Resources

In the complex financial landscape of litigation settlements and judicial awards, Qualified Settlement Funds (QSFs) present a robust solution that simplifies the process for all parties involved. This article comprehensively explains what “QSF” means, the legislative background, how they function, their advantages, and costs.

I. Definition of “QSF”

A “QSF,” or Qualified Settlement Fund, is a specialized trust or fund established under state law primarily dedicated to holding the proceeds from a legal settlement and are also referred to as Qualified Settlement Trusts, 468B Trusts, or 468B funds. The term “468B” originates from Section 468B of the Internal Revenue Code, which authorizes establishing these funds. When created as a trust, a QSF is a Statutory Trust established by the governmental authority.

II. Legislative Background of Qualified Settlement Funds

Qualified Settlement Funds first emerged as part of the Tax Reform Act of 1986. Initially, the law introduced Designated Settlement Funds (DSFs), designed for insurance companies to transfer money to settle claims. However, DSFs had limited applicability and flexibility, leading to the introduction of Qualified Settlement Funds in 1993 through Treasury regulations. Unlike DSFs, QSFs have broader applications and increased flexibility, making them a popular choice in all tort litigation and other cases, whether complex or straightforward.

III. The Three Essential Requirements of a QSF

According to Treasury Regulation 1.468B-1(c), a fund must meet three critical criteria to qualify:

1. Legal Recognition and Jurisdiction: The fund must be approved by a federal or state agency, and it should be subject to the continuing jurisdiction of that agency.
   
2. Purpose of Resolution: The fund must exist to resolve or satisfy one or more claim(s) resulting from an event or series of related events that has led to said claim(s).
   
3. Nature of Claims: The claim(s) should arise out of a tort, breach of contract, or violation of a law, and the fund should be created as a trust under applicable state law.
   

IV. How Qualified Settlement Funds Work

A QSF simplifies the litigation settlement process by providing a structure that benefits both plaintiffs and defendants. The defendant or their insurance company transfers the agreed-upon settlement amount into the fund. Upon transfer, the defendant can claim an immediate tax deduction for the total amount and released from further liabilities associated with the lawsuit.

Once the defendant is released from the case, the QSF allows for the resolution of post-litigation issues. These can include allocation of settlement amounts between different plaintiffs, negotiation of liens, and planning for the settlement’s financial impact. The 468B fund acts as a temporary holding tank for the settlement proceeds until all allocation issues are resolved, and all funds are disbursed.

V. Advantages of Using a Qualified Settlement Fund

There are several advantages to using a QSF in a litigation settlement:

1. Defendant’s Perspective: From the defendant’s perspective, the fund provides an opportunity to end litigation quickly. The defendant gets a complete release from the case once they fund the trust, and they also benefit from an immediate tax deduction.
   
2. Plaintiff’s Perspective: A QSF offers flexibility and time for the plaintiffs. They can allocate the settlement amounts among themselves, negotiate liens, and plan for the financial implications of the settlement without the pressure of immediate disbursement.
   
3. Attorney’s Perspective: Attorneys can also benefit from a settlement fund. For example, they can immediately receive their fees and costs from the fund and preserve the attorney’s option to structure their fees.
   

VI. Considerations

Despite its advantages, establishing a QSF can come with one minor downside: the cost involved. However, using a low-cost platform like QSF 360 makes settlement trusts fast and affordable. Unlike QSF 360’s low costs, other vendors’ costs can include high fees for drafting the trust document, administration fees, filing fees, administration fees, court costs, attorney fees, and potential CPA fees for preparing tax returns.

VII. Tax Considerations

There are several key tax considerations:

1. Economic Performance: The defendant can claim an immediate tax deduction upon transferring funds into a 468B trust, signaling that economic performance has occurred.
   
2. Constructive Receipt: The transfer of funds into the QSF does not trigger constructive receipt, which means that a taxpayer’s receipt of income is subject to limitations.
   
3. Taxation of QSF: The fund’s taxation is on its modified gross income, which excludes the initial transfer of money. All income is taxed at the same rate, with no lower brackets.
   

VIII. The Role of the QSF Administrator

Regulations require the appointment of an “Administrator,” which is usually selected by the plaintiff’s attorney. The QSF Administrator is responsible for distributing funds to satisfy the defendants’ obligations to the claimants, state Medicaid agencies, CMS for Medicare liens, ERISA plans, etc. Also, structured settlements, including making a §130 Qualified Assignment, are available from insurance companies or third parties who shall make periodic payments.

IX. Single Claimant QSF

So-called Single Claimant QSFs have become widely accepted, and several recent court cases have affirmed their use in single-plaintiff cases. While some naysayers oppose the idea of a Single Claimant QSF, during the last 30 years (or the life of 468B), the IRS has not made any known adverse finding or taken any adverse action against any “Single Claimant” settlement fund. Finally, the leading commentator on 468B finds no basis for the Single Claimant QSF myth. (See Actually, Single-Claimant Settlement Funds Are Valid)

X. Conclusion

In conclusion, “QSF” means a “Qualified Settlement Fund” that provides a strategic solution for managing litigation awards and settlements. They offer a structured approach that benefits all parties involved, simplifying the process and providing time for careful planning and negotiation. Their benefits make them a valuable tool in the litigation process.

Follow the associated link to learn more about QSFs.

For more information, contact us at (855) 979-0322.

The world of personal injury settlements is often a complex and intricate labyrinth. One particular aspect, frequently misunderstood, revolves around the taxation of settlements that incorporate punitive damages or interest awarded on the settlement amount. As a critical piece of the puzzle, understanding the nuances of these tax implications is paramount. Let's delve into the intricacies of the Tax Implications of Personal Injury Settlements with Punitive Damages.

Personal injury settlements frequently consist of compensatory and punitive damages. Compensatory damages serve to restore victims to their pre-injury or pre-illness financial state; thus, the Internal Revenue Code (IRC) under Section 104(a)(2) allows such damages received due to physical injuries or illness to be exempt from taxation and provide relief to victims and help them recover without the burden of additional tax liabilities.

Contrarily, punitive damages, and interest, the black sheep of the personal injury settlements family, are considered taxable income. Unlike compensatory damages, punitive damages do not restore the victim to their pre-injury or pre-illness state but penalize the defendant for their egregious misconduct and only serve as a penalty deterrent against similar future behavior. Consequently, under U.S. tax law, punitive damages fall squarely into the taxable income category.

A pivotal decision by the U.S. Supreme Court in O'Gilvie v. United States reinforced the idea that punitive damages linked to personal injury suits, regardless of their association with physical injury or illness, are taxable. Thus, punitive damages are includable in the recipient's gross income for tax purposes.

Recipients of personal injury settlements that include punitive damages must report these amounts. Only the punitive and interest components must be listed as "Other Income" on IRS form Form 1040 (2022), Line 8 (See Schedule 1), allowing the Internal Revenue Service (IRS) to correctly identify the income's nature and apply the appropriate taxation.

Another tax problem arises when punitive damages and attorney fees are contingency-based.  In Commissioner v. Banks and Commissioner v. Banaitis, the U.S. Supreme Court ruled that, for federal income tax purposes, the percentage of a monetary judgment or settlement paid to a taxpayer's attorney under a contingent fee agreement is taxable income to the taxpayer. The Court ruled that when a settlement or judicial award constitutes income, the taxpayer's income shall include the portion paid to the attorney as a contingent fee. A possible solution to avoid the plaintiff's taxation of the attorney fees portion of punitive damages is the Plaintiff Recovery Trust.

However, it is essential to remember that legal landscapes can vary, and tax laws and regulations are subject to change. It is, therefore, advisable to consult with a tax professional or a personal injury attorney who can navigate the intricate legal and tax pathways of personal injury settlements.

Negotiating settlements also requires a careful evaluation of the tax implications. Plaintiffs can receive lump sums or periodic payments of their settlements to spread and minimize tax liability. An example of such a tactic would be to accept payment in installments over several years or the Plaintiff Recovery Trust, which provides lump-sum payments.

It is crucial, however, to refrain from attempts to evade taxes by misrepresenting punitive damages as compensatory damages. Such actions can lead to IRS penalties and interest on unpaid taxes.

In conclusion, the path of personal injury settlements and their corresponding tax implications can be challenging. While compensatory damages provide financial restoration to victims, punitive damages act as a deterrent for outrageous behavior. The contrasting tax implications of these damages reflect their differing purposes. One should always seek expert tax advice to ensure tax compliance.

As the adage goes, only two things are certain in life - death and taxes. It is, therefore, vital to approach taxation with preparedness and diligence and begin by learning more here – Minimizing Taxation of Settlements.

‍

ESPN discussed the regularity of personal injury lawsuit settlements and related financial consequences, interviewing Eastern Point's Chief Trust Officer (Rachel McCrocklin) and Tax Strategist (Jeremy Babener).

"The tax and investment benefits of structuring greatly increase your settlement value."

‍

Fox Business reported on the growth of settlement planning, structured settlements, and Qualified Settlement Funds, interviewing Eastern Point's Chief Trust Officer (Rachel McCrocklin) and Tax Strategist (Jeremy Babener).

"Settling is first about the amount, but plaintiffs gain a lot by planning ahead."

Bloomberg covered the increased use of structured settlements in personal injury cases, interviewing Eastern Point's Chief Trust Officer (Rachel McCrocklin) and Tax Strategist (Jeremy Babener).

"Structured settlements are typically part of a larger settlement plan. In most cases, you can save tax, invest, and protect public benefits, but you have to make those decisions before signing."

Regulatory bodies, such as financial supervisory authorities, set guidelines and enforce compliance with these requirements to maintain the integrity of the financial system. Accordingly, financial institutions are required by federal and international law to conduct "know your client" (KYC) and “anti-money laundering” (AML) monitoring. Such financial institutions include banks, investment firms, insurance companies, money services businesses, private and commercial lenders and other entities involved in financial transactions.

Know Your Client (KYC) and Anti-Money Laundering (AML) Monitoring Goals

KYC and AML regulations aim to prevent money laundering, terrorist financing, and other illicit activities by ensuring that financial institutions have a comprehensive understanding of their clients' identities, ownership, transfer payments, business activities, and sources and uses of funds.

The following provides general classification types of financial institutions that must conduct ongoing KYC and AML monitoring, which includes random and trigger-based information requirements for additional information:

Banks: This includes retail banks, commercial banks, and investment banks. Banks have a significant role in the financial system and handle various types of transactions, making them vulnerable to money laundering and terrorist financing risks.

Investment Firms: Securities brokers, asset management companies, and other investment firms are subject to KYC and AML requirements. These firms handle transactions related to securities trading, investment advisory services, and fund management, which can be susceptible to illicit activities.

Insurance Companies: Insurance providers, including life insurance and general insurance companies, are also obligated to conduct KYC and AML monitoring. Insurance policies can be misused for money laundering purposes, and insurance companies need to verify the identities of policyholders and assess the legitimacy of transactions.

Money Services Businesses (MSBs): MSBs encompass a range of entities such as money transfer services, currency exchange providers, prepaid card issuers, and check cashing businesses. Due to the nature of their services, MSBs are susceptible to being exploited for money laundering or terrorist financing, necessitating robust KYC and AML procedures.

Virtual Asset Service Providers (VASPs): With the rise of digital assets, VASPs, including platforms for asset exchanges and storage services, are increasingly subject to KYC and AML regulations. These entities facilitate the exchange, storage, and transfer of virtual assets, which can be attractive for illicit purposes.

In the global financial landscape, combating money laundering, tax fraud and terrorist financing has become a top priority for regulatory bodies and financial institutions alike. To ensure the integrity of the financial system and prevent illicit activities, various types of financial institutions are required to implement robust KYC and AML measures. This article will provide a detailed list of the types of financial institutions that must conduct KYC and AML data collection and monitoring.

