Qualified Settlement Funds: Everything You Wanted To Know But Were Afraid To Ask

Q: What are Qualified Settlement Funds?

A: Qualified Settlement Funds, Qualified Settlement Trust, QSFs, 468B funds, and even DSFs or Designated Settlement funds (though those are slightly different) are all enabled by section 468B of the Internal Revenue Code, Basically, they are trusts or accounts set up to resolve claims.

Q: How long have these trusts been possible?

A: They date to 1986, when section 468B of the Internal Revenue Code was enacted.

Q: Why was this Code Section enacted?

A: It was really responding to industry practice with class actions. This provision was enacted at the bequest of defendants, so defendants could get their tax deduction currently for settlement payments even though amounts might be tied up among warring multiple plaintiffs for some time. The normal rule is that a defendant can’t claim a deduction until the plaintiff receives the funds. The QSF rules are a big exception to this.

Q: What are the requirements to form a QSF?

A: There are only three requirements. First and foremost, they have to be subject to court supervision. That means you go to court and ask the judge to approve a QSF trust document and take jurisdiction. Second, the trust has to exist to resolve or satisfy legal claims. Third, the trust must qualify as a trust under state law. As you can imagine, those are three pretty easy rules to satisfy.

Q: Who can be a trustee?

Anyone who has legal capacity can be a trustee (so it couldn’t be a minor or a legally incompetent person). But it doesn’t need to be a trust company or a trust specialist. Lawyers and accountants often act as trustees to QSFs. The plaintiff’s lawyer can be a trustee, although I would never recommend that.

Q: Which court can supervise the QSF?

A: Any court. This may be a surprise, but you can go to the court that has jurisdiction over the underlying legal dispute, or you can go to a different court (a state court in a federal matter or vice-versa). You can even go to a probate court. Some people prefer this, since probate judges are usually familiar with trusts.

Q: Can the defendant have an interest in the trust?

A: No, not if the defendant wants to claim his tax deduction right away and get out of the case. One of the requirements for the QSF deduction, the essential ticket allowing the defendant to claim its tax, is that the defendant must relinquish all interest in the money.

Q: Is a QSF taxed separately?

A: Yes, the QSF will apply for and receive its own Employer Identification Number from the IRS. Then the QSF is taxed as a separate entity, basically like a corporation is taxed.

Q: Is a QSF taxed on the amount it receives from the defendant?

A: No, the QSF is not taxed on contributions from one or more defendants to resolve the claims. Those are non taxable contributions. The QSF is only taxed on the income it makes, basically interest and dividends.

Q: Why do people form a QSF?

A: There are many different circumstances where forming a QSF makes sense. One circumstance is where the plaintiff and defendant are negotiating a settlement, and yet they can’t agree on the tax language or tax reporting. Forming a QSF can be a nice bridge to that, allowing the defendant to simply pay over the money. That can enable the plaintiff and the QSF to negotiate the form of the release the plaintiff will later sign with the QSF. It is kind of a tax-free way station in that way.

Q: Are QSFs mostly for class actions?

A: Not today, though QSFs do work nicely in that context. A QSF is ideal in a class action, where either all of the plaintiffs haven’t been identified, or perhaps they have been identified, but a claims procedure is needed to determine exactly who gets what. Still, you certainly don’t have to have a class action to have a QSF. You might just need more time to determine exact numbers, to fix final attorneys’ fees and costs, and even to facilitate structured settlements.

Q: Can a QSF arrange structural settlements?

A: Yes. In fact, that’s a common reason for setting up a QSF. Sometimes the plaintiffs need time to determine the form of a structure, the exact annuity payout, family needs, etc. That’s true for the attorneys as well.

Q: Can structures be purchased for lawyers from a QSF too?

A: Yes. Here again, a desire to structure a recovery (for plaintiffs) and/or to structure attorneys' fees for counsel can be one of the factors militating in favor of forming a QSF.

Q: Is there a time limit on how long a QSF can exist?

A: No. They are flexible, and there is no a time limit. In my experience, QSFs generally exist for a relatively short time, usually a matter of a few weeks or a few months. In complex and large class actions, I've seen QSFs exist for several years to resolve claims. Beyond that, there is no guidance for how long a QSF can last.

Q: Do the constructive receipt and economic benefit doctrines apply to QSFs?

A: Not really. There are broad statutory and non-statutory doctrines in our tax code---the most complex tax code in the world. People with a little tax knowledge find QSFs odd, since they seem to fly in the face of the normal constructive receipt and economic benefit doctrines. The usual operation of those tax doctrines might suggest that plaintiffs and their lawyers are taxable. Bear in mind that, the defendant is getting his tax deduction as soon as the money is put into the QSF. Really, the QSF is a tax free way station. Monies are not treated as received by the plaintiff(s) and lawyers until they are paid out of the QSF.

Q: Can you have a QSF with just one claimant?

A: This is a real hot button question. The statute, section 468B, and the treasury regulations suggest a QSF is possible if you have “one or more” claims, so my answer is that it is probably OK. However, because I know that the IRS has repeatedly said it is studying this issue (and some structured settlement industry insiders have urged Treasury to look at his issue) I urge caution. We know that the statute seems to support single claimant funds, but there is no guidance. We also know the IRS is thinking about this issue. As a result of this uncertainty, I would always want to have at least two claimants.

Q: Is it clear who qualifies as multiple claimants?

A: No. Perhaps husband and wife works, and maybe the lawyer and client works. Optimally, of course, you would want multiple claimants in a real sense, meaning multiple plaintiffs in the case.

Q: Why is the singe claimant issue is a hot button issue?

A: Unfortunately, it has become a kind of flashpoint in the structured settlement industry. Plaintiff brokers often feel they are frozen out of the process by defense brokers and insurance companies. Plaintiff brokers may try to take control of the case (and therefore the commission on the structures) by forming a QSF. Conversely, defense brokers and life insurance companies are concerned, especially with single claimant QSFs, since they also don’t want to be frozen out of the process.

Q: Can't defense brokers and plaintiffs' brokers split commissions?

A: Yes. Many plaintiff and defense brokers do this already, agreeing to split commissions, either evenly or in accordance with efforts expended.

Q: Are QSFs flexible?

A: Absolutely. Class action lawyers are used to using these vehicles, but many lawyers (both plaintiff and defense lawyers) are surprised when they hear about some of these details. They can use a QSF for making the settlement process much smoother, much more efficient, and much more closely tailored to what the plaintiffs (and the plaintiff’s counsel) really need and want. A QSF can be very good for defendants too. I’m not suggesting QSFs are appropriate to settle every case. However, they have almost no downside, and they afford time at what is often a difficult period. They can really save the day in some circumstances.