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Qualified Settlement Fund: Tax Deferred Litigation Awards For All

Qualified Settlement Funds

Litigation settlements and awards can now be invested directly from

the lawsuit to an investment account in the name of the plaintiff on an income

tax deferred basis. This process is through the use of a Qualified Settlement

Fund. This “QSF" is a tax construct created by the federal government and is

controlled, and thereby regulated, by the Internal Revenue Service.

For purposes of this memorandum, the term “Regulation(s)" refers to the IRS

Treasury Regulations, and the term “Code" refers to the IRS Code.

The Regulations extend special tax treatment to certain funds, accounts

or trust called qualified settlement funds (QSFs). Under the Regulations, the

following requirements must be met in order for a fund, account or trust to

qualify as a QSF:

(1) it must be established pursuant to an order of, or be approved by, a

governmental authority;

(2) it must be established to resolve or satisfy certain specified claims

arising from an event, or series of events, that has occurred; and

(3) it must be a trust under applicable state law, or its assets must be

segregated from other assets of the transferor (or related persons).

Thus, a QSF does not need to completely extinguish the taxpayer's

liability and does not need to be established pursuant only to a court order. An

arbitration award that orders the establishment of, or approves, a fund,

account or trust is an order or approval of a governmental authority, provided:

(1) the arbitration award is judicially enforceable and issued pursuant

to a bona fide arbitration proceeding in accordance with the rules a

governmental authority approves; and

(2) the fund, account or trust is subject to the continuing jurisdiction of

the arbitration panel, the court having jurisdiction to enforce the award,

or the governmental authority that approved the rules of the arbitration

proceeding.

The types of claims that a QSF can resolve or satisfy are claims that

give rise to liabilities under the Comprehensive Environmental Response,

Compensation and Liability Act (CERCLA), or that arise out of a tort, breach

of contract, or violation of law.

A QSF may not be used to resolve or satisfy the following types of claims:

(1) liabilities arising under a workers' compensation act or a self-insured health plan;

(2) liabilities to refund the purchase price of, or to repair or replace, products regularly sold in

the ordinary course of the transferor's trade or business;

(3) liabilities of the transferor to make payments to its general trade creditors or debt holders

that relate to a Title 11 or similar case or a workout; or

(4) Liabilities the Service designates in revenue rulings or revenue procedures.

If a fund, trust or account is established to resolve or satisfy both allowable and non-allowable

claims arising from the same event or related series of events, the fund will be a QSF. But economic

performance does not occur with respect to transfers to the QSF for the non-allowable claims.

Taxation of Qualified Settlement Funds

The Regulations provide rules for the taxation of QSFs. Under the Regulations, the modified

gross income of a QSF is subject to tax at the maximum trust rate under CodeSection 1(e). Modified

gross income of a QSF is computed by starting with the gross income of the fund and then making the

following modifications:

(1) The amounts transferred to the QSF to resolve or satisfy a liability for which the fund was

established are excluded from gross income.

(2) A deduction is allowed for administrative costs and other incidental expenses of the fund

that would be deductible in computing the taxable income of a corporation (e.g., state and local

taxes and legal, accounting, and actuarial expenses). Administrative costs and other incidental

expenses do not include legal fees incurred by, or on behalf of claimants.

(3) A deduction is allowed for losses sustained in connection with the sale, exchange or

worthlessness of property held by the fund to the extent the losses would be deductible in deter

mining taxable income of a corporation under Sections 165(f) (capital losses), or 165(g)

(worthless securities), and Sections 1211(a) (capital losses) and 1212(a) (capital loss carryovers

and carrybacks).

(4) A deduction is allowed for the amount of a net operating loss of a QSF to the extent

deductible under Section 172(a) in computing taxable income of a corporation. The net

operating loss of QSF for a taxable year is the excess of the administrative costs and other

incidental expenses plus losses the fund sustained from the sale, exchange or worthlessness of

property over the gross income of the fund (excluding amounts transferred to the fund to

resolve or satisfy the liability for which the fund was established).

The tax imposed on the modified gross income of a QSF is in lieu of any other tax that could be

imposed under Subtitle A of the Code on income of a fund. Consequently, a QSF is not subject to the

alternative minimum tax, the accumulated earnings tax, the personal holding company tax, or the

maximum capital gains rate. However, QSFs are subject to taxes that are not imposed on the income

of a taxpayer, such as the tax on transfers of property to foreign entities under Section 1491. The tax

imposed on the modified gross income of a DSF or QSF may not be reduced or offset by tax credits.

For procedural and administrative purposes under Subtitle F of the Code, a QSF is treated as a

corporation and any tax imposed on the income of the fund is treated as a tax imposed on a

corporation. Consequently, the administrator of a QSF must obtain an employer identification number

for the fund and file an income tax return for each taxable year of the fund regardless of whether the

fund has any gross income. Furthermore, payments and distributions by a QSF are subject to

information reporting requirements and withholding requirements under the Code.

Taxation of Distributions to Claimants

The Regulations provide that the determination of whether a distribution from a QSF to a

claimant is includible in the claimant's gross income is made by reference to the origin of the claim for

which the distribution is made. For example, if a distribution is made to a claimant to compensate the

claimant for personal physical injury or physical sickness, the distribution may be excludable from the

claimant's gross income under Section 104(a)(2). On the other hand, if the distribution is made to

satisfy a claim for unpaid commissions, the distribution will be includible in the claimant's gross

income.

In conclusion, the QSF is an excellent way for plaintiffs to defer income tax on their awards, all

the while allowing the lump sum to earn passive income. The program is efficient, and statutorily

certified. Additionally, the QSF allows the litigator some room for negotiation as their clients will be

able to settle for less and still get more over time, and avoid a taxable event.

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