Existence

2. Request for Prompt Assessment

D. Filing Requirements for Certain Pre-January 1, 1993 QSFs

1. When QSF Filing Requirements May Not Apply

2. Election to Apply QSF Filing Requirements

E. Filing Requirements for a Grantor Trust Election

IX. Tax Reporting Issues

A. Payments and Transfers to a QSF

B. Reporting Payments and Distributions

1. Payments and Distributions

2. Distributions to Claimants

3. Payments to Transferors, or on Behalf of Transferors or Claimants

4. Reporting Requirements Under Sections 6041 and 6041A

5. Section 6041 Reporting Examples

a. Reporting of Attorney Fees for Class Counsel

b. No Reporting When Distributions Are Neither Fixed Nor Determinable

(1) Incentive Awards to Class Representatives

(2) Tax Benefit Rule

(3) Compensation for Destroyed or Injured Capital

(4) Insufficient Information to Know Payment Characterization

c. No Reporting for Amounts Excluded from Gross Income

C. Reporting and Withholding Under Sections 6045, 6049, and 3406

1. Multiple Reporting Requirements

2. Section 6045(a) Reporting Regarding Brokers

3. Section 6045(f) Reporting Regarding Payments to Attorneys

4. Section 6049 Reporting Regarding Interest

5. No Reporting for Amounts that Are Not “Interest”

D. Section 3406 Backup Withholding Requirements

1. Backup Withholding Requirements on Certain Reportable Payments

2. QSF Compliance With Backup Withholding

X. Trustee and Administrator Duties and Powers

A. Permitted Administrators

B. Administrator Duties and Powers

1. Income Tax Returns and Tax Payments

2. Reporting and Withholding

3. Other Administrator Matters

a. Qualified Appraisals and Section 1.468B-3 Statements

b. QSF Transactions

4. QSF Termination

a. Period of Existence

b. Prompt Assessment

c. Request Court Order Confirming Termination

C. Trustee Versus Administrator

XI. Terminating a QSF

A. Period of Existence

B. Prompt Assessment

C. Court Order Confirming QSF Termination

XII. Designated Settlement Funds and Non-QSF Funds

A. Overview

B. Designated Settlement Funds

1. Applicable Definitions

2. Timing of Deductions

3. Taxation of DSFs

a. Modified Gross Income

b. Exclusion from Modified Gross Income

c. Deductions from Modified Gross Income

d. Exemption for CERCLA Settlement Funds Owned by U.S.

4. Distinctions Between DSFs and QSFs

a. QSFs Cover Broader Scope of Claims

b. QSFs Have Fewer Establishment Requirements

c. QSFs Need Not Receive Qualified Payments

d. No Election to Establish QSF

e. DSFs Do Not Require Continuing Court Jurisdiction

f. DSFs Require Administration Independent of Taxpayer

C. Section 1.468B-6 Deferred-Exchange Funds

1. Final Regulations

2. Regs. § 1.468B-6 Addresses Taxation of Escrows, Trusts, and Deferred Exchanges

D. Regs. § 1.468B-7 Pre-Closing Escrow Funds

E. Regs. § 1.468B-8 Contingent-at-Closing Escrow Funds

F. Regs. § 1.468B-9 Disputed Ownership Funds

G. Conclusion


Working Papers

Table of Worksheets

Additional Resources

Worksheet 1 Sample Petition

Worksheet 2 Sample Order

Worksheet 3 Sample Trust Agreement for the Beneficiaries' QSF

Worksheet 4 Release and Indemnity Agreement Between QSF Trust, Claimants/Releasors, and Transferors/Releasees

Worksheet 5 Release and Hold Harmless Agreement Between Claimant/Releasor and QSF/Releasee

Worksheet 6 Petition to Terminate Beneficiaries' Section 468B QSF

Worksheet 7 Proposed Order Terminating Beneficiaries' Section 468B QSF




Treasury Regulations:

Public Laws:

Treasury Rulings: