Qualified Settlement Funds Offer Bountiful Benefits
By Robert W. Wood
Wood & Porter, A Professional Corporation, San Francisco, CA1
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.
QSF Requirements
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.
Conclusion
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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