Qualified Settlement Funds: A Legal and Financial Analysis ...

Qualified Settlement Funds: A Legal and Financial Analysis Showing Why They
Can Be So Beneficial To You and Your Client
Peter H. Wayne IV and Matthew L. Garretson
© Civic Research Institute, Inc.
(reprinted with permission)

Qualified Settlement Funds:
A Legal and Financial Analysis
Showing Why They Can Be So
Beneficial To You and Your Client
Counsel should provide himself or herself with the opportunity to focus on the areas of law the client hired him or
her to advocate and let the QSF serve as a safety net.
PETER H. WAYNE IV AND MATTHEW L. GARRETSON
The richest person in the Entertainment Industry,
David Geffen, once said, “It’s the perfect
definition of a settlement – both parties
didn’t get what they wanted.” Fortunately, Qualified
Settlement Funds (“QSFs”) allow a claimant or
claimants involved in a legal dispute to avoid such a
result. QSFs were established to enable claimants and
defendants to determine how and when settlement
funds are taxed and deductions obtained. Further,
they are a valuable settlement tool whereby claimants
can address critical settlement-related issues
without the stress of settlement negotiations, because
they release defendants from alleged tort (or other)
liability through the doctrine of novation. QSFs,
therefore, are both a useful settlement tool and
Matthew L. Garretson is the founding partner of The
Garretson Law Firm which provides mass tort/class
action settlement allocation and fund administration
services. The firm also handles Medicare / Medicaid
reimbursement claims, government benefit preservation
strategies, and probate administration for individual
and mass tort plaintiffs. Mr. Garretson received his BA
from Yale University and his law degree at Kentucky’s
Salmon P. Chase College of Law and has served
as the special master or administrator of settlement
funds throughout the country. His role in numerous
high profile church-related sexual abuse and civil
rights settlements (including the historic Cincinnati
police brutality/racial profiling settlement) led to his
selection by Lawyers Weekly as 1 of 5 “Lawyers of
asset providing unique tax benefits to claimants and
defendants alike.
LEGISLATIVE HISTORY
The framework for the QSF was created by Congress
in 1986 when Tax Reform Act 1 added Section 468B
to the Internal Revenue Code.
Section 468B regulates the establishment and
administration of Designated Settlement Funds or
1
PL 99-514.
the Year” in Ohio for 2003. He was nominated by his
peers and selected as an Ohio Super Lawyer – Rising
Star in 2005 and 2006. His work was featured in the
LA Times in January of 2005. Peter H. Wayne, IV
earned his undergrad degree in Finance from Miami
University in Ohio and his JD at the Salmon P. Chase
College of Law. While in Law School, Peter worked
for the Garretson Law Firm, LLC in Cincinnati, Ohio
managing the Qualified Settlement Fund Administration
practice and providing counsel in tax advisory,
government benefit preservation and health lien
resolution. Following his graduation he returned home
to Louisville, Kentucky to open a regional office for the
Garretson Law Firm, LLC, enabling the firm to better
serve their Kentucky and Southeastern clients. Mr.
Wayne is also a Kentucky-licensed settlement planning
consultant. The Garretsonfirm web address is www.
garretsonfirm.com.
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“DSFs.” 2 Not only did DSFs arise to assist in class
action lawsuits, but also to allow insured and selfinsured
defendants to determine when their settlement
payments are deducted. 3 Once DSFs were available,
it was only a matter of time before their use was
extended. That extension came from 1992 Treasury
Regulations, 4 which became effective on January
1, 1993. 5 Those Treasury Regulations set forth the
following three requirements for a settlement fund,
account or trust to be treated as a QSF: 6 A fund,
account, or trust satisfies the requirements of Reg.
1.468B-1(c) if:
QSFs were established to enable claimants and
defendants to determine how and when
settlement funds are taxed and deductions obtained.
• It is established pursuant to an order of, or be
approved by, the United States, any state (including
the District of Columbia), territory, possession,
or political subdivision thereof, or any
agency or instrumentality (including a court of
law) of any of the foregoing and is subject to
the continuing jurisdiction of that governmental
authority;
• It is established to resolve or satisfy one or
more contested or uncontested claims that have
resulted or may result from an event (or related
series of events) that has occurred and that has
given rise to at least one claim asserting liability
(I) Under the Comprehensive Environmental
2
26 USC 468B: A DSF is defined as (A) which is established
pursuant to a court order and which extinguishes completely
the tort liability of the defendant or the defendant’s insurance
carrier to the plaintiff, (B) with respect to which no amounts
may be transferred other than in the form of qualified payments,
(C) which is administered by persons a majority of whom are
independent of the defendant or the defendant’s insurance carrier,
(D) which is established for the principal purpose of resolving and
satisfying present and future claims against the defendant (or any
related person or formerly related person) arising out of personal
injury, death, or property damage, (E) under the terms of which
the defendant (or any related person) may not hold any beneficial
interest in the income or corpus of the fund, and (F) with respect
to which an election is made by the defendant.
