What Is A QSF And When Should It Be Used?
by Tab Keener
A Qualified Settlement Fund (QSF) allows taxpayers involved in litigation to receive settlement funds and potentially avoid tax ramifications until the funds are otherwise paid to the taxpayer. Oftentimes a QSF is used in mass tort or other types of class action litigation. A defendant or its insurer may pay money into the QSF, often through a structured settlement, and receive a release of claims by court order while multiple claimants decide upon an allocation among themselves.
Insurance companies and large self-insured businesses typically resist the use of a QSF. Their concern is magnified when a suit involves a single injury and derivative claimants (as in wrongful death and survival actions). The uncertainty is the belief that claimants may have essentially received the economic benefit of the money immediately upon payment into the QSF. The worry is that taxpayers, if taxed, would be motivated to sue the entity funding the settlement to offset the unexpected tax liability.
Birth of the QSF
Structured settlements became popular in the late 1970’s and 1980’s. Insurance companies funding structured settlements became concerned that payments made to an entity, rather than the claimant, would not be tax deductible—as they clearly would be if paid to an individual. Defendants and their insurance carriers wanted to make sure that they could deduct payments in the year in which they were paid rather than when the money was distributed. Congress enacted Section 468B of the Internal Revenue Code in 1986 to address such concerns.
When Section 468B was first enacted it only addressed a “Designated Settlement Fund.” Section 468B was later amended to add an additional section giving the Secretary of the Treasury additional authority to draft regulations further addressing the potential tax ramifications of such a fund. Through a series of regulations, the QSF was created.
To be a QSF, a fund must first be “established pursuant to an order of, or approved by, the United States, any state (including the District of Columbia)… and is subject to the continuing jurisdiction of that governmental authority.” Second, the fund must be “established to resolve or satisfy one or more contested or uncontested claim asserting liability…” The third and final requirement is that the fund must be a “trust under applicable state law, or its assets are otherwise segregated from the assets of the transferor (and related persons).”
Using a QSF When Only a Single Injury Is Involved
Defendants and their insurers often have concern about the potential future tax liability associated with a QSF, which is afforded different tax treatment than a typical settlement annuity. A settlement annuity grows tax free to the benefit of the claimant while earnings in a QSF are taxable to the fund itself. A taxpayer could face serious tax ramifications because of the doctrines of constructive receipt and economic benefit.
This is especially true in the case of a young minor child who would have many years of earnings growth. After reaching the age of majority, the child could bring suit contending that she was not adequately protected through the creation and use of the QSF and should now be entitled to recover the amount of lost earnings due to unfavorable tax treatment. The risk is whether the tax benefits of a structured settlement are lost when a QSF is created and periodic payments begin that only benefit a single claimant or derivative claimants.
To alleviate these problems, claimants and their attorneys may suggest providing additional indemnification and promises to execute a Compromise Settlement Agreement. Such indemnification can add to uncertainty if unfavorable tax treatment were to occur. However, no revenue ruling or regulation clearly describes how a QSF is used when dealing with a single claimant or single injury involving derivative claimants and a structured settlement funds the QSF. Until additional regulations are promulgated, at least be aware that unfavorable tax treatment is a possibility that could undo a hard-fought settlement.
Tab H. Keener is a Shareholder with Downs Stanford, P.C. He can be reached at firstname.lastname@example.org.