WHAT IS A QUALIFIED SETTLEMENT FUND?
468B of the Internal Revenue Code[1] authorizes the establishment of Designated Settlement Funds or Qualified Settlement Funds. These funds are usually collectively referred to as Qualified Settlement Funds (QSFs). These funds are also sometimes called 468B Trusts. The purpose of these funds is to permit a defendant in certain types of litigation to deposit funds into a trust and to receive a full and complete release of liability. The defendant is entitled to a current income tax deduction for the amount paid into the fund at the time the funds are deposited into the trust. This is an exception to the general rule under which the tax deduction is not permitted until the funds are actually disbursed to the plaintiff, which is normally the time in which the plaintiff has received the “economic benefit” of the settlement.
QSFs arose out of class action lawsuits. They can be very useful in personal injury actions and other types of cases where there are multiple plaintiffs. The QSF is usually established prior to trial. The parties agree on a global settlement. The defendant pays that amount into the QSF and the plaintiffs can then take their time in allocating the settlement among themselves and in dealing with various liens, such as Medicaid, Medicare, ERISA, and other liens. The QSF could also be established after a jury award, as long as there is an appeal pending.
A QSF need not be a trust. It may be a fund, account, or trust under state law, or its assets must be otherwise segregated from the transferor’s (or related person’s) other assets.[2] Good practice dictates a written trust agreement. An attorney’s trust account could theoretically serve as a QSF.[3] The problem is that State IOLTA (Interest on Lawyer Trust Accounts) Rules require that income from the attorneys’ trust accounts be paid not to the clients but to State IOLTA funds.
When a QSF is being used for asbestos cases, special rules apply.[4]
ADVANTAGES
There are advantages to both the plaintiff and the defendant in utilizing a 468(b) trust.
Advantages to the Defendant. Advantages to the defendant utilizing a QSF include the following:
Advantages to the Plaintiff. Advantages to the plaintiff utilizing a QSF include the following:
DISADVANTAGES
A disadvantage of establishing a QSF is the cost. There are fees for the drafting of the trust document including all of the ancillary services, such as obtaining information and explaining the document to all of the parties, filing fees, administration and trustee fees, and, possibly, CPA fees for preparing tax returns. A QSF may not be warranted in smaller cases.
TYPES OF CLAIMS
Which claims are permitted and which are not are considered in the following sections.
Permitted Claims. A QSF can be used in claims involving:
In a Private Letter Ruling,[10] the I.R.S. approved the use of a QSF in connection with a bankruptcy case. In that case, the trust was approved by a confirmation order issued by the U.S. Bankruptcy Court, which had continuing jurisdiction over the trust. The trust was established under the laws of the state to resolve employees’ wrongful discharge claims filed under potential theories of tort, breach of contract, or a violation of law. Further, the discharged employees are not general trade creditors of the debtor, nor do their claims belong to any other class excluded by the regulation. Accordingly, the trust is a QSF. The I.R.S. ruled that the debtor is the transferor.
Prohibited Claims. QSFs may not be used in cases:
INCOME TAX CONSIDERATIONS
There are several income tax issues that must be considered in connection with QSFs.
Economic Performance. Economic performance shall be deemed to occur as qualified payments are made by the taxpayer, usually the defendant’s insurer, to a Designated Settlement Fund (QSF).[14] This means that the defendant receives an immediate tax deduction upon depositing the funds in the QSF.
Constructive Receipt. Deposit of the funds in the QSF is not constructive receipt. Because the taxpayer’s receipt of income is subject to substantial limitations, constructive receipt is avoided.[15]
Taxation of Qualified Settlement Funds. Income earned by the QSF is taxed at a rate equal to the maximum rate in effect for such taxable year for trusts.[16] For 2016, the QSF rate is 39.6 percent.[17] All income is taxed at the same rate, there are no lower brackets. The tax is based not on gross income, but on modified taxable income.
The 3.8 percent Medicare tax on unearned income also applies.[18] The tax is the lesser of the undistributed net investment income for such taxable year, or the excess (if any) of:[19]
Because QSFs are separate tax entities and pay tax on any interest and dividend income, the after-tax income then becomes part of the settlement fund and distributions to the claimants can be made with after-tax dollars.
Attorneys’ Fees.
THE 468B TRUSTEE/TRUST ADMINISTRATOR
The Regulations require that a QSF have an “Administrator.”[22] Unless the QSF is a trust, it is not required to have a trustee. If the QSF is a trust, the same person can serve as both Trustee and Administrator or there can be a separate trustee and a separate Administrator. Generally, the Trustee/Administrator is selected by the plaintiff’s attorney. If there is a separate Trustee and Administrator, the duties of each must be clearly defined in the trust document.
In some instances, a court will require an individual trustee to be bonded, which may be difficult or even impossible. A solution is to appoint the individual as Trust Administrator and appoint a Corporate Trustee. The trust document can give the Administrator the duty to make disbursements subject to court order. The Corporate Trustee would take the QSF deposit, subject to the court order, preventing any release of the funds without prior court approval. A similar result might be achieved by having an individual serve as Trustee/Administrator subject to a “safekeeping agreement” with a cooperating bank. The bank would accept the QSF deposits under court order preventing funds from being released without prior court approval.
DISTRIBUTIONS
The Trustee/Administrator is responsible for making distributions from the QSF to claimants, claimants’ attorneys, State Medicaid Agencies to satisfy liens, CMS to satisfy Medicare liens, ERISA Plans to satisfy ERISA liens, and any other lien holders that require satisfaction from the settlement fund.
STRUCTURED SETTLEMENTS
The Trustee/Administrator will be responsible for arranging structured settlements, including making a § 130 Qualified Assignment to a third-party assignee who will make the periodic payments.
[1] I.R.C. § 468B.
[2] Treas. Reg. § 1.468B-1(c)(3).
[3] P.L.R. 200216013 (Jan. 16, 2002).
[4] I.R.S. § 524b.
[5] 45 C.F.R. § 164.512(e)(1)(i).
[6] Treas. Reg. § 1.468B-1(c)(2)(ii).
[7] Treas. Reg. § 1.468B-1(c)(2)(i); 42 U.S.C. § 103.
[8] Treas. Reg. § 1.468B-1(c)(2)(ii).
[9] Treas. Reg. § 1.468B-1(c)(2)(ii).
[10] Priv. Ltr. Rul. 14-90-64-(2005).
[11] Treas. Reg. § 1.468B(1)(g)(3)(1).
[12] Treas. Reg. § 1.468B(1)(g)(3)(2).
[13] Treas. Reg. § 1.468B(1)(g)(3)(3).
[14] I.R.C. § 468B(a).
[15] Treas. Reg. § 1.451-2.
[16] I.R.C. § 468B(b)(1) and I.R.C. § 1(e).
[17] I.R.C. § 411(b).
[18] I.R.C. § 1411(a)(2).
[19] I.R.C. § 1411(a)(2).
[20] I.R.C. § 6041.
[21] Treas. Reg. § 1.468B-2(b)(2).
[22] Treas. Reg. § 1.468B-2(k)(3).
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