Qualified Settlement Funds: A Legal and Financial Analysis Showing Why They Can Be So Beneficial To You and Your Client

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1 Qualified Settlement Funds: A Legal and Financial Analysis Showing Why They Can Be So Beneficial To You and Your Client Peter H. Wayne IV and Matthew L. Garretson Civic Research Institute, Inc. (reprinted with permission)

2 Qualified Settlement Funds: A Legal and Financial Analysis Showing Why They Can Be So Beneficial To You and Your Client Counsel should provide himself or herself with the opportunity to focus on the areas of law the client hired him or her to advocate and let the QSF serve as a safety net. PETER H. WAYNE IV AND MATTHEW L. GARRETSON The richest person in the Entertainment Industry, David Geffen, once said, It s the perfect definition of a settlement both parties didn t get what they wanted. Fortunately, Qualified Settlement Funds ( QSFs ) allow a claimant or claimants involved in a legal dispute to avoid such a result. QSFs were established to enable claimants and defendants to determine how and when settlement funds are taxed and deductions obtained. Further, they are a valuable settlement tool whereby claimants can address critical settlement-related issues without the stress of settlement negotiations, because they release defendants from alleged tort (or other) liability through the doctrine of novation. QSFs, therefore, are both a useful settlement tool and Matthew L. Garretson is the founding partner of The Garretson Law Firm which provides mass tort/class action settlement allocation and fund administration services. The firm also handles Medicare / Medicaid reimbursement claims, government benefit preservation strategies, and probate administration for individual and mass tort plaintiffs. Mr. Garretson received his BA from Yale University and his law degree at Kentucky s Salmon P. Chase College of Law and has served as the special master or administrator of settlement funds throughout the country. His role in numerous high profile church-related sexual abuse and civil rights settlements (including the historic Cincinnati police brutality/racial profiling settlement) led to his selection by Lawyers Weekly as 1 of 5 Lawyers of asset providing unique tax benefits to claimants and defendants alike. LEGISLATIVE HISTORY The framework for the QSF was created by Congress in 1986 when Tax Reform Act 1 added Section 468B to the Internal Revenue Code. Section 468B regulates the establishment and administration of Designated Settlement Funds or 1 PL the Year in Ohio for He was nominated by his peers and selected as an Ohio Super Lawyer Rising Star in 2005 and His work was featured in the LA Times in January of Peter H. Wayne, IV earned his undergrad degree in Finance from Miami University in Ohio and his JD at the Salmon P. Chase College of Law. While in Law School, Peter worked for the Garretson Law Firm, LLC in Cincinnati, Ohio managing the Qualified Settlement Fund Administration practice and providing counsel in tax advisory, government benefit preservation and health lien resolution. Following his graduation he returned home to Louisville, Kentucky to open a regional office for the Garretson Law Firm, LLC, enabling the firm to better serve their Kentucky and Southeastern clients. Mr. Wayne is also a Kentucky-licensed settlement planning consultant. The Garretsonfirm web address is www. garretsonfirm.com. November/December 2007 Vol 21 / No 2 QUALIFIED SETTLEMENT FUNDS: A LEGAL AND FINANCIAL ANALYSIS 71 tfi-2102-s2-garretson.indd Sec2:71 10/14/2007 1:36:41 PM

3 DSFs. 2 Not only did DSFs arise to assist in class action lawsuits, but also to allow insured and selfinsured defendants to determine when their settlement payments are deducted. 3 Once DSFs were available, it was only a matter of time before their use was extended. That extension came from 1992 Treasury Regulations, 4 which became effective on January 1, Those Treasury Regulations set forth the following three requirements for a settlement fund, account or trust to be treated as a QSF: 6 A fund, account, or trust satisfies the requirements of Reg B-1(c) if: QSFs were established to enable claimants and defendants to determine how and when settlement funds are taxed and deductions obtained. It is established pursuant to an order of, or be approved by, the United States, any state (including the District of Columbia), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority; It is established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability (I) Under the Comprehensive Environmental 2 26 USC 468B: A DSF is defined as (A) which is established pursuant to a court order and which extinguishes completely the tort liability of the defendant or the defendant s insurance carrier to the plaintiff, (B) with respect to which no amounts may be transferred other than in the form of qualified payments, (C) which is administered by persons a majority of whom are independent of the defendant or the defendant s insurance carrier, (D) which is established for the principal purpose of resolving and satisfying present and future claims against the defendant (or any related person or formerly related person) arising out of personal injury, death, or property damage, (E) under the terms of which the defendant (or any related person) may not hold any beneficial interest in the income or corpus of the fund, and (F) with respect to which an election is made by the defendant. 