By Robert W. Wood Wood & Porter, A Professional Corporation, San Francisco, CA
Increasingly today, someone involved in litigation is likely to raise the topic of Qualified Settlement Funds. The subject may be broached by a lawyer, client, mediator, judge, or structured settlement broker. Usually, this occurs during settlement negotiations, but it can happen long before.
Section 468B of the Internal Revenue Code provides for a kind of tax-free way station. Variously called a §468B trust, a qualified settlement fund, or a QSF, it is a trust in which monies resolving litigation can repose after the defendant(s) pay a settlement, but before the plaintiffs receive it. Added to the Code in 1986, this provision has certain other ends, but its primary impetus was to secure income tax deductions to defendants. The idea was to enable defendants to claim their tax deductions for settlement payments currently, even though amounts might be tied up among warring plaintiffs for months, or even years.
Although “economic performance” normally keys defendant tax deductions to plaintiff income, §468B offers accelerated deductions. Qualified Settlement Funds (also known as QSFs or 468B funds), are slightly different from Designated Settlement Funds (or DSFs). Section 468B provides for DSFs, and the IRS expanded the concept through regulations in 1993 giving birth to the QSF. QSFs are trusts or accounts set up to resolve claims.
Classically, QSFs were employed in large class actions, where sorting out who is entitled to what, and locating potential class members, can take time. Gradually, however, such vehicles have come to be used in more garden-variety litigation. Today, QSFs are variously used to buy time to iron out final allocations among plaintiffs, determine final attorneys' costs, and facilitate time for plaintiffs to consider structured settlement alternatives. While QSFs are often employed in cases involving many plaintiffs, they are also used where there are just a few plaintiffs.
The normal tax rule is that a defendant cannot claim a deduction until the plaintiff receives the funds. The QSF rules are a big exception to the normal reciprocity between payor and payee in the tax law. Don't underestimate how important this is.
There are three requirements to form a QSF. First and foremost, they must be subject to court supervision. That means you go to court and ask the judge to approve a QSF trust document and take jurisdiction over the assets. Second, the trust has to exist to resolve or satisfy legal claims. Third, the trust must qualify as a trust under state law. These three basic rules are easy to satisfy.
There needs to be a trustee, but there is great flexibility as to who can occupy this role. In fact, even the plaintiff's lawyer can be a trustee, although I would never recommend that. Technically, anyone who has legal capacity can be a trustee (so it could not be a minor or a legally incompetent person). However, the trustee need not be a trust company or a trust specialist. Lawyers and accountants often act as trustees to QSFs.
A court must take jurisdiction over the QSF, but it need not be any particular court. In particular, it need not be a court having a connection to the legal dispute which is being resolved. Thus, you can go to the court that has jurisdiction over the underlying legal dispute, or you can go to a different court. You can use a state court in a federal matter, or vice-versa. You can even go to a probate court. Some advisers prefer this, since probate judges are usually familiar with trusts and trust documents.
The defendant can have no interest in the trust. The defendant wants to claim its tax deduction right away and get out of the case. One of the requirements of the QSF is that, in order for the defendant to claim a tax deduction for the settlement payment, the defendant must relinquish all interest in the money.
Entity Tax Treatment
A QSF must apply for and receive its own Employer Identification Number. The QSF is taxed as a separate entity, basically like a corporation. Notably, however, the QSF is not taxed on contributions from one or more defendants to resolve the claims. Those are nontaxable contributions. The QSF is only taxed on the income it earns on those contributed funds. Usually, that means it is taxed only on interest and dividends.
When to Use a QSF
There are many different circumstances in which forming a QSF makes sense. One circumstance is where the plaintiff and defendant are negotiating a settlement, but they cannot agree on the tax language or tax reporting to be included in the settlement agreement. Forming a QSF can be a nice bridge to such difficulties, allowing the defendant to simply pay over the money, and the plaintiff to worry about the form of the release the plaintiff will later sign with the QSF. You can look at a QSF as a kind of a tax-free way station.
