Must a Court Approve a Qualified Settlement Fund?
A Qualified Settlement Fund (QSF) is a vital tool for settling legal disputes, especially those involving large sums of money. A QSF is a statutory trust or escrow account established to hold and distribute settlement funds to the involved parties. Its main goal is to offer a centralized mechanism that ensures the settlement process is fair, efficient, and transparent.
Must a Court Approve a QSF?
Not necessarily. A QSF must be established pursuant to an order of, or approved by, a “governmental authority” as defined in Treas. Reg. § 1.468B-1(c)(1), which may include a court of law, but can also include a non-court governmental authority with appropriate jurisdiction.
(c) Requirements. A fund, account, or trust satisfies the requirements of this paragraph (c) if -
(1) It is established pursuant to an order of, or is 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;
Practice Note: Because the regulation turns on “order of, or approval by” and “continuing jurisdiction,” parties should confirm (i) the approving authority’s legal power to approve/oversee the fund, (extra territorial approvals with no nexus to the approving authority would be Void Ab Initio) (ii) that the approval instrument expressly provides for continuing jurisdiction and that real continuing jurisdiction is exercised and is not merely a sham, (iii) that the fund’s governing documents align with Treas. Reg. § 1.468B-1(c) and related provisions, and (iv) the powers granted to the QSF administrator are consistent with all applicable state law.
The approving governmental authority must retain “continuing jurisdiction” over the QSF under Treas. Reg. § 1.468B-1(c)(1), while the manner and intensity of oversight may vary, no real or prudent man standard oversight would conflict with the intent of the regulations.
The IRS’s Role
The Internal Revenue Service (IRS) also plays a role in every QSF. For example, the IRS has established rules and procedures for the tax treatment of QSFs and requires certain information or documentation before issuing the EIN linked to the creation of a QSF. IRS guidance: In addition to the regulation, the IRS has issued administrative guidance addressing QSF administration and tax reporting (including the requirement that a QSF generally files Form 1120-SF). Parties should consult current IRS publications/instructions and, where appropriate, seek tax counsel regarding EIN application, information reporting, and withholding considerations.
Whether a court must approve a QSF—or whether a non-court governmental authority may approve it—is addressed in the Treasury Regulations. Treas. Reg. § 1.468B-1(c)(1) provides that a QSF may be established pursuant to an order of, or 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 the fund must be subject to the continuing jurisdiction of that governmental authority. The approving governmental authority must have a significant role in approving and overseeing the establishment and ongoing administration of the QSF.
Case law (limited but instructive): Reported decisions directly addressing whether a QSF must be approved by a court (as opposed to another qualifying “governmental authority”) are uncommon; in practice, disputes more often concern (i) the tax characterization of settlement proceeds and attorney-fee arrangements, (ii) constructive receipt/economic benefit issues, and (iii) administration of settlement funds. When QSF-related issues are litigated, courts generally analyze the arrangement against the governing Treasury Regulation (Treas. Reg. § 1.468B-1), including the requirements that the fund be established pursuant to an order of, or approved by, a governmental authority and be subject to that authority’s continuing jurisdiction.
By analogy, courts evaluating settlement structures frequently emphasize substance-over-form and constructive-receipt principles—concepts that also inform QSF planning and documentation. See, e.g., Commissioner v. Banks, 543 U.S. 426 (2005) (holding that, as a general rule, a litigant’s gross income includes the portion of a recovery paid to the litigant’s attorney as a contingent fee, underscoring that settlement structuring and fund mechanics do not, by themselves, change the underlying tax characterization absent a valid statutory/regulatory basis). Courts also scrutinize whether a claimant has control over, or an unfettered right to, settlement funds (constructive receipt/economic benefit), which is a key reason QSF documentation typically limits claimant control until distributions are authorized. See, e.g., Childs v.Commissioner, 103 T.C. 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996) (upholding structured settlement arrangement and addressing constructive receipt/economic benefit concepts in the settlement context).
Accordingly, while the regulation—not case law—primarily governs the “approval” element for QSF qualification, the existing case law supports careful drafting to ensure the approving governmental authority’s continuing jurisdiction is clear and that claimants do not have impermissible control over the fund prior to distribution.
As noted in a previous article about maximizing settlement benefits, using a QSF can provide significant tax benefits to the parties involved in a legal dispute. Under U.S. tax law, if a taxable settlement is paid directly to a plaintiff, it is generally taxable as income. However, suppose the settlement is paid into a QSF. In that case, the funds are not taxable until distributed to the plaintiff. This singular feature provides significant tax planning opportunities for the parties involved in a legal dispute.
To establish a QSF in the United States, the parties typically seek an order of, or approval by, a qualifying governmental authority (which may be a court or a non-court governmental authority) and ensure the fund is subject to that authority’s continuing jurisdiction, consistent with Treas. Reg. § 1.468B-1(c). The approving authority will review the proposed QSF documentation and, if approved, settlement funds can be deposited into the QSF and later distributed to claimants. It is important to note, however, that the role of the governmental authority in establishing and administering a QSF can vary depending on the jurisdiction and the specific facts of the case. In some instances, the governmental authority may take a more active role in overseeing the QSF. However, in other cases, the governmental authority might approve the establishment of the QSF and leave the fund's administration to other parties.