Commercial and Private Money Lenders, and Loan Companies: Lenders, including but not limited to litigation finance companies, are obligated to conduct KYC and AML monitoring. Lending arrangements are often used as part of tax fraud and can be misused for money laundering purposes, and lenders need to verify the identities of loan recipients and assess the legitimacy of transactions.

Trust Companies and Trust Administrators: Trusts are often used to hide the true beneficial ownership and control of accounts. As these firms handle transactions which can be susceptible to illicit activities, trust companies and trust administrators are subject to KYC and AML requirements.

The following provides a more detailed list of examples of the types of firms that are required to comply with KYC and AML requirements:

Banks

• Commercial banks
• Retail banks
• Investment banks
• Correspondent banks
• Islamic banks
• Foreign bank or companies banking in the US
• Credit unions
• Community credit unions
• Corporate credit unions

Insurance Companies

• Life insurance companies
• Property and casualty insurance companies
• Reinsurance companies

Brokerage and Custodian Firms

• Stock brokerage firms
• ForEx brokerage firms
• Commodity brokerage firms
• Security and custodian/transfer agent firms

Money Services Businesses (MSBs)

• Money transmitters
• Third party assignment companies
• Check cashers
• Currency exchangers
• Prepaid access providers

Commercial and Private Money Lenders, and Loan Companies

• Traditional money lenders (banks credit unions, credit cards)
• Peer-to-peer lending platforms
• Online loan companies
• Pay day money lenders
• Consumer lenders
• Commercial lenders
• Private lenders
• Litigation finance companies

Securities Dealers

• Security exchanges
• Broker-dealers
• Securities clearing and settlement firms

Mutual Funds

• Open-end funds
• Closed-end funds
• Exchange-traded funds (ETFs

Trust and Fiduciary Service Providers

• Trust companies
• Fiduciary service providers
• Escrow service providers
• Trust/custody administration providers

ForEx, Cross Border Accounts, and Anonymous Account Providers

• ForEx institutions
• Foreign assignment companies

Wealth Management Firms

• Wealth Management Firms
• Private placements
• Hedge funds
• Private money managers

Payment Service Providers

• Payment processors
• E-wallet providers
• Mobile payment providers

KYC and AML Requirements

Financial institutions, are required to comply with KYC and AML regulations to mitigate the risk of money laundering and terrorist financing. The specific requirements may vary by jurisdiction, but they generally include:

Customer Identification Program (CIP)

CIPs verify the identity of customers through reliable and independent documents, data, or information, and involve the collection of information such as name, address, date of birth, and identification numbers.

Customer Due Diligence (CDD)

CDD is utilized to assess the risk profile of customers based on factors such as their nature of business, location, and transaction history.

In certain cases, CDD may also involve conducting enhanced due diligence for high-risk customers, including politically exposed persons (PEPs) and those involved in high-value transactions.

Beneficial Ownership Identification

Beneficial Ownership Identification involves identifying and verifying the beneficial owners of legal entity customers and gathering information on individuals who own or control the customer and assessing their risk profile.

Ongoing Monitoring

Financial institutions are required to perform continuous monitoring of customer transactions and activities to detect any suspicious or unusual behavior. The following are the key factors that may prompt a US financial institution to request additional KYC information:

Regulatory Compliance: Financial institutions must comply with regulatory frameworks such as the Bank Secrecy Act (BSA) and the USA PATRIOT Act. These regulations require institutions to establish and maintain effective KYC programs to verify the identity of their customers and assess their risk profile. Additional KYC information may be requested to meet regulatory obligations and ensure compliance [1].

Risk-Based Approach: Financial institutions are expected to adopt a risk-based approach to KYC. This means that they must assess the risk associated with each customer and adjust their due diligence measures accordingly. If a customer is considered high risk based on factors such as their country of origin, business activities, or transaction patterns, the institution may request additional KYC information to gain a better understanding of the customer's profile and detect any potential red flags [1].

Changes in Customer Profile: Financial institutions need to keep customer information up to date. Financial Institutions should develop policies to review and confirm the customer information is current. Also, if the financial institution becomes aware, or has reason to believe, of potential changes in a customer's profile, such as changes in ownership, business activities, or transaction patterns, the institution may request additional KYC information to ensure the accuracy and completeness of customer records [3].

Transaction Monitoring: Financial institutions have an obligation to monitor customer transactions for material changes in transactional activity or suspicious activities and to report any suspicious transactions to the appropriate authorities. If a customer's transactions trigger alerts or raise suspicions, the institution may request additional KYC information to further investigate the nature and purpose of the transactions [1].

Compliance with FATCA: The Foreign Account Tax Compliance Act (FATCA) is a US law that requires foreign financial institutions to report information about financial accounts held by US taxpayers or entities with substantial US ownership interests. Financial institutions subject to FATCA may request additional KYC information to comply with these reporting obligations [2].

It's important to note that the specific triggers for requesting additional KYC information may vary based on the institution's internal policies, risk assessment processes, and regulatory requirements. Financial institutions must exercise discretion and judgment in determining when additional KYC information is necessary to ensure compliance and mitigate risk.

Conclusion

The importance of KYC and AML measures cannot be overstated in today's financial landscape. Various types of financial institutions, including lending companies, are required to verify a client’s identity (including but not limited to all Underlying Beneficial Owners and Control Person) as a crucial part of preventing money laundering and terrorist financing. By implementing robust KYC procedures, collecting relevant customer data, and conducting thorough AML monitoring, these institutions fulfill their mandated duty to contribute to the global efforts in maintaining the integrity and security of the financial system.

It's important to note that the lists provided in this article are not exhaustive. Financial institutions should always stay up to date with the latest regulations and guidance issued by the relevant authorities to ensure compliance.