3 John J. Campbell, 468b Qualified Settlement Funds in Single Claimant Plaintiff Physical Injury Settlements, The Medicare Set Aside Bulletin, Issue 18 (August 1, 1005). (QSFs came about to help in class action lawsuits where the individual shares of a settlement to various class members are not determined and to allow insured and self-insureds to deduct their settlement payments when made as opposed to when a settlement trust trustee disburses the funds). 4 Reg B-1. 5 See Restatement (Second) of Contracts, section 280 (1981). 6 Reg B-1. Response, Compensation and Liability Act of 1980 (hereinafter referred to as CERCLA), as amended, 42 U.S.C et seq.; or (II) Arising out of a tort, breach of contract, or violation of law, or (III) Designated by the Commissioner in a revenue ruling or revenue procedure; and The fund, account, or trust is a trust under applicable state law, or its assets are otherwise segregated from other assets of the transferor (and related parties). 7 It is no coincidence that the requirements for a QSF and DSF are so similar. The requirements for a QSF, although not specifically mentioned in Section 468B, clearly fall within the realm of a DSF. 8 As mentioned above, the impetus behind the QSF was to merely extend on the DSF; the only difference being that a QSF allows for a broader range of claims to be considered, including environmental and breach of contract claims. 9 The legislature simply wanted the benefit of the DSF to reach a larger audience. WHY A QSF? QSFs are useful tools that ensure proper client counseling can occur before, during, and even after settlement. QSFs uniquely introduce a degree of breathing space to the settlement process that is made valuable by: 1. Allocating the settlement proceeds among the claimants; 2. Verifying and negotiating liens and / or subrogation claims; 3. Determining the appropriate role and underwriting 10 of a structured settlement annuity; 7 Reg B-1(c). 8 See U.S. v. Brown, 334 F. 3d 1197 (10th Cir. 2003) and John J. Campbell, 468b Qualified Settlement Funds in Single Claimant Plaintiff Physical Injury Settlements, The Medicare Set Aside Bulletin, Issue 18 (August 1, 2005). 9 Don McNay and William Garmer, Is a qualified settlement fund right for your client? Trial Magazine (January Unless provided with evidence to the contrary, annuity companies assume a claimant has a normal medical condition and, therefore, a normal life expectancy. As a result, published annuity rates are by sex and age only. However, substandard (i.e., lower) annuity rates are available if the annuity company is provided with evidence that the claimant s life expectancy is less than normal. Many serious injuries can reduce a claimant s life expectancy. However, it is not necessary that the reduced life expectancy be caused by the injury that is the subject of the claim. Any claimant, therefore, may qualify for a substandard rate. Physicians who are employed for that purpose by the annuity companies make the evaluation of a claimant s life expectancy. Their evaluation is based on a review of medical information provided to them. 72 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS November/December 2007 Vol 21 / No 2 tfi-2102-s2-garretson.indd Sec2:72 10/14/2007 1:36:44 PM

4 4. Evaluating the need to preserve governmental entitlement benefits (e.g. the need for the establishment of a special needs trust); and 5. Enabling a host of other decisions to be made without the pressure associated with the litigation itself. This breathing space is made available because, as mentioned above, while temporarily parked in the QSF, the assets are not constructively received by or an economic benefit to a claimant. Furthermore, given the valid concerns that lawyers have about adding unreasonable delay or expense to the transfer of settlement funds to clients, QSFs may be created and administered to: 1. Facilitate placement of a structured settlement annuity without requiring the signature / participation of the defense; Resolve and satisfy any and all private companies or government agencies that may have a reimbursement right or lien against a claimant s settlement amount. 