3
John J. Campbell, “468b Qualified Settlement Funds in Single
Claimant Plaintiff Physical Injury Settlements,” The Medicare
Set Aside Bulletin, Issue 18 (August 1, 1005). (QSFs came about
to help in class action lawsuits where the individual shares of a
settlement to various class members are not determined and to
allow insured and self-insureds to deduct their settlement payments
when made as opposed to when a settlement trust trustee
disburses the funds).
4
Reg. 1.468B-1.
5
See Restatement (Second) of Contracts, section 280 (1981).
6
Reg. 1.468B-1.
Response, Compensation and Liability Act of
1980 (hereinafter referred to as CERCLA), as
amended, 42 U.S.C. 9601 et seq.; or (II) Arising
out of a tort, breach of contract, or violation of
law, or (III) Designated by the Commissioner in a
revenue ruling or revenue procedure; and
• The fund, account, or trust is a trust under applicable
state law, or its assets are otherwise segregated
from other assets of the transferor (and
related parties). 7
It is no coincidence that the requirements for a QSF
and DSF are so similar. The requirements for a QSF,
although not specifically mentioned in Section 468B,
clearly fall within the realm of a DSF. 8 As mentioned
above, the impetus behind the QSF was to merely
extend on the DSF; the only difference being that
a QSF allows for a broader range of claims to be
considered, including environmental and breach of
contract claims. 9 The legislature simply wanted the
benefit of the DSF to reach a larger audience.
WHY A QSF?
QSFs are useful tools that ensure proper client
counseling can occur before, during, and even after
settlement. QSFs uniquely introduce a degree of
breathing space to the settlement process that is made
valuable by:
1. Allocating the settlement proceeds among the
claimants;
2. Verifying and negotiating liens and / or subrogation
claims;
3. Determining the appropriate role and underwriting
10 of a structured settlement annuity;
7
Reg. 1.468B-1(c).
8
See U.S. v. Brown, 334 F. 3d 1197 (10th Cir. 2003) and John
J. Campbell, “468b Qualified Settlement Funds in Single Claimant
Plaintiff Physical Injury Settlements,” The Medicare Set Aside
Bulletin, Issue 18 (August 1, 2005).
9
Don McNay and William Garmer, “Is a qualified settlement
fund right for your client?” Trial Magazine (January 2002.
10
Unless provided with evidence to the contrary, annuity
companies assume a claimant has a normal medical condition
and, therefore, a normal life expectancy. As a result, published
annuity rates are by sex and age only. However, substandard
(i.e., lower) annuity rates are available if the annuity company
is provided with evidence that the claimant’s life expectancy is
less than normal. Many serious injuries can reduce a claimant’s
life expectancy. However, it is not necessary that the reduced
life expectancy be caused by the injury that is the subject of the
claim. Any claimant, therefore, may qualify for a substandard
rate. Physicians who are employed for that purpose by the annuity
companies make the evaluation of a claimant’s life expectancy.
Their evaluation is based on a review of medical information
provided to them.
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4. Evaluating the need to preserve governmental
entitlement benefits (e.g. the need for the establishment
of a special needs trust); and
5. Enabling a host of other decisions to be made
without the pressure associated with the litigation
itself.
This breathing space is made available because, as
mentioned above, while temporarily parked in the
QSF, the assets are not constructively received by or
an economic benefit to a claimant.
Furthermore, given the valid concerns that lawyers
have about adding unreasonable delay or expense to
the transfer of settlement funds to clients, QSFs may
be created and administered to:
1. Facilitate placement of a structured settlement
annuity without requiring the signature / participation
of the defense; 11
2. Resolve and satisfy any and all private companies
or government agencies that may have a
reimbursement right or lien against a claimant’s
settlement amount.
3. “Fast track” the payment of settlement proceeds
to those clients who determine quickly that they
are not interested in any form-of-settlement
options besides a lump sum award; 12
4. Minimize expenses to settlement; 13
5. Make monies available to settle claims and while
not being subject to the defendant’s creditors;
11
Section 130(c) “qualified assignment means any assignment
to make periodic payments as damages, or as compensation under
any workmen’s compensation act, on account of personal injury or
sickness if the assignee assumes such liability from a person who is
a party to the suit or agreement, or the workmen’s compensation
claim and if the other factors of Section130(c) are met. Rev. Proc.