‍

Receiving a settlement from a lawsuit can provide much-needed financial relief, but it can also raise important questions about the taxability of those funds. Understanding the tax implications of lawsuit settlements is crucial for individuals seeking to maximize compensation, minimize the associated tax impact, and avoid potential pitfalls with the Internal Revenue Service (IRS).

In this analysis, we focus on:

• Are settlement payments taxable income,
• How to avoid paying taxes on a lawsuit settlement, and
• The confusing and complex world of lawsuit settlements and awards taxation, explore when an award or settlement is taxable, discuss strategies to minimize tax liability, analyze the distinction between physical injury and non-physical injury claims, and highlight the critical role of settlement agreements, Qualified Settlement Funds (QSFs), and Plaintiff Recovery Trusts in minimizing the tax impact on lawsuit settlements and awards.

Understanding the Taxability of Lawsuit Settlements

Generally, the primary law regarding the taxability of amounts received from lawsuit awards and settlements is Section 61 of the Internal Revenue Code (IRC).

Specifically, this code section states that “gross income means all income from whatever source derived…” unless another code section exempts the income source.¹ Section 104 of the IRC excludes taxable income settlements and awards due to lawsuits stemming from physical injuries.² However, the relevant IRS guidance states that one should consider “the facts and circumstances surrounding each settlement payment” to determine the settlement proceeds’ purpose accurately, as “not all amounts received from a judicial award or settlement are exempt from taxes.”³

Types of Judicial Awards and Settlements

Judicial awards and settlements can be divided into groups to determine whether the associated payments are taxable or non-taxable. According to relevant IRS guidance, “the first group includes claims relating to physical injuries, and the second group is for claims relating to non-physical injuries.”⁴ Once funds have been classified into one of these two groups, a further subdivision is made, and the funds will usually fall into the following categories:

• Actual damages resulting from physical or non-physical injury
• Emotional distress damages arising from the actual physical or non-physical injury
• Punitive damages
• Compensatory Damages
• Interest on the award or settlement

Importantly, award or settlement proceeds received for personal physical injuries or sickness are excludable from the recipient’s gross income under IRC Section 104(a)(2).⁵ For emotional distress recoveries to be excludable from taxation, the underlying damages must be due to personal physical injuries or illness.

Pro Tip: Any amount which is a reimbursement of past actual medical expenses that was previously deducted is also taxable.⁶

Pro Tip: Punitive damages are never excludable from gross income (thus, they are always taxable), except for damages awarded for wrongful death in states where only punitive damages may be awarded.⁷

Strategies to Minimize Your Tax Liability on Settlement Money

There are several strategies plaintiffs can employ to minimize their tax liability on settlement money. Plaintiffs may reduce their taxable income by justifiably allocating damages to non-taxable award categories like physical injuries and medical expenses and decreasing amounts related to emotional distress.

Structured settlements offer a way to spread payments over multiple years and may keep the plaintiff in a lower tax bracket and reduce the overall tax burden compared to receiving a lump sum.

QualifiedSettlement Funds (QSFs) provide short-term tax deferral and flexibility forplaintiffs to plan when and how to receive payments while allowing defendantsto claim an immediate tax deduction. QSFs act as a settlement resolution taxtool, assuming tort liability from defendants. While QSFs do not directlyprovide long-term tax reduction benefits, they facilitate spreading settlementpayments over time a̶s̶ ̶r̶e̶g̶u̶l̶a̶r̶ ̶i̶n̶c̶o̶m̶e̶ ̶o̶r̶ ̶c̶a̶p̶i̶t̶a̶l̶ ̶g̶a̶i̶n̶s̶ instead oftaking a large lump sum, which can significantly lower the taxes owed bykeeping the plaintiff out of higher tax brackets in a given tax year. A QSFshould be strongly considered for every settlement, as they facilitate lienresolution and other post-settlement issues and disputes.

‍

Legal Insights and Professional Tax Advice

Navigating the complex tax implications of lawsuit settlements requires guidance from subject matter experts and experienced tax professionals. Consulting with an experienced settlement tax expert before finalizing a settlement agreement or even before filing the case can provide valuable insights into the potential tax consequences and help plaintiffs negotiate more favorable tax outcomes.

If justified, allocating damages to non-taxable categories like physical injuries and medical expenses may be helpful. However, avoid unwarranted attempts to negotiate the amount reported on Form 1099, as adverse tax consequences may arise from such tactics.

Pro Tip: Be aware that above-the-line income deductions for attorney fees typically raise IRS audit flags, and the IRS, as their examination guidelines call for, will apply scrutiny to the elements of the original pleadings, which is often known as the origin-of-the-claim test. The IRS can use the original pleadings against the taxpayer to disallow exemption classification. The origin-of-the-claim test (not the 1099 issued) will determine the nature of legal fees, thereby deciding how the attorney fees are treated for tax purposes. It is essential to examine the facts of the pleaded claim(s) and ask why the individual hired an attorney – for example, was it to enforce a civil right violation or enforce some other claim(s)? Answering these questions should enable the determination of whether the fees are nondeductible personal expenses, business or income-related, or capitalizable as related to a property interest. As much as some advisors will lead you to believe otherwise, if not justified, there are severe potential adverse consequences for classifying the attorney’s fee portion in this manner.

Commissioner v. Banks

In Commissioner v. Banks, 543 U.S. 426 (2005), the United States Supreme Court addressed the question of the plaintiff’s taxation of the portion of a judgment or settlement paid to a taxpayer’s attorney under a contingent-fee agreement.

There, the Court held that the total (taxable) settlement proceeds, including the contingent attorney fee portion, are income attributable to the plaintiff-taxpayer for federal income tax purposes. As such, attorney fees also impact a plaintiff’s tax obligations, and the Tax Cuts and Jobs Act of 2017 severely limited the deductibility of legal fees. Tools like structured settlement annuities and Plaintiff Recovery Trusts can significantly mitigate the tax burden and maximize the plaintiff’s net recovery.