3. Fast track the payment of settlement proceeds to those clients who determine quickly that they are not interested in any form-of-settlement options besides a lump sum award; Minimize expenses to settlement; Make monies available to settle claims and while not being subject to the defendant s creditors; 11 Section 130(c) qualified assignment means any assignment to make periodic payments as damages, or as compensation under any workmen s compensation act, on account of personal injury or sickness if the assignee assumes such liability from a person who is a party to the suit or agreement, or the workmen s compensation claim and if the other factors of Section130(c) are met. Rev. Proc , CB 470, provides the rules by which a QSF will be considered a party to the suit or agreement, or the workmen s compensation claim for purposes of Section 130(c). 12 If the form-of-settlement component of the clientcounseling model is employed early, lawyers should be able to identify these clients prior to settlement and shape the QSF motion practice to allow the QSF Administrator to transfer funds to these fast track clients as soon as the defendant tenders the settlement proceeds to the QSF. 13 For instance, if the administer is appropriately licensed, his or her fee might be offset by (1) a portion of the standard money management fees charged by the financial institution at which the funds are on deposit; and /or (2) a potion of the interest earned or growth on the proceeds while they are invested in the QSF fund - This is similar to most escrow arrangements wherein interest is not applied to the fund corpus due to the higher cost of administration; and / or a portion of the structured settlement commission payable to a broker when certain clients chose to structure all or part of their settlement award. Such cost-saving arrangements should be disclosed to the client and / or approved by the court as part of the 468B fund pleadings. 6. Allow monies to earn interest for the benefit of the plaintiff (unlike a typical Interest on Lawyers Trust Accounts ( IOLTA account). QSFs also permit defendants to disengage from litigation and qualify for economic performance. Payments made by defendants are in exchange for a release from the present claimants and possible future claimants. Once a payment is made to a QSF, the litigation process will cease for a defendant, thereby reducing Payments made by defendants are in exchange for a release from the present claimants and possible future claimants. legal costs and freeing the resources being used in such litigation. Further, QSFs permit defendants to deduct their payments to a QSF as if the defendants had paid claimants directly or paid into an irrevocable and unconditional fund established to receive payments for the benefit of claimants, thereby permitting a current income tax deduction if available. The ability of defendants to be completely released from present and future claimants, despite a cause of action remaining alive, is permitted through the legal doctrine of novation (party substitution), which has the added affect of adding a new party as substitute obligor who was not a party to the action (the new party is always the QSF Administrator), and discharging the original defendants by agreement of all the parties, completely extinguishing any alleged liability of defendants. 14 A DEEPER BENEFIT LIEN RESOLUTION As mentioned above, QSFs introduce an amount of breathing space after a settlement value is determined that is not otherwise available. This breathing space will allow the lawyer to concentrate on any potential liens that may exist against a client s settlement. Why is this important? In torts, resolution of health care liens represents a great deal more than merely an administrative function. Personal injury lawyers traditionally develop expertise in litigation and tort law relevant to establishing the plaintiff s personal injury claim. The law and legal processes relevant to 14 If the form-of-settlement component of the client-counseling model is employed early, lawyers should be able to identify these clients prior to settlement and shape the 468B motion practice to allow the 468B Administrator to transfer funds to these fast track clients as soon as the defendant tenders the settlement proceeds to the 468B. November/December 2007 Vol 21 / No 2 QUALIFIED SETTLEMENT FUNDS: A LEGAL AND FINANCIAL ANALYSIS 73 tfi-2102-s2-garretson.indd Sec2:73 10/14/2007 1:36:45 PM

5 vindicating personal injury claims are distinct from developing law and legal processes relevant to evaluating a health care plan s right of recovery and resolving the plan s reimbursement claims and liens. Further, as For certain clients the lien resolution strategy may arguably be as important a factor in the client s final net (in pocket) recovery as any other aspect of proving and litigating the case. seen in recent settlements, for certain clients the lien resolution strategy may arguably be as important a factor in the client s final net (in pocket) recovery as any other aspect of proving and litigating the case. Equally important, the process also must ensure that plaintiffs future benefits will not be denied as a direct result of improperly considering the agencies interest in any settlement. The broad sweep of expenditures that Medicare, Medicaid, private health insurers, and the Department of Veterans Affairs may attempt to recover must be vigorously evaluated