93-94, 1993-2 CB 470, provides the rules by which a QSF will be
considered “a party to the suit or agreement, or the workmen’s
compensation claim” for purposes of Section 130(c).
12
If the “form-of-settlement” component of the clientcounseling
model is employed early, lawyers should be able to
identify these clients prior to settlement and shape the QSF motion
practice to allow the QSF Administrator to transfer funds to these
“fast track” clients as soon as the defendant tenders the settlement
proceeds to the QSF.
13
For instance, if the administer is appropriately licensed, his
or her fee might be offset by (1) a portion of the standard money
management fees charged by the financial institution at which the
funds are on deposit; and /or (2) a potion of the interest earned or
growth on the proceeds while they are invested in the QSF fund -
This is similar to most escrow arrangements wherein interest is not
applied to the fund corpus due to the higher cost of administration;
and / or a portion of the structured settlement commission payable
to a broker when certain clients chose to structure all or part of
their settlement award. Such cost-saving arrangements should be
disclosed to the client and / or approved by the court as part of
the 468B fund pleadings.
6. Allow monies to earn interest for the benefit of
the plaintiff (unlike a typical Interest on Lawyers’
Trust Accounts (“IOLTA” account).
QSFs also permit defendants to disengage from litigation
and qualify for economic performance. Payments
made by defendants are in exchange for a release from
the present claimants and possible future claimants.
Once a payment is made to a QSF, the litigation
process will cease for a defendant, thereby reducing
Payments made by defendants are in exchange
for a release from the present claimants and
possible future claimants.
legal costs and freeing the resources being used in such
litigation. Further, QSFs permit defendants to deduct
their payments to a QSF as if the defendants had paid
claimants directly or paid into an irrevocable and
unconditional fund established to receive payments
for the benefit of claimants, thereby permitting a current
income tax deduction if available.
The ability of defendants to be completely released
from present and future claimants, despite a cause of
action remaining alive, is permitted through the legal
doctrine of novation (party substitution), which has
the added affect of adding a new party as substitute
obligor who was not a party to the action (the new
party is always the QSF Administrator), and discharging
the original defendants by agreement of all the
parties, completely extinguishing any alleged liability
of defendants. 14
A DEEPER BENEFIT – LIEN RESOLUTION
As mentioned above, QSFs introduce an amount of
breathing space after a settlement value is determined
that is not otherwise available. This breathing space
will allow the lawyer to concentrate on any potential
liens that may exist against a client’s settlement.
Why is this important? In torts, resolution of health
care liens represents a great deal more than merely
an administrative function. Personal injury lawyers
traditionally develop expertise in litigation and tort
law relevant to establishing the plaintiff’s personal
injury claim. The law and legal processes relevant to
14
If the “form-of-settlement” component of the client-counseling
model is employed early, lawyers should be able to identify
these clients prior to settlement and shape the 468B motion practice
to allow the 468B Administrator to transfer funds to these “fast
track” clients as soon as the defendant tenders the settlement
proceeds to the 468B.
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vindicating personal injury claims are distinct from
developing law and legal processes relevant to evaluating
a health care plan’s right of recovery and resolving
the plan’s reimbursement claims and liens. Further, as
For certain clients the lien resolution strategy
may arguably be as important a factor in the
client’s final “net” (in pocket) recovery as any
other aspect of proving and litigating the case.
seen in recent settlements, for certain clients the lien
resolution strategy may arguably be as important a
factor in the client’s final “net” (in pocket) recovery
as any other aspect of proving and litigating the case.
Equally important, the process also must ensure that
plaintiffs’ future benefits will not be denied as a direct
result of improperly considering the agencies’ interest
in any settlement.
The “broad sweep” of expenditures that Medicare,
Medicaid, private health insurers, and the
Department of Veterans Affairs may attempt to
recover must be vigorously evaluated and audited.
For instance, in light of recent changes in lien-related
laws and regulations, it is imperative to scrutinize
carefully the nature of the damages that were
originally claimed by plaintiffs; the objective compensation
criteria utilized to allocate the aggregate
settlement proceeds; as well as the language in the
release to determine what the health care agencies
may be entitled to recover.
By establishing a QSF, counsel is able to avoid
tackling both the client’s tort action and subrogation
action simultaneously; settle the underlying tort
case, remove the defendant from the equation, and
then allow counsel to focus on any subrogation issues
that might exist. While it is likely still advisable to
hire outside counsel to resolve the liens that relate to
a settlement, a QSF allows counsel to take the time
necessary to locate a reputable firm to perform this
service and furthermore, it allows that firm the peace
of mind in knowing that they possess the time necessary
to adequately consider the client’s situation and
how those liens may affect their final recovery. Lastly,
it is important to note that a QSF not only permits
the lien resolution process to proceed with no further
involvement from a defendant, but also takes the
pressure off of counsel and his or her client to quickly
determine how their receipt of the settlement proceeds
will affect their government benefits. Time is likely
an attorney’s most valuable tool when dealing with
government benefits preservation and lien resolution.