It is crucial for plaintiffs, with tax implications in mind, to shield their settlements from excessive taxation by seeking professional tax advice and carefully shaping the settlement agreements.

Conclusion

Lawsuit settlements can provide much-needed financial relief, but understanding their tax implications is crucial for maximizing compensation while avoiding issues with the IRS. By recognizing the distinction between physical injury and non-physical injury settlements, utilizing settlement agreements effectively, and considering tools like Qualified Settlement Funds and the Plaintiff Recovery Trust, plaintiffs can minimize their tax liability and protect their financial interests. Seeking guidance from experienced tax professionals and attorneys is essential to navigating the maze of settlement taxation.

Proactive tax planning and carefully structured settlement agreements shield the associated proceeds from unnecessary taxation. By being informed and working closely with legal and financial experts, plaintiffs can ensure they receive the full benefits of their settlements while minimizing their tax obligations, allowing them to focus on moving forward after successfully resolving their legal claims.

FAQs

How can I minimize taxes on a lawsuit settlement?

To minimize taxes on settlement money, consider the following strategies:

• Establish a Plaintiff Recovery Trust – you must do so before the final settlement or judicial award, including appeals.
• Establish a Qualified Settlement Fund with QSF 360 to provide deferral options and time for planning.
• Maximize exclusions for medical expenses.
• Allocate, in detail, all damages in the Settlement Agreement to specify what each portion covers and stipulate the payment into a QSF.

Which types of settlements are exempt from taxes?

Settlements for physical injuries are generally not taxable. Therefore, you typically do not need to pay taxes on these types of settlement money (except for any associated punitive damages, which are always taxable).

How should I report a taxable lawsuit settlement on my tax return?

The taxable portion of a legal settlement, including those that involve previously deducted medical expenses related to physical injuries or illnesses and punitive damages, should be reported as miscellaneous (other) income on your tax return. Any interest earned on the settlement the plaintiff receives is also taxable.

‍

A Qualified Settlement Fund (“QSF”) is a distinctive financial tool that plays a crucial role in litigation or non-litigation dispute settlements. A QSF is a tax-efficient financial mechanism that allows the parties settling a dispute to manage their funds effectively and securely.

This white paper focuses on the question of ownership of the QSF and its property. Specifically, this white paper deals with who owns a QSF and who owns the property within the Qualified Settlement Fund.

An extensive list of case law dealing with the topics is included at the end of this document.

1. What is a QSF?

A Qualified Settlement Fund is a statutorily authorized “fund, account, or trust…”¹ that allows a defendant in a dispute to assign its associated financial liability to the QSF. Although not required to be trusts, QSFs are typically created under an irrevocable trust structure rather than as a non-trust-based fund or account. A QSF may not be established or operated as a revocable (grantor) trust – unless the single defendant establishes the trust pursuant to § 1.468B-1(K). Because of this, traditional trust rules and laws apply—including provisions addressing trust asset ownership and asset title. QSFs are a valuable tool available to quarreling parties in the dispute settlement process. Qualified Settlement Funds afford beneficial tax consequences to the parties, serve as a controlled distribution mechanism, allow for fairness and transparency, and allow flexibility in the complex world of modern-day dispute resolution.

2. Establishment and Approval of a QSF

A QSF trust must be created as a “statutory trust” and approved by a “Governmental Authority” as defined by § 1.468B-1(c) and, as mentioned above, established under state trust law. The regulations in § 1.468B-1 cover aspects such as transfers to the fund, income earned by the Qualified Settlement Fund, and distributions made by the fund. Although not required to settle a dispute, the parties to the dispute may choose to use a QSF, or the Court having jurisdiction over the matter itself may order a QSF. When a QSF is established for settlement purposes, the defendant or their insurer transfers the agreed settlement or judicial award amount into the Qualified Settlement Fund.

Pro Tip:

A court is not required to approve the trust. Any “governmental authority defined by 1.468B-1(c)(1) may authorize the creation."

3. What Constitutes Qualified Settlement Fund Trust Property?

Qualified Settlement Fund trust property consists of the assets the defendant (or their insurance carriers) transferred into the settlement trust to resolve one or more claims arising from an event or a related series of events against the defendant. QSF trust property can include cash, real estate, or tangible or intangible property such as bank accounts or business interests. A QSF trust can hold any property transferred into it. It is important to note that while a settling party (or their insurance carrier) may have transferred settlement funds into the QSF trust, the funding of the QSF trust does not create an ownership interest in the plaintiffs (claimants), their attorneys, agents, or any other third party.

4. Legal Title and Ownership of the Property in a QSF Trust

Like any other trust, a QSF trust has the following characteristics:

• The QSF trust’s assets constitute separate property and are not owned by the grantor, defendants, beneficiaries, claimants (plaintiffs), or any other third party with a contract with the claimant.
• Assets held in a QSF trust are titled in the trustee’s name; thus, the trustee is the title owner to act on behalf of the QSF trust.
• The trustee still has agency and fiduciary duties subject to applicable law, the QSF trust terms, and any associated administrative agreements.

Once assets are transferred to the Qualified Settlement Fund trust and titled as the legal property of the trustee, such assets are held in trust for the future beneficial expectations of claimants once allocated and vested by the trustee.

Pro Tip:

26 U.S. Code § 468B(b)(3)(C) plainly states that “the fund shall be treated as the owner of the property in the fund (and any earnings thereon).” There can be no question of ownership based on the black-letter law established by Congress. Building on the statute, numerous court cases have upheld and expanded this portion of the law. You now have the silver bullet answer, but you can keep reading for additional reasons that reinforce the statutory provision and why the ownership of a QSF is not held by the claimants or their attorneys.