and audited. For instance, in light of recent changes in lien-related laws and regulations, it is imperative to scrutinize carefully the nature of the damages that were originally claimed by plaintiffs; the objective compensation criteria utilized to allocate the aggregate settlement proceeds; as well as the language in the release to determine what the health care agencies may be entitled to recover. By establishing a QSF, counsel is able to avoid tackling both the client s tort action and subrogation action simultaneously; settle the underlying tort case, remove the defendant from the equation, and then allow counsel to focus on any subrogation issues that might exist. While it is likely still advisable to hire outside counsel to resolve the liens that relate to a settlement, a QSF allows counsel to take the time necessary to locate a reputable firm to perform this service and furthermore, it allows that firm the peace of mind in knowing that they possess the time necessary to adequately consider the client s situation and how those liens may affect their final recovery. Lastly, it is important to note that a QSF not only permits the lien resolution process to proceed with no further involvement from a defendant, but also takes the pressure off of counsel and his or her client to quickly determine how their receipt of the settlement proceeds will affect their government benefits. Time is likely an attorney s most valuable tool when dealing with government benefits preservation and lien resolution. Thus, a QSF is exactly that TIME. ESTABLISHING A QSF In order to establish a QSF, counsel must ensure that all of the requirements set forth in Reg B-1 are met. The most common way a QSF is established is through court order. Pursuant to Reg B- 1(c)(1), courts possess the authority to sign an order creating a QSF. Further, in United States v. Brown, the Tenth Circuit Court of Appeals stated that a [Qualified Settlement] Fund satisfies subparagraph (1) of 1.468B-1(c) if it is established pursuant to an order of a court of law. 15 Because a Court has jurisdiction over an underlying litigation, it also has jurisdiction over the establishment of a QSF which is created to resolve the settlement matters relating to the legal dispute. The second prong of Reg B-1 is satisfied so long as the QSF is established to resolve a claim arising Under CERCLA or arising out of a tort, breach of contract, or violation of law, or designated [an acceptable claim] by the IRS Commissioner in a revenue ruling or revenue procedure. It is important to note that a QSF may not be established to resolve a claim arising under (1) a worker s compensation act or self-insured plan; (2) an obligation to refund the purchase price of, or to repair or replace, products regularly sold in the ordinary course of the taxpayer s trade or business; (3) an obligation of the taxpayer to make payments to its general trade creditors or debt holders that relates to a bankruptcy case, or a work-out; or (4) a designation [an unacceptable claim] by the commissioner in a revenue ruling or a revenue procedure. 16 The third prong of the QSF establishment requirements demand that the QSF be in conformity with the situs state s laws regulating the formulation of trusts or that its assets be segregated from the other assets of the transferor. Lastly, while it is typical for all of these elements to be present simultaneously, they need not be. For example, the treasury regulations provide that if there is a fund that meets the criteria for both the second and third prongs of Reg B-1, but has yet to obtain an order authorizing its establishment, the transferor and the settlement fund administrator can make an election back for the fund to be a QSF upon the later of (1) the date the requisite purpose and asset segregation or trust tests have been met or (2) January 1 of the calendar year in which requirements 1, 2 and 3 are met in totality. 17 Procedural Process. The claimant or defendant moves for the entry of an order by the court to (a) establish 15 U.S. v. Brown, 348 F.3d 1200 (2003). 16 Reg B-1(g). 17 Reg B-1(j). 74 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS November/December 2007 Vol 21 / No 2 tfi-2102-s2-garretson.indd Sec2:74 10/14/2007 1:36:45 PM

6 a QSF and (b) completely release any liability of the defendant and its liability insurer once the insurer pays the agreed-upon settlement amount in the QSF s account. The motion is to stipulate that the claimants and the Fund Administrator will agree to the terms of the Fund Administrator s allocation of the amount placed in the QSF through the execution of fund agreements and releases 18. The motion is to further specify that no settlement proceeds are to be set apart for any individual claimant, or otherwise made available so that he or she may draw upon or otherwise control said settlement proceeds. Next, the motion should authorize the fund administrator to distribute immediately all attorney fees to counsel for claimants consistent with existing contingency