Thus, a QSF is exactly that – TIME.
ESTABLISHING A QSF
In order to establish a QSF, counsel must ensure that
all of the requirements set forth in Reg. 1.468B-1
are met. The most common way a QSF is established
is through court order. Pursuant to Reg. 1.468B-
1(c)(1), courts possess the authority to sign an order
creating a QSF. Further, in United States v. Brown,
the Tenth Circuit Court of Appeals stated that a
“[Qualified Settlement] Fund satisfies subparagraph
(1) of § 1.468B-1(c) if it is established pursuant to
an order of … a court of law.” 15 Because a Court has
jurisdiction over an underlying litigation, it also has
jurisdiction over the establishment of a QSF which
is created to resolve the settlement matters relating
to the legal dispute.
The second prong of Reg. 1.468B-1 is satisfied so
long as the QSF is established to resolve a claim arising
Under CERCLA or arising out of a tort, breach of contract,
or violation of law, or designated [an acceptable
claim] by the IRS Commissioner in a revenue ruling
or revenue procedure. It is important to note that a
QSF may not be established to resolve a claim arising
under (1) a worker’s compensation act or self-insured
plan; (2) an obligation to refund the purchase price
of, or to repair or replace, products regularly sold in
the ordinary course of the taxpayer’s trade or business;
(3) an obligation of the taxpayer to make payments to
its general trade creditors or debt holders that relates
to a bankruptcy case, or a work-out; or (4) a designation
[an unacceptable claim] by the commissioner in
a revenue ruling or a revenue procedure. 16 The third
prong of the QSF establishment requirements demand
that the QSF be in conformity with the situs state’s laws
regulating the formulation of trusts or that its assets be
segregated from the other assets of the transferor.
Lastly, while it is typical for all of these elements
to be present simultaneously, they need not be. For
example, the treasury regulations provide that if there
is a fund that meets the criteria for both the second
and third prongs of Reg. 1.468B-1, but has yet to
obtain an order authorizing its establishment, the
transferor and the settlement fund administrator can
make an “election back” for the fund to be a QSF
upon the later of (1) the date the requisite purpose
and asset segregation or trust tests have been met or
(2) January 1 of the calendar year in which requirements
1, 2 and 3 are met in totality. 17
Procedural Process. The claimant or defendant moves
for the entry of an order by the court to (a) establish
15
U.S. v. Brown, 348 F.3d 1200 (2003).
16
Reg. 1.468B-1(g).
17
Reg. 1.468B-1(j).
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a QSF and (b) completely release any liability of the
defendant and its liability insurer once the insurer
pays the agreed-upon settlement amount in the QSF’s
account. The motion is to stipulate that the claimants
and the Fund Administrator will agree to the terms
of the Fund Administrator’s allocation of the amount
placed in the QSF through the execution of fund agreements
and releases 18 . The motion is to further specify
that no settlement proceeds are to be set apart for any
individual claimant, or otherwise made available so
that he or she may draw upon or otherwise control
said settlement proceeds.
Next, the motion should authorize the fund administrator
to distribute immediately all attorney fees to
counsel for claimants consistent with existing contingency
fee contracts, 19 and state that further court
approval for such fee distribution shall only be necessary
to the extent required by law (i.e., for minors or
incompetents). The motion should also state that as
soon as possible after the entry of the order, the fund
administrator will file with the court a declaration of
supporting materials setting forth:
1. The release and indemnity agreement, completely
extinguishing the defendant’s liability;
2. The claimants’ agreement for allocation and
form of the settlement; and
3. The agreement and release between the QSF and
individual claimants (“fund agreements”).
It is important that the claimant or defendant also
move for the entry of an order by the court (a) appoint
a QSF fund administrator, 20 and (b) establish terms
of the QSF. This motion should be simultaneously
submitted with the entry of an order.
Next, the claimant or defendant moves for the
entry of an order by the court (a) to approve settlement
with the defendant, and (b) for dismissal with
prejudice of the defendant(s). Once the court executes
this order the defendant’s only remaining requirement
18
The fund agreements and releases must state that, as part
of the release and indemnity agreement, the defendant paid and
clients consented to certain sums in full and final settlement of all
claims that the claimants had or may have against the defendant.