North Carolina Dept. of Revenue v. Kimberley Rice Kaestner

It is important to note that in a properly constructed QSF, the mere potential of a future benefit from a trust does not confer ownership. In North Carolina Dept. of Revenue v. Kimberley Rice Kaestner 1992 Family Trust, the Supreme Court of the United States held that when a trustee maintains control of the trust, the mere expectation of a benefit from the trust does not imbue the beneficiaries of a trust with the right to “control, possess, or enjoy the trust assets.”² It is hornbook law that the ability to request via a petition that the trustee considers an action does not constitute control, possession, or enjoyment of trust assets.

Additionally, note that well-drafted QSF trust documents are vital in ensuring trust ownership. Well-drafted sample language regarding ownership might read something like:

For the purpose of clarity and the avoidance of confusion; (i) the sole ownership of the Assets of the Trust resides with the trust, and (ii) the trustee has the sole authority, control, and absolute discretion over the funds held within the trust, their disposition and the application of the Claw Back (Reversion) provision, and (iii) the trustee has the sole authority, control and absolute discretion over the operation of the Trust subject to the continuing jurisdiction of the Governing Authority.

5. Vesting of Rights in QSF Trust Assets

Understanding the difference between a vested interest and a contingent interest is central to the question of ownership. When a person or entity has only a contingent interest in the property (such as in a QSF), they lack absolute and unconditional ownership rights. In the case of a QSF, the trustee must vest the right to such property by such action —to create absolute and unconditional ownership rights to the property.

Third parties (such as a law firm’s contingent fee interest or a hospital medical lien) asserting a claim to property in the QSF trust do not have a vested interest in such property – they only have a claim against the underlying client. In a properly constructed Qualified Settlement Fund, the trustee is the only authorized party who may vest a benefit and qualify a claimant as a “distributee,” as defined by the state trust code. A law firm, on behalf of a claimant or other party, may petition the trustee to consider vesting a right in trust assets and distributing them. However, the trustee, in their discretion, may approve or deny the request based on various factors such as unresolved liens, ongoing litigation, other claims, or other uncertainty or factors. Only when the trustee approves the petition for distribution is the party making the petition vested in that property.

It is helpful to note that well-drafted Qualified Settlement Fund trust documents are crucial. Well-drafted sample language regarding ownership might read something like:

“Vested Right” – Means: that the trustee may, in its sole authority and absolute discretion, elect to vest a right to a portion of the Trust Assets for a Distribution to a Claimant. Prior to the trustee vesting a right to any portion of the Trust Assets, no Claimant has a Vested Right to any Trust Assets. All Trust Assets are Unvested Rights and only constitute a mere future expectancy until the trustee grants the benefit as a Vested Right in its sole authority and absolute discretion. Upon a Claimant obtaining a Vested Right, they become a Distributee, as defined herein, only to the extent of that specific Vested Right and Distribution, and such claimant shall remain an unqualified Claimant relative to any other potential future benefit expectancy. Only the trustee may confer a Vested Right, and no provision of this Trust Administration Agreement and the Trust Agreement shall confer any absolute Vested Right. The Vested Right provision is a Material Purpose of the Trust.

AND

Trustee may from time to time, in its sole authority and absolute discretion, after granting a Vested Right, thereby qualifying the claimant as a Distributee as defined herein, disburse to a Claimant a vested interest in the trust as follows:

(a) Distribute directly to the claimant; and/or

(b) Distribute to the IOLTA account of the Law firm or Attorney representing the Claimant; and/or

(c) Distribute to the Claimant’s Guardian, Conservator, Parent, Family member or another person who has assumed responsibility for the care of such claimant, for his or her suitable support, maintenance, welfare, education or other appropriate needs; and/or

(d) Hold in a Trust and distribute by direct application in such amounts for the benefit of the claimant; and/or

(e) Assign into a “first party” Special Needs Trust to preserve the government benefits of the claimant; and/or

(f) Distribute or assign in such manner as the trustee, in its sole authority and absolute discretion, deems appropriate or necessary.

6. No Attorney (or other Agent) Ownership Claims

There is often the question of whether attorneys (or other such agents) have an ownership right in the Qualified Settlement Fund trust or the assets held in such trust. The answer is a resounding NO.

The United States Supreme Court addressed this question in Commissioner v. Banks. There, the Court held that a “lawyer is not a joint owner of his client’s claim in the legal sense any more than the commission salesman is a joint owner of his employer’s accounts receivable.”³ The reasoning for this holding was based on the basic premise of agency law that, even when the agent is acting independently and without the consultation of the principal, the agent is still obligated “to act solely on behalf of, and for the exclusive benefit of, the client-principal, rather than for the benefit of the attorney or any other party.”⁴ The Court specifically stated that attorneys (or other such agents) who may have contingent-fee agreements (or other payment agreements) with the plaintiffs might be entitled to secondary claims against the claimants by contract with the claimants), but they are certainly not entitled to claim ownership rights over those assets.⁵

In sum, attorneys and other plaintiffs’ agents do not have ownership rights in assets held in a QSF trust. Still, they may claim a security interest in such assets. It is helpful to think of a security interest like a lien levied against someone else’s property—you do not own the property in question, but you can assert a claim against it at the appropriate time and through the proper mechanisms.

7. QSF Management and Disbursement Can Impact Ownership

To avoid imputed ownership by triggering the constructive receipt or economic benefit doctrines, noted tax commentators have suggested that funds held in a QSF should be disbursed within twelve (12) calendar months of resolving all associated secondary matters. This recommendation is to avoid using a Qualified Settlement Fund as a mere tax deferral scheme. Platforms like QSF 360 provide integrated management of the associated QSF duration.

8. Decanting Does Not Affect QSF Ownership

Decanting is creating a new trust or sub-trust and transferring the trust property and terms into a segregated version of the original trust. Decanting is not a distribution; it does not vest ownership or a distribution to any beneficiary and usually does not trigger constructive receipt or economic benefit doctrines. In the case of a QSF trust, decanting is the transfer (as a look-through, secondary transfer) of the defendant’s liability and the associated assets into a new QSF trust or a Sub-QSF trust. The act of decanting related to a Qualified Settlement Fund often results in multiple ongoing funding events as various recoveries from carriers or defendants are received over time. Remember, when a trust is decanted (whether into a new trust or sub-trusts), the same terms and conditions of the original trust apply to new or sub-trusts.