Another circumstance where you may want to form a QSF is in a class action, where all of the plaintiffs haven't been identified. Alternatively, even if they have been identified, you may need to establish a claims procedure to determine exactly who gets what. Traditionally, QSFs were used mostly for class actions.
Today, however, that is no longer true. QSFs are still widely used in class actions, but you don't have to have a class action to have a QSF. You might just need more time to determine exact numbers, to fix final attorneys' fees and costs, etc.
At its most basic, a structured settlement is simply an arrangement calling for payments over time. There are tax, financial planning and asset protection advantages to arranging a structure. A QSF can facilitate structured settlements, generally involving the purchase of annuities that provide regular payments to plaintiffs for a term of years or for life.
In fact, a desire for implementing structured settlements is a common reason for setting up a QSF. The plaintiffs may need time to determine the form of a structure, the exact annuity payout, family needs, etc. Not only that, but structures can be purchased for lawyers from a QSF too. Attorneys' fee structures are also becoming increasingly common. A QSF can give needed time to work out all the details before tax consequences attach to the money.
QSFs are flexible, and there is no express time limit on their duration. In my experience, QSFs usually exist for a relatively short time, sometimes a matter of a few weeks or a few months. In simple cases, that can be enough time to determine who will get what, to investigate and select structured settlements, etc. In complex and large class actions, however, QSFs may exist for several years to resolve claims. There appears to be no outside time limit for how long a QSF can last.
As you evaluate the benefits of a QSF, bear in mind that there are broad statutory and non-statutory doctrines in our tax code--the most complex tax code in the world. People with a little tax knowledge find QSFs odd, since they seem to fly in the face of the normal constructive receipt and economic benefit doctrines that might suggest that plaintiffs and their lawyers are taxable when money is irrevocably set aside for them in a trust. The QSF truly operates as a tax free holding pattern. Monies are not treated as received by the plaintiff(s) and lawyers until they are paid out of the QSF. Yet, the defendant is entitled to a tax deduction as soon as the money is put into the QSF.
Single Claimant QSFs?
One of the most controversial issues today is whether you can legitimately have a QSF with just one claimant. The statute itself and the treasury regulations suggest that a QSF should work fine if you have “one or more” claims. Thus, from a technical viewpoint, I would argue that a single claimant QSF is probably OK.
However, the IRS has repeatedly said it is studying this issue. Not only that, but some structured settlement industry insiders have urged Treasury to come down one way or the other on the point. Because of this, I urge caution.
Although the statute seems to support single claimant funds, there is no guidance, and the IRS is thinking about this issue. The structured settlement industry is quite polarized on this point. Personally, I always want to have at least two claimants, but there is even debate about what we mean by two or more claimants.
For example, in considering what multiple claimants should mean, are husband and wife enough? What about lawyer and client, since the lawyer's share of the case generally also gets into the QSF? Optimally, of course, there will be two or more named claimants, but it is not crystal clear that is required.
I would avoid the single claimant debate whenever possible, even though ultimately, I predict single claimant funds will eventually be OK'd. Moreover, if I'm wrong and they are disallowed, I think the disallowance is likely to be prospective only. Nevertheless, if you can avoid this issue entirely until it is resolved, you are better off.
QSFs are tremendously flexible, and their uses are increasing. Class action lawyers are used to these vehicles, but many lawyers (both plaintiff and defense lawyers) are surprised when they hear about the fundamental benefits of a QSF, which stand as a huge exception to fundamental constructive receipt and economic benefit tax rules. Both plaintiffs and defense counsel can use a QSF for making the settlement process much smoother, much more efficient, and much more closely tailored to what the plaintiffs (and the plaintiff's counsel) really need and want.
For more information, in the Tax Management Portfolios, see Wood, 522 T.M., Tax Aspects of Settlements and Judgments, and in Tax Practice Series, see ¶1340, Payments Made Pursuant to Judgements and Settlements.
1 Robert W. Wood practices law with Wood & Porter, in San Francisco, and is the author of Taxation of Damage Awards and Settlement Payments (Tax Institute 3rd. ed. 2008) available at www.taxinstitute.com. This discussion is not intended as legal advice, and cannot be relied upon for any purpose without the services of a qualified professional.
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