In addition to the approval from the governmental authority, a QSF is also subject to regulatory tax law enforcement by the IRS. The IRS's involvement stems from the fact that QSFs are often used to resolve disputes involving taxable proceeds liabilities; the IRS wants to make sure that the funds in the QSF comply with relevant tax laws.
Obtaining an EIN
The parties involved in a legal dispute must submit an EIN application to the agency to obtain an EIN from the IRS. The IRS' EIN-related systems define what an eligible QSF is.
What it is...
A settlement fund is a fund for the principal purpose of settling and paying claims against the electing taxpayer under Internal Revenue Code (IRC) Section 468B.
A fund, account, or trust is a settlement fund if it meets the following requirements:
- Governmental order or approval requirement
- Resolve or satisfy requirement
- Segregation requirement
All settlement funds must file a Form 1120-SF (U.S. Income Tax Return for Settlement Funds). A settlement fund cannot elect to file a Form 1041 (U.S. Income Tax Return for Estates and Trusts). If you do not intend to file Form 1120-SF, your organization is not considered a settlement fund.
Note: The regulations do not require a “court order” specifically; they require an order of, or approval by, a qualifying governmental authority (which may include a court) and continuing jurisdiction by that authority. IRS guidance describing QSF requirements is consistent with this regulatory framework.
Risks of Escrow-Based “QSF” Structures (Especially in Minors’ Settlements).
Parties should use caution with arrangements marketed as “escrow-based QSFs” where settlement proceeds are placed into an escrow account controlled by plaintiffs’ counsel and/or the claimants, because excessive claimant/counsel control can undermine the core QSF premise that the fund is subject to the continuing jurisdiction of the approving governmental authority and administered pursuant to that authority’s order or approval. See Treas. Reg. § 1.468B-1(c)(1) (order/approval and continuing jurisdiction requirements). In addition, where minors are involved, an escrow structure that leaves meaningful control with counsel or the claimants can create heightened risk that the minor’s interests are not independently protected (e.g., inadequate safeguards on timing, investment, fees, and distributions) and may conflict with jurisdiction-specific requirements for court approval and supervision of minors’ compromises and distribution vehicles.
Even apart from minors’ compromise rules, structures that effectively allow a claimant to direct or access funds before authorized distribution can raise constructive receipt/economic benefit concerns in the settlement context. See, e.g., Childs v. Comm’r, 103 T.C. 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996) (constructive receipt/economic benefit analysis in structured settlement context); Commissioner v. Banks, 543 U.S. 426 (2005) (substance-over-form considerations in settlement recoveries). Accordingly, if an escrow account is used in connection with a purported QSF—particularly in cases involving minors—parties should ensure (i) the approving governmental authority’s continuing jurisdiction is real and documented, (ii) the fund administrator is independent and bound by the approval order and governing documents, and (iii) claimants and counsel do not retain unilateral control over investment or distribution decisions outside the authority’s supervision.
QSF Background
It is important to note that establishing and administering a QSF trust can be complicated and may differ depending on the jurisdiction of the approving government authority and the specific details of the case. Therefore, it is recommended to consult with experienced legal and financial professionals to identify the particular requirements for establishing and managing a QSF in your jurisdiction. Experience tells us that using a court to establish a QSF can take months and cost thousands of dollars in legal fees and court costs. However, solutions like QSF 360 provide quick, affordable, and straightforward solutions with experienced government agencies.
In addition to tax benefits, there are several other advantages to using a QSF in settling legal disputes. One of the main advantages is that a QSF can provide a centralized mechanism for the settlement of claims, which can help to reduce the administrative burden on the parties involved in the dispute. This feature can be vital in cases involving both single and multiple plaintiffs or defendants or in cases involving complex legal issues. Another advantage of using a QSF is that it can help to provide a measure of security for the parties involved in the dispute. By depositing the settlement funds into a QSF, the parties ca ensure that the funds will be available to pay any future claims or liabilities that may arise. This element can be essential in cases with a risk of future claims or liabilities, such as cases involving product liability or environmental claims.
Summary
While a QSF must be established pursuant to an order of, or approved by, a “governmental authority” and be subject to that authority’s continuing jurisdiction, a court is not always required because a qualifying non-court governmental authority may approve the QSF. See Treas. Reg. § 1.468B-1(c)(1) (defining “governmental authority” to include the United States, any state (including the District of Columbia), territory, possession, or political subdivision, and any agency or instrumentality (including a court of law) of any of the foregoing, and requiring continuing jurisdiction).
In appropriate matters, third-party administrators and technology platforms (e.g., QSF 360) may streamline QSF formation and administration by providing standardized documentation, tax reporting workflows, and distribution controls; however, the parties should confirm that the approval instrument and governing documents satisfy Treas. Reg. § 1.468B-1 and that the structure does not give claimants or counsel impermissible control over settlement proceeds prior to authorized distributions (constructive receipt/economic benefit principles). In particular, parties should use caution with escrow-based arrangements marketed as “QSFs” where funds are held in accounts controlled by plaintiffs’ counsel and/or claimants, as such control can increase compliance risk and, in matters involving minors, may heighten the risk that minors’ interests and jurisdiction-specific minors’ compromise protections are not adequately safeguarded. See, e.g., Childs v. Comm’r, 103 T.C. 634 (1994), aff’d, 89 F.3d 856 (11th Cir. 1996) (structured settlement; constructive receipt/economic benefit analysis); Commissioner v. Banks, 543 U.S. 426 (2005) (settlement proceeds characterization; substance-over-form considerations).
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