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Qualified Settlement Funds

By Thomas D. Begley, Jr.

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:

  • Defendant Removed from Litigation. Defendants want to be out of the case. By using a QSF a defendant can pay and go. The defendant pays the funds into the QSF and the plaintiffs later deal with liens, allocate the settlement between themselves, determine how much should be lump sum and how much to structure, determine whether any Special Needs Trusts are required, and wait while a guardian is appointed for an incapacitated plaintiff, if required.
  • Deduction to Defendant. Defendants and their insurers are able to obtain immediate tax deductions, rather than waiting for “economic performance” to occur.

♦ Advantages to the Plaintiff. Advantages to the plaintiff utilizing a QSF include the following:

  • Defendant Removed from Allocation of Settlement. Where QSF trusts are used, the defendant leaves to the plaintiff the issue of allocating the settlement among injured parties. This often gives the plaintiff greater flexibility in shaping the settlement. There are often advantages to allocating portions of the settlement to family members other than the injured plaintiff.
  • Plaintiff’s Attorneys’ Fees and Costs. When a QSF trust is used, the plaintiff’s counsel can be paid fees immediately from the QSF and litigation expenses can also be paid.
  • Income to Plaintiff. The plaintiff will immediately begin to receive income from the settlement held by the QSF trust. Without the trust, the defendant would be holding the money and the plaintiff would not be receiving the benefit of the income.
  • Negotiations. Time is no longer a factor in negotiations with Medicare, Medicaid, ERISA, and third-party insurers. Additional time is available to negotiate and satisfy those liens.
  • Forms of Distributions. Establishment of a QSF trust gives the plaintiff time to determine how much of the settlement to take as a lump sum and how much, if any, to structure.
  • Conflict Resolution Among Related Plaintiffs. A QSF trust gives the plaintiff’s attorney, who may be representing more than one family member, time to resolve conflicts between them. One parent may have abandoned the injured child, for example. The other parent may be the custodial parent providing almost total care. How much does each parent receive?
  • Removes Defense Structured Settlement Broker from the Case. The relationship between plaintiff’s structure brokers and defense brokers can be rancorous. If the QSF purchases the structure, the defense broker is effectively removed from consideration.
  • Eliminates the Risk of Insolvency. If plaintiffs believe that the defendant or the defendant’s insurer is financially unstable, the QSF can be used as a vehicle into which funds can be immediately transferred.
  • International Litigation. QSFs can be used to collect settlements from defendants that are located outside the country and can be used by foreign plaintiffs to collect from defendants located in the country.
  • In cases involving a large number of claimants, an administrator of a QSF can obtain a Qualified Protective Order (QPO) that complies with the requirements of HIPAA and allows for limited use of Protected Health Information (PHI). This avoids the necessity of obtaining specific HIPAA releases from each settling claimant. Those releases would otherwise be necessary to negotiate subrogation claims in personal injury cases. A QSF administrator often retains the services of an outside vendor for lien resolution. The vendor may be required to disclose PHI to a number of different parties in order to secure release or payment requirements to settle the claims. The QPO is a good solution. A QPO is defined as an order of the court or of an administrative tribunal or a stipulation by the parties to the litigation or administrative proceeding that prohibits the parties from using or disclosing the PHI for any purpose other than the litigation or proceeding for which the information was requested.[5] The regulation further requires the return to the covered entity or destruction of the PHI at the end of the litigation or proceeding.
  • Assists Structuring Attorneys’ Fees. Once settlement proceeds are deposited in an attorney trust account, it is too late for the lawyer to structure his fee. By making the deposit into a QSF, plaintiff’s counsel has time to consider payment options including whether or not to structure his fee.
  • Multiple Defendants. A QSF can also be useful in cases involving multiple defendants or where all disputes with a single defendant cannot be resolved at one time. All monies can be held in a QSF until all defendants settle.

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:

  • Tort,[6]
  • The Comprehensive Environmental Response, Compensation and Liability Act (CERCLA),[7]
  • Breach or contract,[8] or
  • Violation of law.[9]

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:

  • Arising from worker’s compensation or self-insured health plan,[11]
  • Involving liabilities to refund the purchase price of or repair or replace products sold in the ordinary course of the transferor’s business,[12] or
  • Involving the obligation of the transferor to make payments to its general trade creditors[13] and debt holders relating to a bankruptcy case or workout.

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]

  • The adjusted gross income for such taxable year over.
  • The dollar amount of which the highest tax bracket begins for such taxable year.

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.

  • Plaintiff’s Attorney’s Fees. In most instances, the transferor will transfer to the QSF the entire settlement amount, including that portion that is payable to the personal injury attorney or attorneys for attorneys’ fees under the engagement letters signed between the plaintiffs and plaintiffs’ attorney. In rare instances, the transferor will pay the plaintiff’s attorneys’ fees directly and only transfer to the QSF the net amount due to the plaintiff. When attorneys’ fees are paid to the QSF, they do not represent gross income to the QSF, and when they are paid by the QSF they do not represent a tax deduction to the QSF. The QSF administrator/trustee must determine whether disbursements are subject to withholding requirements and whether disbursements of attorneys’ fees to class counsel in the underlying litigation are reportable.[20]
  • QSF Attorneys’ Fees. Normally, a QSF will engage a law firm to perform legal services on behalf of the QSF. Such legal expenses are necessary to administer the QSF and to process claims and are deductible by the QSF as ordinary business expenses.[21] Whether or not the legal fee is immediately deductible or must be capitalized is determined by the origin of the claim.

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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