In addition, the agreement shall specify claimants enter into the
fund agreements and releases in order to provide payments in full
settlement and discharge of all claims against the QSF that are or
might have been subject to the original lawsuit.
19
The fund administrator distributes attorney’s fees and costs
upon receiving an affidavit by the attorney and finding it to be
in compliance with the contingent fee agreement relating to the
claims for which the settlement proceeds are being received by
the Fund.
20
The Fund administrator must submit themselves to the
jurisdiction of the court for purposes of proceedings relating to
this appointment.
is to provide the fund administrator with the information
statement set forth in Reg. 1.468B-3(e)(2). This
statement must provide for the amount transferred
to the QSF, including identifying information for the
transferor and the QSF (name, address, and taxpayer
identification number), the date of transfer, and the
amount transferred. The statement must be provided
by February 15 of the year following the date of this
order.
The most common way a QSF is established is
through court order
Lastly, the fund administrator is to petition the
court for (a) approval of distribution to the plaintiffs,
and (b) certification of fund agreements. The petition
states that the fund administrator certifies that fund
agreements and releases were reached for all claims
of which the Fund Administrator possesses actual
knowledge, and requests the court to enter its order
authorizing disbursement of the funds pursuant to
those fund agreements and releases.
WHAT THE SETTLEMENT AGREEMENT
MUST SAY
The importance of the language contained in a settlement
agreement cannot be overstated. A QSF allows
for the time necessary to resolve all liens for injuryrelated
payments made by the both private companies
and governmental agencies as well the time necessary
to choose the appropriate income stream to both
meet a claimant’s needs and protect their government
benefits. A QSF can be rendered useless if the
language in a settlement agreement can be construed
as bestowing an economic benefit on or constructive
receipt to the claimant. Such a construction would
eliminate the ability to capitalize on the tax benefits
of a structured settlement and jeopardize a claimant’s
government benefits.
In order to ensure that the client avoids such pitfalls,
it is important that the settlement agreement
recite the following:
This Release is given in exchange for a $100,000
payment by the Releasees into the ___Jon Doe___
Qualified Settlement Fund. The receipt for which
will be acknowledged, and the funds distributed
according to the terms and conditions of the Order
establishing the ___Doe___ Qualified Settlement Fund
and Appointing the Fund Administrator issued by
the Probate Court of Alpha County (State of Beta).
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Releasees further agree to enter into Fund Agreements
with the Fund Administrator, in which they accept the
Fund Administrator’s allocation of their derivative,
separate or other claims.
Further, and equally as important, is that the
Defense or their insurer make their settlement payment
made payable to “___Alpha Beta___ as Fund
Administrator of the ___Doe___ Qualified Settlement
Fund.” Making the check made payable to the
settlement administrator as administrator of the QSF
eliminates a potential argument from the IRS that
the receipt of funds by the Fund Administrator was
constructive receipt by or an economic benefit to
the claimant. By confirming that both the settlement
agreement and the settlement payment language mirror
the above, counsel is protecting the client from
any subsequent claim of taxation by the IRS.
MAKINGS OF A FUND ADMINISTRATOR
The claimant’s counsel should qualify potential fund
administrators with the same standards that they use
for other experts to whom they turn to for assistance
in resolving client matters (i.e., physicians, investigators,
expert witnesses, etc.). 21 For instance, does the
candidate fully comprehend to following?
Motion Practice. Has he or she drafted such documents
in the past? Has he or she served as a fund
administrator before?
Allocation Issues (conflict/tax/public benefits/
liens). Does he or she understand how to avoid the
multiple plaintiff conflicts consistent with the ABA
Model Rules of Professional Conduct for lawyers?
Does he or she understand how to allocated proceeds
between wrongful death and survivorship in order
to minimize tax implications? Does he or she understand
the client’s public benefits? (I.e., is it helpful or
harmful to allocated proceeds to the derivative claim
of the parent of an injured child on Medicaid?) Does
he or she understand how to allocated an individual
plaintiff’s damages amount pain and suffering, medicals,
wage loss etc.
Tax Filing Procedure . Does he or she fully understand
the tax filing and accounting requirements:
obtaining W9 forms from all attorneys that are to be
paid from the QSF; obtaining the taxpayer ID number
for the QSF fund; Preparing quarterly estimated
tax payments for the QSF; maintaining accounting
records necessary to complete tax return for the
QSF; preparing Form 1099’s for all attorneys (and
21
Compare Smith v. Farber, 704 A.2d 569 (N.J. Super. App.
Div. 1997) and Swann v. Waldman, 465 A.2d 844 (D.C. 1983) and
Geller v. Harris, 685 NYS2d 734 (N.Y. App. Div. 1999).
claimants if required); preparing the annual tax return
for Qualified Settlement Fund; and final accounting
and affidavit?