fee contracts, 19 and state that further court approval for such fee distribution shall only be necessary to the extent required by law (i.e., for minors or incompetents). The motion should also state that as soon as possible after the entry of the order, the fund administrator will file with the court a declaration of supporting materials setting forth: 1. The release and indemnity agreement, completely extinguishing the defendant s liability; 2. The claimants agreement for allocation and form of the settlement; and 3. The agreement and release between the QSF and individual claimants ( fund agreements ). It is important that the claimant or defendant also move for the entry of an order by the court (a) appoint a QSF fund administrator, 20 and (b) establish terms of the QSF. This motion should be simultaneously submitted with the entry of an order. Next, the claimant or defendant moves for the entry of an order by the court (a) to approve settlement with the defendant, and (b) for dismissal with prejudice of the defendant(s). Once the court executes this order the defendant s only remaining requirement 18 The fund agreements and releases must state that, as part of the release and indemnity agreement, the defendant paid and clients consented to certain sums in full and final settlement of all claims that the claimants had or may have against the defendant. In addition, the agreement shall specify claimants enter into the fund agreements and releases in order to provide payments in full settlement and discharge of all claims against the QSF that are or might have been subject to the original lawsuit. 19 The fund administrator distributes attorney s fees and costs upon receiving an affidavit by the attorney and finding it to be in compliance with the contingent fee agreement relating to the claims for which the settlement proceeds are being received by the Fund. 20 The Fund administrator must submit themselves to the jurisdiction of the court for purposes of proceedings relating to this appointment. is to provide the fund administrator with the information statement set forth in Reg B-3(e)(2). This statement must provide for the amount transferred to the QSF, including identifying information for the transferor and the QSF (name, address, and taxpayer identification number), the date of transfer, and the amount transferred. The statement must be provided by February 15 of the year following the date of this order. The most common way a QSF is established is through court order Lastly, the fund administrator is to petition the court for (a) approval of distribution to the plaintiffs, and (b) certification of fund agreements. The petition states that the fund administrator certifies that fund agreements and releases were reached for all claims of which the Fund Administrator possesses actual knowledge, and requests the court to enter its order authorizing disbursement of the funds pursuant to those fund agreements and releases. WHAT THE SETTLEMENT AGREEMENT MUST SAY The importance of the language contained in a settlement agreement cannot be overstated. A QSF allows for the time necessary to resolve all liens for injuryrelated payments made by the both private companies and governmental agencies as well the time necessary to choose the appropriate income stream to both meet a claimant s needs and protect their government benefits. A QSF can be rendered useless if the language in a settlement agreement can be construed as bestowing an economic benefit on or constructive receipt to the claimant. Such a construction would eliminate the ability to capitalize on the tax benefits of a structured settlement and jeopardize a claimant s government benefits. In order to ensure that the client avoids such pitfalls, it is important that the settlement agreement recite the following: This Release is given in exchange for a $100,000 payment by the Releasees into the Jon Doe Qualified Settlement Fund. The receipt for which will be acknowledged, and the funds distributed according to the terms and conditions of the Order establishing the Doe Qualified Settlement Fund and Appointing the Fund Administrator issued by the Probate Court of Alpha County (State of Beta). November/December 2007 Vol 21 / No 2 QUALIFIED SETTLEMENT FUNDS: A LEGAL AND FINANCIAL ANALYSIS 75 tfi-2102-s2-garretson.indd Sec2:75 10/14/2007 1:36:45 PM