In general, all states allow for trust decanting, but the definitions and requirements differ by state, as the below examples indicate.

In Virginia, “decanting power” is defined as the power of an authorized fiduciary to distribute property from one trust to another or modify the first trust’s terms.⁶ Additionally, § 64.2-779.12 of the Virginia code sets out some limitations on decanting power, such as limiting the fiduciary’s ability to exercise its decanting power if the first-trust instrument expressly prohibits it.

In Michigan, “trust decanting” is defined as the process of transferring property from one trust to another.⁷ The statute also sets out two conditions that must be met for the transfer to be valid. First, the terms of the second trust must not materially change the beneficial interests of the beneficiaries of the first trust. Second, the governing instrument of the subsequent trust must not be inconsistent with the tax planning that informed the first trust.

In Florida, the term “decanting” is not specifically defined, but the statute allows for a trustee with absolute power to distribute trust property to distribute some or all of the property to a second trust.⁸ The statute has additional requirements, such as requiring the trustee to notify all qualified beneficiaries in advance of such distribution and requiring that the beneficiaries of the second trust must include only beneficiaries of the first trust.⁹

Thus, decanting is not an act by the trustee to vest any benefit, nor is it a determination of an unqualified right as a distributee. It is merely the transfer of all or a part of a trust which continues the original intent of the original trust into one or more subsequent trusts. In the case of a Qualified Settlement Fund trust, the trustee may decant a portion of the settlement to facilitate a more rapid administration of the QSF.

Well-drafted sample language regarding decanting might read something like:

“Decant” (a.k.a. Decanting) - Means: the distribution of part or all of the Assets of the Trust or a subsequent Trust into a recipient trust pursuant to the terms of this Trust Administration Agreement and the Trust Agreement as an exercise of the trustee’s sole authority and absolute discretion. Specifically, the trustee may invade the principal of the trust to create another Trust for the claimant’s best interests, welfare, comfort or happiness which for the purpose of the trust constitutes an “absolute power” under the laws of the Principal Place of Administration.

9. Notational Accounting is not Ownership

Qualified Settlement Fund trusts may have multiple claimants and other third parties with adverse interests who assert claims against the QSF trust. During the administration, the trustee and/or the trust administrator (as applicable) may use notational workpapers to administer the Qualified Settlement Fund and maintain records of claims asserted against the QSF trust. These notational workpapers or related documents do not vest any benefits nor change the ownership status of the QSF trust or its assets. Many trusts include within their terms and conditions a stipulation that administrative notational utility records or worksheets do not constitute a record of a vested right.

As noted previously, it is only when the trustee, in their sole authority and absolute discretion, (i) vests a claimant to a right in QSF trust assets; (ii) qualifies a claimant as a beneficiary-distributee; and (iii) the trustee does, in fact, disburse the funds to the vested and qualified claimant-beneficiary that a claimant becomes an owner of the funds.

Accordingly, notational allocation worksheets do not constitute a trustee’s affirmative action to vest a right.

Well-drafted sample language regarding notational accounting might read something like:

For the purpose of clarity and the avoidance of doubt, it is conclusively stipulated that interim worksheets, interim allocations, interim calculations, interim working papers and interim ministerial sub-accounts of the trust are solely for the administrative and ministerial convenience of the Trustee and Trust Administrator, are only notational and do not convey or establish any Vested Right, constructive receipt or economic benefit to or on any respective Claimant. Further, interim notional allocations may change from time to time at the discretion of the trustee.

10. No Power of Appointment

A Power of Appointment is a type of power that the grantor of a trust confers to another person (the “Power Holder”). A Power of Appointment allows the Power Holder to direct the distribution of property to any person or entity subject to the terms and conditions specified in the trust’s documents. The Power of Appointment can be general or limited, but we will not delve into the differences in this paper as the distinction does not affect ownership of QSF trust assets.

In a well-constructed Qualified Settlement Fund, only the trustee will have a Power of Appointment, thereby allowing the trustee, in its sole authority and absolute discretion, to vest beneficial rights in claimants to trust assets.

QSF trust language here again provides clarity:

The trustee shall solely possess a general power of appointment to allocate, resolve and settle all claims and obligations of this Trust and the associated Settlement Agreement which the trustee may exercise from time to time, in its sole authority and absolute discretion. For the purpose of clarity and avoidance of confusion; no Claimant holds any general or specific power of appointment nor may they exercise such within the meaning of § 2041 and § 2514 of the Internal Revenue Code.

11. No Constructive Receipt or Economic Benefit

The constructive receipt and economic benefit doctrines help determine whether a taxpayer has taxable income in a given year and under certain circumstances. We address these concepts in this paper because they can indicate whether a taxpayer has “income” or access to income from a given source, thereby triggering an ownership claim.

As noted by Robert Wood, a distinguished tax attorney and the foremost authority on Qualified Settlement Funds:

“The benefits of a QSF are enormous and provide a firewall to the fundamental tax concepts of constructive receipt and economic benefit. QSFs promote dispute resolution and are specifically authorized by section 468B and the regulations. The constructive receipt and economic benefit rules are non-IRC tax doctrines borne in the case law. Constructive receipt broadly stands for the proposition that a taxpayer with a legal right to receive money who simply chooses not to receive it is still taxed because he could have received it. The economic benefit doctrine is similar. It stands for the concept that when money is irrevocably set aside for someone and will inure to his benefit, he should be taxed on it, even if he cannot receive it immediately. If waiting is the only impediment, the IRS can tax it. QSFs bypass both these rules, but they do so for valuable policy reasons: dispute resolution.”¹⁰