TAX BENEFITS
The Defendant. As previously mentioned, QSFs arose
largely as a result of insured and self-insured defendants
wanting to deduct their settlement payments in
the year in which a payment is made to a QSF, rather
than the year a settlement administrator decides to disburse
those funds. A defendant is permitted to deduct
the transfer of cash into a QSF without recognizing a
gain or a loss in the year in which the payment into
the QSF is made. However, if a defendant decides
to transfer property, the defendant must account for
the gain or loss on the transfer equaling the difference
between the fair market value of the property
and the taxpayer’s income tax basis in the property. 22
In such a scenario, the defendant will be permitted a
deduction for the transfer into the QSF equal to the
fair market value of the QSF, but certain types of nonpublicly
traded securities or partnership interests must
be accompanied with a “qualified appraisal.” 23
The Claimant. Often the most important aspect of a
QSF is how the settlement proceeds held in a QSF
are recognized by a claimant or claimants from a tax
standpoint. If the QSF and settlement agreement are
drafted properly and the settlement payment is made
payable to the Fund, then a claimant need not recognize
a taxable event until a payment is received from
the QSF itself. Once a disbursement is made from the
QSF to a claimant, the claimant will need to report its
receipt to the IRS and will be taxed on its receipt as if
the defendant had paid the claimant directly. Therefore,
if the payment by the defendant into the QSF
was in lieu of lost wages due to the claimant, then the
QSF’s payment to the claimant must be recognized as
wages and taxed accordingly. But, if the defendant’s
payment into the QSF was as a result of personal
injuries suffered by the claimant, the claimant could
avail itself of Section 104(a)(2)’s personal injury
tax exemption and possess the monies tax free. The
essence behind a claimant’s ability to avoid recognizing
22
George W. Kuney, Qualified Settlement Funds: A Tool to
Shelter Gains and Taxable Income with Payments on Account of
Disputed Claims, 24 Calif. Bankr. J. No. 2, pgs. 137-144 (1998)
Citing Treas. Reg. 1.468B-3(a)(1)
23
George W. Kuney, “Qualified Settlement Funds: A Tool to
Shelter Gains and Taxable Income with Payments on Account of
Disputed Claims,” 24 Calif. Bankr. J. No. 2, pgs. 137-144 (1998)
citing Reg. 1.468B-3(b).
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a taxable event upon the defendant’s payment into the
QSF is such payment’s failure to be neither constructive
receipt, economic benefit, nor a cash equivalency.
Constructive Receipt. Section451 provides that “the
amount of any item of gross income shall be included
in the gross income for the taxable year in which
received by the taxpayer.” 24 Treasury Regulations help
further refine the definition of constructive receipt
by stating, “gains, profits, and income are received
by the taxpayer are to be included in gross income
from the taxable year in which they are actually or
constructively received by the taxpayer.” 25 Further,
the Treasury Regulations state, “income, although
no actually reduced to taxpayer’s possession, is constructively
received in the taxable year during which
it is credited to this account, set apart for him, or
otherwise made available so that he may draw upon
it at any time, or so that he could have drawn upon
it during the taxable year if notice of intention to
withdraw had been given. 26 But, income is not constructively
received if the taxpayer’s control is subject
to substantial limitations or restrictions. 27
While a defendant’s payment into a QSF in order to
settle an existing lawsuit is a payment into a fund, it
is not into such a trust or fund that allows the claimant
the ability to draw upon the settlement monies
at any time or withdraw funds by providing notice
to the settlement administrator. The QSF is created
to help fully settle claims that exist between the
defendants and claimants. While the total settlement
value is finalized upon the defendants’ payment into
the QSF and subsequent release, the claimants’ claims
are still alive and the portion that is to be disbursed
to the claimants is yet to be determined. The fund
administrator is to settle fully the existing claims with
the approval of and upon the order of the court by
entering into subsequent qualified settlement fund
agreements and releases (the “Fund Agreements”)
with persons or entities asserting those claims. Until
such time that Fund Agreements are executed, no
settlement proceeds are to be set apart for claimants,
or otherwise made available so that they may draw
upon or otherwise control said settlement proceeds.
The substantial limitations placed on a claimants’
receipt of settlement proceeds quashes the potential
for constructive receipt to exist.
Economic Benefit Doctrine. The economic benefit
doctrine developed from case law and requires a
determination that the actual receipt of property or
the right to receive property in the future confers a
24
Section 451.
25
Reg. 1.451-1(a) (as amended in 1999).
26
Reg. 1.451-2(a) (as amended in 1979).
