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Settlement Fund vs. Qualified Settlement Fund (QSF)

June 13, 2024

Explore the differences between a Settlement Fund and a Qualified Settlement Fund (QSF). Learn their roles in resolving legal disputes, their benefits, and how they function. Understand the components of a QSF and why it's a superior solution.

A settlement fund is an account where the defendant’s payment holds (escrow) funds payable to the plaintiffs. Informal settlement fund escrow accounts have become less common due to their limitations compared to Qualified Settlement Funds (“QSFs”).

Both settlement funds and QSFs help settle legal disputes, offering a way to distribute settlement funds. Knowing the difference between a settlement fund and a QSF and how they function is crucial for individuals contemplating settling a legal issue.

Understanding the Basics:

Definition and Purposes of a Settlement Fund vs a QSF

A settlement fund, sometimes known as an escrow fund, compensation fund, or claims fund, is a pool of money set aside to resolve a legal dispute or pending claim(s). It is a financial resource from which disburses a defendant’s settlement obligations to the appropriate affected individuals or entities. The primary purpose of settlement funds is to provide streamlined and efficient ways to resolve disputes, provide tax benefits, promote fairness, and ensure that the parties receive their equitable share. However, ordinary settlement funds are not tax-efficient and typically do not offer the same financial flexibility and protections as a QSF. On the other hand, QSFs have built-in tax efficiencies for both plaintiffs and defendants that ordinary settlement funds do not provide.

By establishing a “QSF” settlement fund, the defendants can avoid contentious, lengthy, tax-inefficient, and costly post-settlement distribution processes and receive an immediate resolution and tax deduction. Likewise, with a QSF, plaintiffs have virtually unlimited time to settle secondary claims, create financial plans, and minimize tax burdens.

lawyers discussing case outside of courthouse

Exploring the Role of Settlement Funds

Both settlement funds and QSFs help streamline and simplify the resolution process for all involved parties, including the courts, by resolving all related claims via a single fund that acts as the alter ego of the defendant(s) and disburses the associated funds.

Furthermore, settlement funds and Qualified Settlement Funds both provide an expedient resolution process, which is particularly advantageous in cases where plaintiffs may face financial hardships, require immediate financial assistance, or have secondary disputes, complex liens, or government benefit considerations.

In cases where multiple plaintiffs are involved, both a QSF and a settlement fund allow for an equitable distribution of the available funds among all the affected parties and ensure that all claimants receive their fair share and benefit from the tax-deferred time to plan adequately.

Settlement funds and QFS can also offer confidentiality and privacy to the parties involved; thus, settlement negotiations, terms, and associated confidentiality agreements can remain private.

However, only Qualified Settlement Funds created under Section 468B provide and preserve valuable tax, financial planning, and other benefits for the defendant and plaintiffs. Non-QSF settlement funds do not have the same tax benefits and, in fact, may accelerate taxation and erode valuable tax planning options that would be available via a Qualified Settlement Fund.

Components of a QSF Settlement Fund

A QSF has several essential components, including:

Approval

IRS regulation requires the approval of the creation of a QSF by a “governmental authority.” Proven platforms such as QSF 360 provide a quick and easy online platform to create a QSF in as little as one business day.

lawyer holding settlement money and pen

Transfers (Contributions)

Once established, a QSF requires the transfer of funds from the defendants or responsible parties into the QSF.

Administration

Once the settlement fund, as a QSF, is established, administration by independent and experienced QSF administrators is necessary. The QSF Trustees and QSF Administrators are responsible for overseeing the QSF funds, ensuring compliance with Section 468B and the agreed-upon settlement terms, and managing the distribution of compensation to the claimants.

Settlement fund administrators are crucial in implementing the necessary procedures and controls to ensure the distribution process is carried out according to settlement terms.

Distribution

The distribution process may involve several steps, such as establishing claimants’ eligibility, calculating the appropriate allocation, resolving liens and secondary disputes, and issuing payments to the plaintiffs. To ensure transparency and accountability, the QSF administrators must maintain accurate records of all distributions and provide regular reports to the relevant parties.

Conclusion

Establishing and utilizing non-QSF settlement funds and Qualified Settlement Funds provides a solution for resolving legal disputes fairly and efficiently. However, Qualified Settlement Funds (QSF) settlement funds are generally a superior solution to “non-QSF” settlement funds. By establishing a “QSF” settlement fund, the defendants can avoid contentious, lengthy, tax-inefficient, and costly post-settlement distribution processes and receive an immediate tax deduction.

Further, the Plaintiffs benefit from valuable tax advantages and additional financial planning flexibility and time.

To access more educational information about settlement funds and Qualified Settlement Funds, visit here.

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Frequently Asked Questions

Under IRC § 61, all income from whatever source derived is taxable unless a specific exclusion applies. Lawsuit settlements are included in gross income by default. The key exceptions are physical injury and physical sickness recoveries under IRC § 104(a)(2), which are excluded from gross income when received as compensation for a physical injury or physical sickness claim.

IRC § 104(a)(2) excludes from gross income damages received on account of personal physical injuries or physical sickness. The exclusion applies to compensatory damages only. The injury or sickness must be physical — emotional distress damages, employment discrimination recoveries, breach of contract proceeds, and punitive damages do not qualify for the exclusion and are taxable.

Yes. Punitive damages are taxable as ordinary income regardless of whether the underlying claim involves a physical injury. IRC § 104(a)(2) does not exclude punitive damages. Even in a physical injury case where compensatory damages are excluded, any punitive damages awarded are included in the plaintiff's gross income and subject to federal income tax.

For most plaintiffs, no. The Tax Cuts and Jobs Act of 2017 suspended miscellaneous itemized deductions under IRC § 67(g) for tax years 2018 through 2025, eliminating the attorney fee deduction for most civil litigation recoveries. IRC § 62(a)(20) provides an above-the-line deduction only for qualifying discrimination and whistleblower cases. Plaintiffs in personal injury, breach of contract, and most tort cases cannot deduct attorney fees under current law.

A Qualified Settlement Fund (QSF) under IRC § 468B separates the timing of the defendant's payment from the plaintiff's taxable receipt of funds. The defendant transfers proceeds to the QSF and takes an immediate tax deduction. The plaintiff does not recognize taxable income until distribution from the QSF, preserving a planning window to implement structured settlements, Plaintiff Recovery Trusts, Special Needs Trusts, or other tax-minimization strategies before receiving taxable income.

A Plaintiff Recovery Trust (PRT), administered by Eastern Point Trust Company, addresses the attorney fee double tax created by Commissioner v. Banks, 543 U.S. 426 (2005), and worsened by TCJA 2017. The PRT separates the attorney fee portion of the settlement from the plaintiff's taxable recovery, allowing each party to recognize income only on their respective portion. Eastern Point Trust Company has saved plaintiffs $30 million or more through PRT structures. The PRT is implemented during the QSF administration window before taxable distributions occur.

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