7 Releasees further agree to enter into Fund Agreements with the Fund Administrator, in which they accept the Fund Administrator s allocation of their derivative, separate or other claims. Further, and equally as important, is that the Defense or their insurer make their settlement payment made payable to Alpha Beta as Fund Administrator of the Doe Qualified Settlement Fund. Making the check made payable to the settlement administrator as administrator of the QSF eliminates a potential argument from the IRS that the receipt of funds by the Fund Administrator was constructive receipt by or an economic benefit to the claimant. By confirming that both the settlement agreement and the settlement payment language mirror the above, counsel is protecting the client from any subsequent claim of taxation by the IRS. MAKINGS OF A FUND ADMINISTRATOR The claimant s counsel should qualify potential fund administrators with the same standards that they use for other experts to whom they turn to for assistance in resolving client matters (i.e., physicians, investigators, expert witnesses, etc.). 21 For instance, does the candidate fully comprehend to following? Motion Practice. Has he or she drafted such documents in the past? Has he or she served as a fund administrator before? Allocation Issues (conflict/tax/public benefits/ liens). Does he or she understand how to avoid the multiple plaintiff conflicts consistent with the ABA Model Rules of Professional Conduct for lawyers? Does he or she understand how to allocated proceeds between wrongful death and survivorship in order to minimize tax implications? Does he or she understand the client s public benefits? (I.e., is it helpful or harmful to allocated proceeds to the derivative claim of the parent of an injured child on Medicaid?) Does he or she understand how to allocated an individual plaintiff s damages amount pain and suffering, medicals, wage loss etc. Tax Filing Procedure. Does he or she fully understand the tax filing and accounting requirements: obtaining W9 forms from all attorneys that are to be paid from the QSF; obtaining the taxpayer ID number for the QSF fund; Preparing quarterly estimated tax payments for the QSF; maintaining accounting records necessary to complete tax return for the QSF; preparing Form 1099 s for all attorneys (and 21 Compare Smith v. Farber, 704 A.2d 569 (N.J. Super. App. Div. 1997) and Swann v. Waldman, 465 A.2d 844 (D.C. 1983) and Geller v. Harris, 685 NYS2d 734 (N.Y. App. Div. 1999). claimants if required); preparing the annual tax return for Qualified Settlement Fund; and final accounting and affidavit? TAX BENEFITS The Defendant. As previously mentioned, QSFs arose largely as a result of insured and self-insured defendants wanting to deduct their settlement payments in the year in which a payment is made to a QSF, rather than the year a settlement administrator decides to disburse those funds. A defendant is permitted to deduct the transfer of cash into a QSF without recognizing a gain or a loss in the year in which the payment into the QSF is made. However, if a defendant decides to transfer property, the defendant must account for the gain or loss on the transfer equaling the difference between the fair market value of the property and the taxpayer s income tax basis in the property. 22 In such a scenario, the defendant will be permitted a deduction for the transfer into the QSF equal to the fair market value of the QSF, but certain types of nonpublicly traded securities or partnership interests must be accompanied with a qualified appraisal. 23 The Claimant. Often the most important aspect of a QSF is how the settlement proceeds held in a QSF are recognized by a claimant or claimants from a tax standpoint. If the QSF and settlement agreement are drafted properly and the settlement payment is made payable to the Fund, then a claimant need not recognize a taxable event until a payment is received from the QSF itself. Once a disbursement is made from the QSF to a claimant, the claimant will need to report its receipt to the IRS and will be taxed on its receipt as if the defendant had paid the claimant directly. Therefore, if the payment by the defendant into the QSF was in lieu of lost wages due to the claimant, then the QSF s payment to the claimant must be recognized as wages and taxed accordingly. But, if the defendant s payment into the QSF was as a result of personal injuries suffered by the claimant, the claimant could avail itself of Section 104(a)(2) s personal injury tax exemption and possess the monies tax free. The essence behind a claimant s ability to avoid recognizing 22 George W. Kuney, Qualified Settlement Funds: A Tool to Shelter Gains and Taxable Income with Payments on Account of Disputed Claims, 24 Calif. Bankr. J. No. 2, pgs (1998) Citing Treas. Reg B-3(a)(1) 23 George W. Kuney, Qualified Settlement Funds: A Tool to Shelter Gains and Taxable Income with Payments on Account of Disputed Claims, 24 Calif. Bankr. J. No. 2, pgs (1998) citing Reg B-3(b). 76 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS November/December 2007 Vol 21 / No 2 tfi-2102-s2-garretson.indd Sec2:76 10/14/2007 1:36:45 PM

