Understanding the Taxation and Benefits of Qualified Settlement Funds (QSFs)

Qualified Settlement Funds (QSFs), or 468B Trusts, are tax-qualified trusts designed to manage the proceeds from litigation settlements. These unique financial tools offer many advantages for plaintiffs, defendants, lawyers, and settlement administrators alike, but they also come with their own tax implications.

What Is a Qualified Settlement Fund?

As per Section 1.468B-1 et seq. of the Internal Revenue Code (IRC), QSFs operate solely to resolve certain types of litigation, allowing the defendant to deposit funds into a trust and receive a full release of liability. They first arose from class action lawsuits and are now commonly used in various cases, including personal injury actions and other cases involving multiple plaintiffs.
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The fund may be a trust, an account, or even a segregated portion of the transferor’s assets. Although a written trust agreement is generally a good practice, an attorney’s trust account could theoretically serve as a QSF. However, particular rules apply to the establishment and operation of a QSF.

Key Features of a QSF

1. Easy: With QSF 360, QSFs are quick, easy, and straightforward to establish and maintain.
   
2. Tax Benefits: Defendants can get an immediate tax deduction, while Plaintiffs can defer their income.
   
3. Flexibility: Plaintiffs can plan when and how to be paid.
   
4. Release of Liability: Defendants receive a full release of liability once they deposit the funds into the QSF.
   
5. Orderly Administration: QSFs offer an orderly way to manage and distribute settlement proceeds.
   
6. Advantages of Qualified Settlement Funds: QSFs are a win-win solution for all parties involved in litigation. They provide defendants with a quick exit strategy, plaintiffs with financial control, and attorneys with flexible fee structures. They even help settlement administrators by simplifying the process.
   

Advantages for Defendants

Defendants can benefit from QSFs in several ways:

• Immediate Release from Litigation: Defendants can extricate themselves from litigation by depositing the agreed settlement amount into the QSF. The plaintiffs can then take their time in allocating the settlement among themselves and dealing with various liens.
  
• Immediate Tax Deduction: Instead of waiting for “economic performance” to occur, defendants and their insurers can obtain immediate tax deductions.

Advantages for Plaintiffs

Plaintiffs also stand to gain from the use of QSFs:

1. Control Over Settlement Allocation: With the defendant out of the picture, the plaintiff has greater flexibility in dividing the settlement among injured parties, often leading to more advantageous outcomes.
   
2. Immediate Income from Settlement: The plaintiff may start immediately receiving income from the settlement once received by the QSF.
   
3. Time for Negotiations: Having a QSF trust gives the plaintiff extra time to negotiate and satisfy liens from Medicare, Medicaid, ERISA, and third-party insurers.
   
4. Choice of Distribution Methods: The plaintiff can decide how much of the settlement to take as a lump sum and how much to structure.
   
5. Resolution of Conflicts Among Plaintiffs: If a lawsuit involves multiple plaintiffs with conflicting interests, a QSF trust can provide time to resolve these conflicts.
   

The low cost of QSF 360 to establish a QSF is typically overwhelmingly outweighed by the added benefits gained through vastly improved financial returns.

Taxation of Qualified Settlement Funds

Since QSFs are separate tax entities, they are required to pay tax on any interest and dividend income. The tax rate is equal to the maximum rate in effect for trusts, which is currently 39.6%. Remember that the tax is a self-financing tax resulting solely from the interest earned on the QSF.
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Several other income tax considerations must be taken into account when dealing with QSFs:

• Economic Performance: The defendant receives an immediate tax deduction upon depositing the funds in the QSF.
  
• Constructive Receipt: The deposit of the funds in the QSF is not considered constructive receipt, as the taxpayer’s (Claimant’s) receipt of income is subject to substantial limitations.
  
• Economic Benefit: The deposit of the funds in the QSF is not considered Economic Benefit, as the taxpayer’s (Claimant’s) receipt of income is (i) not fixed nor vested, (ii) subject to the claims of other Claimants, and (iii) is subject to the QSF’s creditors.
  
• Gross Settlement Proceeds: When settlement proceeds are paid to the QSF, they do not represent gross income to the QSF, and when the QSF pays them, they do not represent a tax deduction to the QSF. The QSF administrator/trustee must determine whether disbursements are subject to withholding requirements (such as backup withholding or, in the case of wage cases – wage-based withholding). Disbursements of attorneys’ fees in the underlying litigation are always reportable as taxable income.
  

It’s crucial to note that the tax implications of QSFs can be complex, and working with an experienced QSF trustee/administrator, such as Eastern Point Trust Company, can assist you in navigating potential pitfalls.

The Role of the QSF Trustee/Administrator

The Regulations require a QSF to have an “Administrator.” 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. The Trustee/Administrator is responsible for making distributions from the QSF to claimants, 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.
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Additionally, the Trustee/Administrator assists with the proper funding process of any structured settlements, including making a §130 Qualified Assignment to a third-party assignee who shall make the periodic payments.
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Additionally, the Trustee/Administrator oversees the KYC/AML process of the QSF.

Taxability of Settlement Funds

The general rule for the taxability of amounts received from the settlement of lawsuits and other legal remedies is established in IRC Section 61. This section dictates that all income is taxable from whatever source derived unless exempted by another code section. However, the facts and circumstances surrounding each settlement payment are essential to determine the purpose of the underlying settlement or judicial award because not all amounts received from a settlement are exempt from taxes.
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Awards and settlements can be divided into generally distinct groups to determine whether the payments are taxable or non-taxable. The most common are claims relating to physical injuries, and the other is for claims relating to non-physical injuries but other damages, as shown below, which may apply:

• Actual Damages: resulting from physical or non-physical injury;
  
• Emotional distress damages: arising from the actual physical or non-physical injury;
  
• Punitive, Statutory, or Penalty Damages: awarded in addition to actual damages in certain circumstances. Punitive, Statutory, or Penalty damages are considered punishment and typically awarded at the court’s discretion.
  
• Interest on the Judgement Damages: interest to compensate the plaintiff for the lost time value of money.

Conclusion

In conclusion, Qualified Settlement Funds offer a unique solution for managing and distributing litigation settlement proceeds. QSFs provide significant benefits for all parties involved but also have complex tax implications that require careful management. As such, working with experienced professionals when dealing with QSFs is crucial to ensure compliance with all tax and regulatory requirements.

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