27
Id.
current economic benefit on the recipient. Sproull
became the seminal case on this doctrine and set
forth the required elements, which are, as restated in
Thomas v. U.S .:
1. There must be some fund in which money or
property is placed;
2. The fund must be irrevocable and beyond the
reach of the creditors of the party who transferred
the funds to the escrow or trust; and
3. The beneficiary must have vested right to the
money, with the receipt conditioned only on the
passage of time. 28
While a defendant’s payment into a QSF would satisfy
both of the first two elements of the economic benefit
doctrine, a QSF beneficiary (the claimant) would never
satisfy the third element because claimants do not
possess vested rights in the money that is placed into
a QSF until the settlement administrator determines
a claimants allocated portion of the settlement monies
and enters into and executes with court approval
a fund agreement with the claimants and disburses
the cash from the QSF to them. All of these requirements
stand in stark contrast to the economic benefit
doctrine’s requirement that the claimant’s possession
be conditioned solely on the passage of time.
Cash Equivalency Doctrine . The cash equivalency
doctrine is another common law doctrine that the IRS
attempts to use on occasion to find future payments or
rights to payments taxable in the year an agreement
is made as opposed to the year in which the money
is physically received. The doctrine is defined quite
well in Cowden , 29 where the court said:
If promise to pay of a solvent obligor is unconditional
and assignable, not subject to set-offs, and is of a kind
that is frequently transferred to lenders or investors at
a discount not substantially greater than the generally
prevailing premium for the use of money, such promise
is the equivalent of cash and taxable in like manner
as cash would have been taxable had it been received
by the taxpayer rather than the obligation. 30
A defendant’s payment of settlement monies into
a QSF is neither unconditional nor assignable by the
claimant. Further, the payment is subject set-offs as
a result of potential third parties that may possess a
subrogation interest in a claimants recovery. As mentioned
previously, there are several steps that must be
28
Sproull, 16 TC 244, 247 (1951), aff’d. 194 F. 2d 541 (6th
1952); Thomas v. U.S. 45 F. Supp. 2d. 618, 620 (1999), aff’d. 213
F. 3d 927 (6th 2000).
29
289 F. 2d 20 (1961).
30
Id.
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accomplished before a claimant possesses any rights
to the monies that are placed into a QSF and those
very steps help to eliminate the potential application
of the cash equivalency doctrine.
Single Claimant QSF. There exists significant
debate over whether a QSF is a viable settlement
tool for a single claimant involved an in injurious
incident where no other derivative action at law
exists. The main arguments in opposition to the
single claimant QSF are the same taxation doctrines
that apply to multiple claimant QSFs – “economic
benefit” and “constructive receipt.” Similar to above
neither doctrine is triggered by a single claimant
QSF.
First, neither the definition above for economic
benefit nor the IRS’ definition from PLR 200138006,
“In order for a taxpayer to include an amount in
income under this doctrine, the amount must be set
aside irrevocably, for the taxpayer’s sole benefit,
without restrictions or conditions based upon the
occurrence of future events,” captures a claimant’s
position with respect to a QSF. 31 The money that
The QSF’s basis in property that is distributed or
sold is the fair market value of the property on
the date of its transfer to the fund.
is placed in a QSF, as discussed above, is not set
aside for the taxpayer’s sole benefit and possesses
a multitude of conditions and restrictions that are
based on future events. Second, the fact the a taxpayer/claimant
must execute fund agreements with
the Fund Administrator in order to receive his or
her share of the QSF settlement proceeds stands in
direct contrast to the definition of constructive receipt
regardless of whether the QSF involves a claimant or
claimants. Third, in addition to the arguments that
stand in opposition to either the economic benefit or
constructive receipt doctrines, Rev. Rul. 93-94, the
ruling by the IRS that provides the rules under which
a QSF will be considered a “party to the suit or agreement”
for the purposes of Section 130, continuously
references singular “claimant” as opposed to the
plural “claimants” throughout the ruling. It is hard
to fathom that the IRS would repetitively reference
the singular form of a word unless it intended to do
so. In conclusion, a QSF is a settlement tool that can
be utilized by either many claimants or a singular
claimant involved in one of the aforementioned Reg.
1.468B-1(c)(2) categories.
31
PLR 200138006 (May 7, 2001).