8 a taxable event upon the defendant s payment into the QSF is such payment s failure to be neither constructive receipt, economic benefit, nor a cash equivalency. Constructive Receipt. Section451 provides that the amount of any item of gross income shall be included in the gross income for the taxable year in which received by the taxpayer. 24 Treasury Regulations help further refine the definition of constructive receipt by stating, gains, profits, and income are received by the taxpayer are to be included in gross income from the taxable year in which they are actually or constructively received by the taxpayer. 25 Further, the Treasury Regulations state, income, although no actually reduced to taxpayer s possession, is constructively received in the taxable year during which it is credited to this account, set apart for him, or otherwise made available so that he may draw upon it at any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. 26 But, income is not constructively received if the taxpayer s control is subject to substantial limitations or restrictions. 27 While a defendant s payment into a QSF in order to settle an existing lawsuit is a payment into a fund, it is not into such a trust or fund that allows the claimant the ability to draw upon the settlement monies at any time or withdraw funds by providing notice to the settlement administrator. The QSF is created to help fully settle claims that exist between the defendants and claimants. While the total settlement value is finalized upon the defendants payment into the QSF and subsequent release, the claimants claims are still alive and the portion that is to be disbursed to the claimants is yet to be determined. The fund administrator is to settle fully the existing claims with the approval of and upon the order of the court by entering into subsequent qualified settlement fund agreements and releases (the Fund Agreements ) with persons or entities asserting those claims. Until such time that Fund Agreements are executed, no settlement proceeds are to be set apart for claimants, or otherwise made available so that they may draw upon or otherwise control said settlement proceeds. The substantial limitations placed on a claimants receipt of settlement proceeds quashes the potential for constructive receipt to exist. Economic Benefit Doctrine. The economic benefit doctrine developed from case law and requires a determination that the actual receipt of property or the right to receive property in the future confers a 24 Section Reg (a) (as amended in 1999). 26 Reg (a) (as amended in 1979). 27 Id. current economic benefit on the recipient. Sproull became the seminal case on this doctrine and set forth the required elements, which are, as restated in Thomas v. U.S.: 1. There must be some fund in which money or property is 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 right to the money, with the receipt conditioned only on the passage of time. 28 While a defendant s payment into a QSF would satisfy both of the first two elements of the economic benefit doctrine, a QSF beneficiary (the claimant) would never satisfy the third element because claimants do not possess vested rights in the money that is placed into a QSF until the settlement administrator determines a claimants allocated portion of the settlement monies and enters into and executes with court approval a fund agreement with the claimants and disburses the cash from the QSF to them. All of these requirements stand in stark contrast to the economic benefit doctrine s requirement that the claimant s possession be conditioned solely on the passage of time. Cash Equivalency Doctrine. The cash equivalency doctrine is another common law doctrine that the IRS attempts to use on occasion to find future payments or rights to payments taxable in the year an agreement is made as opposed to the year in which the money is physically received. The doctrine is defined quite well in Cowden, 29 where the court said: If promise to pay of a solvent obligor is unconditional and assignable, not subject to set-offs, and is of a kind that is frequently transferred to lenders or investors at a discount not substantially greater than the generally prevailing premium for the use of money, such promise is the equivalent of cash and taxable in like manner as cash would have been taxable had it been received by the taxpayer rather than the obligation. 30 A defendant s payment of settlement monies into a QSF is neither unconditional nor assignable by the claimant. Further, the payment is subject set-offs as a result of potential third parties that may possess a subrogation interest in a claimants recovery. As mentioned previously, there are several steps that must be 28 Sproull, 16 TC 244, 247 (1951), aff d. 194 F. 2d 541 (6th 1952); Thomas v. U.S. 45 F. Supp. 2d. 618, 620 (1999), aff d. 213 F. 3d 927 (6th 2000) F. 2d 20 (1961). 30 Id. November/December 2007 Vol 21 / No 2 QUALIFIED SETTLEMENT FUNDS: A LEGAL AND FINANCIAL ANALYSIS 77 tfi-2102-s2-garretson.indd Sec2:77 10/14/2007 1:36:45 PM

