Qualified Settlement Funds
Called many things--QSFs, 468B funds, qualified settlement trusts or
designated settlement funds/DSFs--these special funds can provide immediate
tax benefits and help facilitate a negotiated settlement in lieu of
litigation.
IRC Section 468B Background and Class Action Litigation
Qualified settlement funds are authorized by IRC Section 468B, which was
enacted in 1986 in response to class action litigation. Federal income tax
law generally holds that a defendant to an action cannot claim an immediate
income tax deduction associated with a settlement arrangement until the
plaintiff(s) receives the funds. Prior to passage of IRC Section 468B,
defendants wanted to be able to claim a deduction for the payment of a
settlement, but without having to wait for the class action plaintiffs and
counsel to agree on distribution arrangements and percentages. In cases
involving complex issues, including those having a large class, the
disbursement process can take months, if not years. IRC Section 468B
provides the mechanism that prevents delays in realizing tax benefits
associated with securing a settlement.
QSF Requirements
IRC Section 468B and the associated regulations set forth three basic
criteria in order for a fund to qualify as a qualified settlement fund (QSF).
First, a QSF must be ordered or approved by a court. In practical terms,
this means seeking approval for the proposed settlement document from a
judge and requesting that the court take jurisdiction over the trust assets.
Great latitude is afforded as to what kind of venue can approve a QSF for a
given matter. It can be a state or federal court. There need not be any
nexus to the underlying litigation. Some practitioners have voiced a
preference for the use of probate courts since they have broad experience in
dealing with trust issues.
The second requirement is that the trust agreement must exist for the
purpose of resolving or satisfying a legal claim. Regulations on this point
cast a wide net, including claims “arising out of a tort, breach of contract
or violation of law. . .” (IRC Reg. Section 1.468B-1(c)(2)(ii)).
The third requirement simply mandates that the QSF document actually qualify
as a trust under state law. Similar to other trust arrangements, anyone with
legal capacity can act as the trustee of the QSF. In fact, accountants often
act as trustee under QSF arrangements. There does not appear to be a minimum
or maximum time frame within which the QSF must endure.
Tax Treatment and Benefits
A federal EIN (Employer Identification Number) must be secured for the trust
by filing Form SS-4 with the IRS. As a separate legal entity, the QSF pays
income tax only on the taxable earnings (over a certain amount) on
contributed funds, not on the amount that a defendant contributes initially
to the trust.
If a defendant’s goal in the settlement context--to secure an immediate
income tax benefit and “wash their hands clean” of the matter--is to be
achieved, one essential requirement exists: The defendant--under the terms
of the QSF--must relinquish all interest in the QSF assets.
Commonly, disputes over tax language and reporting can be an obstacle when
parties are trying to agree on settlement language. QSFs act as a bridge in
this regard: QSF assets are not deemed to have been received by the
plaintiffs -- and therefore no income tax liability is incurred -- until
assets are actually paid out of the QSF. Plaintiffs (and their counsel)
don’t have to realize receipt of the QSF assets while they are still
negotiating with defendants over some of the QSF terms. And defendants have
the ability to simply pay over the agreed-upon amount into the QSF and
secure the tax deduction while other issues are being resolved by the
plaintiffs.
Conclusion
Increasingly, qualified settlement funds are acting as tax-free buffer
zones. Plaintiffs can have time to work out unresolved details without
having adverse income tax consequences attach to QSF assets. Defendants can
claim an immediate income tax deduction for irrevocably providing settlement
funds, without having to wait to claim the deduction and be out-of-pocket
while issues are being finalized.
A QSF should be explored in litigation matters where settlement seems
prudent and the flexibility and benefits of a QSF are evident. From a tax
perspective, QSFs can provide valuable benefits.
You may encounter a situation that lends itself to a QSF. If you do, call a
professional who can assist you in taking advantage of the inherent tax
benefits associated with a QSF arrangement. It can be a win-win situation
for plaintiffs and defendants alike. Please
contact us today.
This newsletter is provided by
Somerset for our clients and other interested persons upon request.
Since technical information is presented in generalized fashion, no
final conclusion on these topics should be made without further review.
For additional information on the issues discussed, please contact
Steve Riddle,
Tom
Thieme,
Rex Collins or
Doug
Ayres
of our
Litigation & Valuation Team.
This document is not intended or written to be used, and cannot be used,
for the purpose of avoiding tax penalties that may be imposed on the
taxpayer.
Somerset CPAs,
P.C.
3925 River Crossing Parkway, Third Floor
Indianapolis, Indiana 46240
317.472.2200 • 800.469.7206 • FAX 317.208.1200
www.somersetcpas.com