The Qualified Settlement Fund. In order for a settlement
administrator to properly administer a QSF, it
is important that the administrator obtain an EIN
number for the fund itself. 32 The most important
administrative duties include making the necessary
tax payments when due as well as withholding and
reporting the appropriate amount of money and
information. An administrator is obligated to make
tax deposits at a federal depository using the Form
8109(B), the Federal Tax Deposit Coupon, quarterly
for tax estimates and on March 15th for the final tax
return. A QSFs tax liability is determined by applying
the maximum tax rate 33 to the QSF’s “modified gross
income” for the given tax year. 34 Treasury Regulations
describe a QSF’s “modified gross income” as gross
income as described in Section 61 less the following
exclusions and deductions: (1) amounts transferred
to the qualified settlement fund by, or on behalf of, a
transferor to resolve or satisfy a liability for which the
fund is established and (2) administrative costs and
other incidental expenses incurred in connection with
the operation of the qualified settlement fund that
would be deductible under chapter 1 of the Internal
Revenue Code in determining the taxable income of a
corporation. Administrative costs and other incidental
expenses include state and local taxes, legal, accounting,
and actuarial fees relating to the operation of the
qualified settlement fund, and expenses arising from
the notification of claimants and the processing of
their claims. 35 Further, a QSF’s gross income includes
the gain or loss from the sale or distribution of property
equal to the fair market value of the property on
the date of distribution. The QSF’s basis in property
that is distributed or sold is the fair market value of
the property on the date of its transfer to the fund. 36
It should be noted that QSFs are unable to deduct for
payments made on behalf of claimants, such as attorney’s
fees and costs awarded for obtaining a settlement
or judgment or for the distribution or return of
assets to the transferor.
It is very important that a settlement administrator
make a determination on the tax status of future
QSF distributions near the beginning of the fund’s
32
Reg. 1.468B-2(k)(4).
33
The Economic Growth and Tax Relief Reconciliation Act
of 2001, PL 107-16, implemented a staged tax decrease in the tax
rates that began in 2001 and was accelerated by the Jobs Growth
Tax Relief Reconciliation Act of 2003, PL 108-27. As a result of
these acts the maximum tax rate to be applied to the gross income of
QSFs is 35% until 2011 when it is set to go back up to 39.6%.
34
Reg. 1.468B-2(a).
35
Reg. 1.468B-2(b).
36
Jude P. Damasco and Todd F. Taggart, “Taxation and reporting
of qualified settlement funds,” The Tax Adviser (1996 American
Institute of Certified Public Accountants Inc.).
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existence. A QSF administrator must determine from
the facts and circumstances giving rise to a QSF being
established whether or not one or more of the transferors
would have had to report a distribution via a
Form 1099 or withhold any tax had the defendant
made the distribution directly to the claimant. 37 A QSF
must fulfill reporting and withholding obligations
on distributions from the QSF as if the QSF was the
original defendant. As a result of this obligation, it is
always important that the settlement administrator
require that the defendants provide to them the necessary
information to make the appropriate withholding
and reporting determinations. The failure of which
to do so could prevent the settlement administrator
from having the information necessary to meet their
QSF obligations. Failing to report or withhold the
right information or money may subject the QSF to
large IRS penalties that the settlement administrator
may not even become aware of until 36 months later. 38
For example, failing to prepare and file a Form 1099,
when one is required, may subject the fund to a penalty
of at least $100 per document, which in the case
of a large class action, where hundreds of 1099s may
be necessary, is an overwhelming mistake. 39 Thus, it
highly important that a QSF administrator pay close
attention to both the tax requirements of a QSF and
those that would have applied had the defendant paid
the claimant directly.
37
Id.
38
The IRS uses a standardized calendar to address EIN related
issues.
39
Jude P. Damasco and Todd F. Taggart, “Taxation and reporting
of qualified settlement funds,” The Tax Adviser (1996 American
Institute of Certified Public Accountants Inc.).
CONCLUSION
In a world where the average individual believes the
IRS is rarely on his or her side, QSFs are the exception.
Regardless of whether or not you are an attorney for
a class of claimants or a single injured claimant with
derivatively injured spouse, parents, or chrildren,
QSFs can be an excellent resource for an attorney’s
practice. Resolving liens is a complicated and convoluted
aspect of tort law and demands significant
attention and the same can be said for government
benefit preservation and advising a claimant about
the tax ramifications of their settlement.
It highly important that a QSF administrator pay
close attention to both the tax requirements of
a QSF and those that would have applied had the
defendant paid the claimant directly.
All of these aforementioned areas of law are often
not a part of the general expertise of an attorney’s
practice and this is only compounded during a lawsuit
where a defendant is trying to avoid liability and
resolve their case as soon as possible. Because of this,
it is advisable to become the tortoise and not the hare.
Counsel should provide himself or herself with the
opportunity to focus on the areas of law the client
hired him or her to advocate and let the QSF serve
as a safety net. The client that receives his settlement
award first only to later lose government benefits or
be subject to litigation as a result of an ERISA lien is
far worse off than the client that receives their settlement
award second, but free and clear of any further
claim or litigation.
■
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