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By: Tab H. Keener

Downs.Stanford, P.C.

Dallas, Texas

A Qualified Settlement Fund (QSF) allows tax payers involved in litigation to receive settlement funds and potentially avoid tax ramifications until the funds are otherwise paid to the taxpayer. Often times a QSF is used in mass tort or other types of class action litigation. A defendant may pay money into the QSF and receive a release of claims by court order while multiple claimants decide upon an allocation among themselves. [1]

Insurance companies and large self-insured businesses typically resist the use of a QSF. Their concern is magnified when a suit involves a single injury and derivative claimants (as in wrongful death and survival actions). The uncertainty is that claimants may have essentially received the economic benefit of the money immediately upon payment into the QSF. The worry is that taxpayers, if taxed, would be motivated to sue the entity funding the settlement to offset the unexpected tax liability.

A. Birth of the QSF

Structured settlements became popular in the late 1970s and 1980s. Insurance companies funding structured settlements became concerned that payments made to an entity rather than the claimant would not be tax deductible - as it clearly would be if paid to an individual. Defendants and their insurance carriers wanted to make sure that they could deduct payments in the year in which they were paid rather than when the money was distributed. Congress enacted Section 468B of the Internal Revenue Code in 1986 to address such concerns.

When Section 468B was first enacted it only addressed a Designated Settlement Fund.[2] 468B was later amended to add an additional section giving the Secretary of the Treasury additional authority to draft regulations further addressing the potential tax ramifications of such a fund.[3] Through a series of regulations, the QSF was created. First, a fund is a QSF it if is established pursuant to an order of, or approved by, the United States, any state (including the District of Columbia) and is subject to the continuing jurisdiction of that governmental authority.[4] Second, the fund must be established to resolve or satisfy one or more contested or uncontested claim asserting liability[5] The third and final requirement is that the fund must be a trust under applicable state law, or its assets are otherwise segregated from the assets of the transferor (and related persons).[6]

B. Questions Concerning Use of a QSF When Only a Single Injury Is Involved

Defendants and their insurers often have concern about the potential future tax liability associated with a QSF, which is afforded different tax treatment than a typical settlement annuity.[7] By comparison, a settlement annuity grows tax free to the benefit of the claimant while earnings in a QSF are taxable to the fund itself. For example, the tax rate is 39.6% according to 2009 tax rate schedules. Due to the doctrines of constructive receipt and economic benefit, the taxpayer could face serious tax ramifications, possibly in the amount of hundreds of thousands of dollars. This is especially true in the case of a young minor child who would have many years of earnings growth. After reaching the age of majority, the child could bring suit contending that she was not adequately protected through the creation and use of the QSF and should now be entitled to recover the amount of lost earnings due to unfavorable tax treatment.

To alleviate these problems claimants and their attorneys may suggest providing additional indemnification and promise to execute a Compromise Settlement Agreement. However, no revenue ruling or regulation clearly states that a QSF may be used when dealing with a single claimant or single injury involving derivative claimants.[8] A QSF is often suggested by claimants and their attorneys to bypass an approved list of annuity companies or in an effort to cut out brokers suggested by defendants and their insurers.

In conclusion, until additional regulations are promulgated, clearly stating that a QSF may be used with single or derivative claimants, counsel should be wary to agree to use a QSF. During settlement negotiations, counsel should be vigilant to ensure that a QSF is not part of any settlement agreement among the parties until these issues are resolved.

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[1] Payment of settlement funds by defendant or defendants insurer are generally entitled to income tax deduction treatment under 26 U.S.C. Section 162. See 26 C.F.R. Section 1.468B-3(G).

[2] Section 468B of the Internal Revenue Code is titled Special Rules for Designated Settlement Funds. The statute sets forth the definition of a Designated Settlement Fund (DSF) and includes six detailed elements that must be satisfied to establish a DSF. See 26 U.S.C. Section 468B.

[3] By the Technical and Miscellaneous Revenue Act of 1988, Congress amended 26 U.S.C. Section 468B to add subpart (G), which is authority for the QSF regulations.

[4] 26 C.F.R. Section 1.468B-1(c)(1).

[5] 26 C.F.R. Section 1.468B-1(c)(2).

[6] 26 C.F.R. Section 1.468B-1(c)(3).

[7] See I.R.C. 104(a)(2), 130, and 468B.

[8] Cf. 26 C.F.R. Section 1.468B-1(c)(2) allowing one or more claimants.