The doctrine of constructive receipt states that if funds are set aside for a taxpayer, credited to the taxpayer’s account, or “otherwise made available so that [the taxpayer] may draw upon it at any time…” even though the taxpayer may not have possession of those funds, such funds will be considered constructively received by the taxpayer and thus taxable.¹¹ However, the federal regulations clearly state that “income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.”¹² In essence, if funds have been set aside for a taxpayer, such as a plaintiff via a QSF trust, but the taxpayer’s access to or control of those funds is subject to substantial limitations or restrictions, there is no constructive receipt, no taxable income, and thus no ownership claim. In the instance of a QSF trust, a defendant (or their insurance carriers) will assign their liabilities to the QSF trust and fund it with settlement funds. However, as has been repeatedly stated, there are a multitude of persons and entities that can make a claim (or petition for distribution) on QSF trust assets, but it is ultimately the trustee—subject to various terms and conditions, secondary claims, and various other contingencies—that has the power to vest a claimant and make distributions of QSF assets. Because of this, claimants’ control of receipt of funds is subject to substantial limitations or restrictions.

The economic benefit doctrine was established in case law, with Sproull c. Comm’r. of Internal Revenue being the seminal case for this doctrine. In Sproull, the Court held that a taxpayer received an economic benefit when his employer placed a bonus in trust for the taxpayer’s sole benefit.¹³ The tax court reasoned that since the taxpayer had nothing to do but assert his claim against the trust, the trustee’s only duties were to hold the monies in favor of the taxpayer, and “the trust agreement contained no restriction whatever on [taxpayer’s] right to assign or otherwise dispose…” of the trust’s assets, the taxpayer had an economic benefit.¹⁴ Out of this case came the Sproull elements—when all of the following three are present, there is an economic benefit.

“(1) There must be some fund in which money or property has been placed;

(2) The fund must be irrevocable and beyond the reach of the creditors of the party who transferred the funds to the escrow or trust; and

(3) The beneficiary must have vested rights to the money, with receipt conditioned only on the passage of time.”¹⁵

In the case of a Qualified Settlement Fund, the first two elements are easily found to be present. However, the third element is not present in a properly structured QSF trust. As has been discussed, the rights of a beneficiary (plaintiff) of a QSF trust and any other party claiming assets in the QSF trust are not vested, and the receipt of funds is not conditioned only on the passage of time; it is in the trustee’s sole and absolute discretion and authority—based on several conditions—to determine when and if to vest beneficiaries and make disbursements of funds.

Thus, in a properly constructed QSF, there is no constructive receipt or economic benefit, and, as such, there is no receipt or ownership of funds.

12. The Ability to Structure and Assign Implicitly Demonstrates the Lack of Ownership

The ability to structure or assign from a Qualified Settlement Fund is well-established and widely implemented. A structure requires that the QSF trust assign the defendant’s original settlement obligation (which was transferred to the QSF), its liability, and associated assets to a third party (an insurance carrier or assignment company). If a claimant or attorney had ownership or control over the Qualified Settlement Fund assets, there would be actual receipt of funds and thus no ability to structure or assign. Because of this, no insurance carrier or assignment company would agree to any such assignments. Accepting this proposition would render decades of court precedent, tax precedent, IRS precedent, and business structures null and void—a ludicrous proposition.

13. Lack of IRS Action

If it were correct that the claimants owned funds in a QSF, then “Actual Receipt” would occur upon the funding of the QSF, triggering immediate taxation and eliminating the ability to structure or assign the settlement proceeds. Pattern and practice demonstrate that this is not the case. In the multiple decades of the history of QSFs, the IRS has never found nor asserted ownership (actual receipt) of funds held in an adequately constructed QSF. The IRS’ past Private Letter approvals and audits of QSFs show no corresponding enforcement action by the IRS. Accordingly, the notion of ownership of the Qualified Settlement Fund funds by the claimants is unsupported by fact, history, and legal doctrine. The IRS’ consistent actions demonstrate beyond any possible argument the falsity of claimants asserting ownership of the Qualified Settlement Fund or its property.

14. Congressional Intent

Regarding QSF ownership, Congress has expressed its intent in § 468B, so the IRS’ determination will be controlling. The IRS has issued a regulation stating that “if a fund, account, or trust that is a qualified settlement fund could be classified as a trust within the meaning of § 301.7701–4 [of the CFR], it is classified as a qualified settlement fund for all purposes of the Internal Revenue Code...”¹⁶ Section 301.7701–4 of the CFR says that a “‘trust’ as used in the Internal Revenue Code refers to an arrangement created…by an inter vivos declaration whereby trustees take title to property …”¹⁷

Pursuant to the plain language of the statutes and regulations, and with the over three decades of IRS precedent clearly showing the IRS’ interpretation of “ownership” for QSF purposes, the matter of ownership of the QSF and its assets is fully settled and establishes that the claimants are NOT the owners of the QSF or its assets. No reasonable court would find that the trustee of a QSF Trust is not the owner of the QSF Trust’s assets.

15. Conclusion on Qualified Settlement Fund Ownership

Qualified Settlement Funds are a valuable and common-place settlement tool, but it is essential to understand these trusts’ ownership structure. Assets held in a QSF trust are statutorily established to be owned by the QSF, not the claimants nor their attorney agents. Said QSF assets are “legally titled” in the name of the trustee. Further, a QSF trustee is solely empowered to vest rights to Qualified Settlement Funds assets in beneficiaries in the trustee’s sole and absolute discretion. Additionally, because the sole act of funding a QSF does not vest any party with rights to such assets, the constructive receipt and economic benefit doctrines are not triggered. Finally, a QSF’s duration under § 1.468B-1 is defined by the time taken to fulfill its intended purpose and resolve all related secondary matters such as liens, secondary litigation, appeals, and other conditional matters. This flexible duration, combined with the safeguards of a QSF, offers a comprehensive solution for managing settlement funds. A Qualified Settlement Fund enjoys the status and protection of a trust and does not convey ownership to the claimants until the trustee has resolved applicable secondary claims and allocated and vested a right to a distribution.

‍