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The Use of Qualified Settlement Funds vs. IOLTA Accounts in Law Firms

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Introduction: Qualified Settlement Funds vs. IOLTA Accounts

Lawyers and law firms are bound by specific rules and regulations when managing client funds to ensure ethical and responsible financial practices. Two standard methods for handling client funds are through Qualified Settlement Funds (QSFs) and Interest on Lawyer Trust Accounts (IOLTAs). In this article, we will explore whether a lawyer or law firm may create a Qualified Settlement Fund by discretion or at the client’s direction; or if the lawyer or law firm must deposit the client funds in an IOLTA.

IOLTA Accounts: A Brief Overview

IOLTAs have been an essential tool for law firms since their introduction in 1981. Before IOLTAs, lawyers and law firms were required to deposit client funds into non-interest-bearing checking accounts, ensuring that lawyers and law firms couldn’t financially benefit from their clients’ money. However, with the introduction of IOLTAs, lawyers and law firms were permitted to place these funds into an interest-bearing trust account, with the interest being used to fund legal representation for indigent defendants by the respective state’s Legal Services Corporation.

Additionally, the interest generated from IOLTAs is used to finance various other activities such as providing legal aid for low-income residents, funding law school scholarship programs, improving the administration of justice, assisting those who cannot afford legal services, and supporting non-profit organizations and public service programs. It’s important to note that while IOLTA programs are available in every state, the specific guidelines and requirements may vary.

Three significant shortcomings of holding funds in an IOLTA are:

  • Funds placed in an IOLTA lose the ability to be assigned to periodic payments arrangements, and
  • The client’s best interests are not protected because the client receives no interest on the funds held in the IOLTA, and the lost economic benefit may be material for larger settlements, and
  • IOLTAs only provides up to $250,000 of FDIC insurance. QSF platforms have proprietary banking networks that can provide up to $240 million of FDIC insurance protecting the client settlement to a greater degree

Qualified Settlement Funds: An Overview

QSFs are another mechanism used in the legal industry to receive settlement payments. QSFs provide a way to hold and manage settlement proceeds before they are distributed to the intended recipients. As such, a QSF receives funds directly from the defendant and is separate and apart from any associated requirement to hold funds in an IOLTA pursuant to IRC §1.468B-1 et seq.

When utilizing a QSF, the lawyer or law firm never takes possession of the settlement proceeds, and, as such, the lawyer or law firm need not place the funds in the IOLTA.

Can a Lawyer or Law Firm Create a QSF at the Client’s Direction?

In general, establishing a QSF requires the approval of a governmental authority as provided for in IRC §1.468B-1(c) et seq. While a lawyer or law firm may utilize their discretion to determine that a QSF is the best option in the circumstances, often clients direct the lawyer or law firm to create a QSF (subject to the governmental authority approval process). Lawyers or law firms may find that having a clear written directive from the client to establish a QSF eliminates any questions regarding the client’s intent and knowledge and demonstrates disclosure. Platforms like QSF360 offer simple – free to use – draft client QSF directive forms and can create a QSF in as little as one business day.

Practice point: Consider the benefit of the QSF in preserving special tax treatment, having the time to seek more competitive financial product returns, and the interest earned by the plaintiff which would all otherwise be lost if the funds were held in an IOLTA; all of which can be significant and frequently justify the small costs of utilizing a QSF in smaller settlements.

Should a Lawyer or Law Firm Deposit Client Funds in an IOLTA?

The decision to deposit client funds in an IOLTA depends on several factors, including the nature and amount of the funds and the duration for which the funds will be held. IOLTAs are primarily intended for holding smaller amounts of client funds for very short periods of time.

However, in cases where a significant amount of funds (>$250,000) shall be held for a modest period of time, establishing a QSF is often a more suitable option. QSFs provide the necessary structure to manage and distribute settlement funds while ensuring compliance with legal and tax requirements and offer the benefit of additional time for the plaintiff to plan and preserve beneficial tax treatment to elect a stream of future periodic payments.

Additionally, with a QSF, the client receives the credited interest earned on the funds. In cases with larger settlements (>$250,000), the client receiving the credited interest resolves several potential ethical issues for the plaintiff’s lawyer as only the QSF preserves the client’s best interests.

Choosing the Appropriate Approach

Determining whether to use a QSF or an IOLTA requires consideration of the specific circumstances and legal requirements. An often used general rule is that if the settlement exceeds $250,000, use a QSF to ensure that 100% of the settlement is covered by FDIC insurance. As always, legal professionals should adhere to all applicable ethical standards and the rules of professional conduct.

Conclusion

In summary, lawyers and law firms have options for managing client funds depending on the circumstances. While IOLTAs are commonly used for holding smaller amounts of funds for shorter periods, QSFs offer a structured approach for managing more significant settlement amounts, economically benefit the client by the receipt of earned interest, provide valuable time to plan financial decisions more carefully, and preserve unique tax options that are lost when funds are placed in an IOLTA. Understanding what is in your client’s best interest ensures ethical compliance.

Disclosure: This content is an overview. It is not a detailed analysis and offers no legal or tax opinion on which you should solely rely. Always seek the advice of competent legal and tax advisors to review your specific facts and circumstances before making any decisions or relying on the content herein.
Any opinions, views, findings, conclusions, or recommendations expressed in the content contained herein are those of the author(s) and do not necessarily reflect the view of the Eastern Point Trust Company, its Affiliates, or their clients. The mere appearance of content does not constitute an endorsement by Eastern Point Trust Company (“EPTC”) or its Affiliates. The author’s opinions are based upon information they consider reliable, but neither EPTC nor its Affiliates, nor the company with which such author(s) are affiliated, warrant completeness, accuracy or disclosure of opposing interpretations.

EPTC and its Affiliates disclaim all liability to any party for any direct, indirect, implied, special, incidental, or other consequential damages arising directly or indirectly from any use of the content herein, which is expressly provided as is, without warranties.
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