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Qualified Settlement Funds: An In-Depth Analysis

By

(Guest Author)

Published

11/14/2023

A hand holding a pen drawing on an imposed illustration of a bar graph ramping up

Qualified Settlement Funds (QSFs) are powerful financial tools designed to provide flexibility and tax efficiency in complex dispute resolution scenarios. These funds are instrumental when plaintiffs and defendants negotiate a settlement but cannot agree on tax language or reporting specifics. In this comprehensive guide, we'll explore the origins, benefits, and practical applications of QSFs and the implications for various stakeholders involved in the settlement process.

Section 1: Origins of Qualified Settlement Funds

Qualified Settlement Funds originate from Section 468B of the Internal Revenue Code. This section was introduced as part of the Tax Reform Act of 1986 to streamline the settlement process in multi-plaintiff lawsuits. Initially, QSFs were predominantly used for class actions and other complex cases involving multiple plaintiffs. However, their use has expanded to include various legal disputes, from personal injury cases to breach of contract claims.

Section 2: Establishing a Qualified Settlement Fund

Establishing a QSF is a relatively straightforward process. The fund must satisfy three fundamental requirements:

It must be established under the jurisdiction of a governmental authority, which will also exercise ongoing supervision over the fund.
The fund must be set up to resolve or satisfy one or more legal claims. These can range from tort claims to violations of law.
If established as a trust, the fund must qualify as a trust under applicable state law, necessitating a trust agreement and trustee.

Section 3: Tax Implications for Defendants

When defendants contribute to a QSF, they can immediately claim a tax deduction for the settlement payments. This feature is a significant benefit, as under ordinary tax rules, defendants cannot claim a deduction until the plaintiff receives the money. A QSF effectively creates an exception to these rules, allowing defendants to claim deductions even if the funds remain tied up in the QSF for an extended period.

26 CFR 1.468B-3(c) clearly states that “economic performance” occurs upon the funding of a QSF:

(c) Economic performance—(1) In general. Except as otherwise provided in this paragraph (c), for purposes of section 461(h), economic performance occurs with respect to a liability described in §1.468B–1(c)(2) (determined with regard to §1.468B–1(f) and (g)) to the extent the transferor makes a transfer to a qualified settlement fund to resolve or satisfy the liability.

Note that 26 U.S. Code §461 - General rule for taxable year of the deduction - is the statute that controls when an expense is deductible upon “economic performance.” Below are the applicable provisions of §461(h) as stipulated in §1.468B-3(c) as being satisfied.

(h) CERTAIN LIABILITIES NOT INCURRED BEFORE ECONOMIC PERFORMANCE

(1) IN GENERAL
For purposes of this title, in determining whether an amount has been incurred with respect to any item during any taxable year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs.

(2) TIME WHEN ECONOMIC PERFORMANCE OCCURS
Except as provided in regulations prescribed by the Secretary, the time when economic performance occurs shall be determined under the following principles:

(A) Services and property provided to the taxpayer
If the liability of the taxpayer arises out of—

(i) the providing of services to the taxpayer by another person, economic performance occurs as such person provides such services,
(ii) the providing of property to the taxpayer by another person, economic performance occurs as the person provides such property, or
(iii) the use of property by the taxpayer, economic performance occurs as the taxpayer uses such property.

(B) Services and property provided by the taxpayer
If the liability of the taxpayer requires the taxpayer to provide property or services, economic performance occurs as the taxpayer provides such property or services.
‍
(C) Workers compensation and tort liabilities of the taxpayer
If the liability of the taxpayer requires a payment to another person and—

(i) arises under any workers compensation act, or
(ii) arises out of any tort, economic performance occurs as the payments to such person are made. Subparagraphs (A) and (B) shall not apply to any liability described in the preceding sentence.

(D) Other items
In the case of any other liability of the taxpayer, economic performance occurs at the time determined under regulations prescribed by the Secretary.

Section 4: Tax Treatment of Qualified Settlement Funds

The tax treatment of QSFs is relatively straightforward. The IRS assigns a QSF its own Employer Identification Number (EIN). The QSF is taxed separately but not on the money contributed by the defendants. Instead, it is taxed on the earned income, such as interest and dividends. However, the QSF can deduct certain expenses, often resulting in no tax due.

Section 5: Benefits of Using Qualified Settlement Funds

QSFs offer myriad benefits for all parties involved in the dispute resolution process. For defendants, they provide an opportunity to claim tax deductions immediately and remove themselves from ongoing litigation. For plaintiffs, they offer time to make crucial decisions regarding the allocation of settlement funds, the negotiation of lien claims, and the implementation of financial planning strategies. Moreover, QSFs facilitate the resolution of disputes among multiple plaintiffs and lawyers, contributing to an efficient and fair settlement process.

Section 6: Qualified Settlement Funds and Structured Settlements

Structured settlements, which involve payments made over time, can also be facilitated through QSFs. These settlements can offer tax, financial planning, and asset protection advantages. Notably, a QSF allows the timing of a structured settlement to be delayed until after the defendant is out of the picture. This feature allows plaintiffs to consider the various financial options available to them, including the form of structure, the exact annuity payout, and family needs.

Section 7: The Role of Trustee in Qualified Settlement Funds

The trustee of a QSF plays a critical role in managing the fund. Almost anyone who is not a minor or legally incompetent can serve as a trustee. While the trustee does not need to be a trust company or specialist, they need to be able to manage the QSF's assets responsibly, as the trustee is responsible for making distributions from the QSF to claimants, dealing with any liens, and arranging structured settlements, as necessary.

Section 8: The Duration of Qualified Settlement Funds

There is no explicit limit on the duration of a QSF. In simple cases, a QSF may exist for a few months, providing enough time to resolve lien issues, determine the allocation of funds, and consider structured settlement options. A QSF may need to exist for several years in more complex cases. The needs of the QSF, including but not limited to ongoing disputes regarding the distribution of funds and related factors, should dictate the duration of a QSF.

Section 9: The Use of Qualified Settlement Funds in Different Types of Claims

QSFs can be used to resolve various legal claims, including those arising from tort, contract breach, or other violation of law. However, there are certain types of claims where using a QSF is prohibited, such as liabilities arising from a workers' compensation act, obligations to refund the purchase price of products sold in the ordinary course of business, and liabilities related to bankruptcy cases or workouts.

Section 10: The Role of Qualified Settlement Funds in Tax Planning

Contrary to some misconceptions, forming a QSF does not complicate tax planning for plaintiffs. A QSF can enhance the plaintiff's chances of achieving the desired tax treatment. When plaintiffs and defendants cannot agree on tax language or reporting specifics, a QSF can bridge these difficulties, allowing the plaintiff to negotiate the appropriate tax reporting with a neutral party, such as the QSF trustee.

Section 11: Conclusion

Qualified Settlement Funds afford the defendant immediate tax deductions and are a flexible tax-efficient tool that can facilitate smooth and equitable dispute resolution. By providing a “safe harbor” for settlement funds during the allocation and planning phase, QSFs enable all parties to navigate complex settlements more effectively. Whether you're dealing with a multi-plaintiff lawsuit, a complicated personal injury case, or a contentious contract dispute, a QSF could be an essential part of your strategy.

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