9 accomplished before a claimant possesses any rights to the monies that are placed into a QSF and those very steps help to eliminate the potential application of the cash equivalency doctrine. Single Claimant QSF. There exists significant debate over whether a QSF is a viable settlement tool for a single claimant involved an in injurious incident where no other derivative action at law exists. The main arguments in opposition to the single claimant QSF are the same taxation doctrines that apply to multiple claimant QSFs economic benefit and constructive receipt. Similar to above neither doctrine is triggered by a single claimant QSF. First, neither the definition above for economic benefit nor the IRS definition from PLR , In order for a taxpayer to include an amount in income under this doctrine, the amount must be set aside irrevocably, for the taxpayer s sole benefit, without restrictions or conditions based upon the occurrence of future events, captures a claimant s position with respect to a QSF. 31 The money that The QSF s basis in property that is distributed or sold is the fair market value of the property on the date of its transfer to the fund. is placed in a QSF, as discussed above, is not set aside for the taxpayer s sole benefit and possesses a multitude of conditions and restrictions that are based on future events. Second, the fact the a taxpayer/claimant must execute fund agreements with the Fund Administrator in order to receive his or her share of the QSF settlement proceeds stands in direct contrast to the definition of constructive receipt regardless of whether the QSF involves a claimant or claimants. Third, in addition to the arguments that stand in opposition to either the economic benefit or constructive receipt doctrines, Rev. Rul , the ruling by the IRS that provides the rules under which a QSF will be considered a party to the suit or agreement for the purposes of Section 130, continuously references singular claimant as opposed to the plural claimants throughout the ruling. It is hard to fathom that the IRS would repetitively reference the singular form of a word unless it intended to do so. In conclusion, a QSF is a settlement tool that can be utilized by either many claimants or a singular claimant involved in one of the aforementioned Reg B-1(c)(2) categories. 31 PLR (May 7, 2001). The Qualified Settlement Fund. In order for a settlement administrator to properly administer a QSF, it is important that the administrator obtain an EIN number for the fund itself. 32 The most important administrative duties include making the necessary tax payments when due as well as withholding and reporting the appropriate amount of money and information. An administrator is obligated to make tax deposits at a federal depository using the Form 8109(B), the Federal Tax Deposit Coupon, quarterly for tax estimates and on March 15th for the final tax return. A QSFs tax liability is determined by applying the maximum tax rate 33 to the QSF s modified gross income for the given tax year. 34 Treasury Regulations describe a QSF s modified gross income as gross income as described in Section 61 less the following exclusions and deductions: (1) amounts transferred to the qualified settlement fund by, or on behalf of, a transferor to resolve or satisfy a liability for which the fund is established and (2) administrative costs and other incidental expenses incurred in connection with the operation of the qualified settlement fund that would be deductible under chapter 1 of the Internal Revenue Code in determining the taxable income of a corporation. Administrative costs and other incidental expenses include state and local taxes, legal, accounting, and actuarial fees relating to the operation of the qualified settlement fund, and expenses arising from the notification of claimants and the processing of their claims. 35 Further, a QSF s gross income includes the gain or loss from the sale or distribution of property equal to the fair market value of the property on the date of distribution. The QSF s basis in property that is distributed or sold is the fair market value of the property on the date of its transfer to the fund. 36 It should be noted that QSFs are unable to deduct for payments made on behalf of claimants, such as attorney s fees and costs awarded for obtaining a settlement or judgment or for the distribution or return of assets to the transferor. It is very important that a settlement administrator make a determination on the tax status of future QSF distributions near the beginning of the fund s 32 Reg B-2(k)(4). 33 The Economic Growth and Tax Relief Reconciliation Act of 2001, PL , implemented a staged tax decrease in the tax rates that began in 2001 and was accelerated by the Jobs Growth Tax Relief Reconciliation Act of 2003, PL As a result of these acts the maximum tax rate to be applied to the gross income of QSFs is 35% until 2011 when it is set to go back up to 39.6%. 34 Reg B-2(a). 35 Reg B-2(b). 36 Jude P. Damasco and Todd F. Taggart, Taxation and reporting of qualified settlement funds, The Tax Adviser (1996 American Institute of Certified Public Accountants Inc.). 78 JOURNAL OF TAXATION AND REGULATION OF FINANCIAL INSTITUTIONS November/December 2007 Vol 21 / No 2 tfi-2102-s2-garretson.indd Sec2:78 10/14/2007 1:36:46 PM

10 existence. A QSF administrator must determine from the facts and circumstances giving rise to a QSF being established whether or not one or more of the transferors would have had to report a distribution via a Form 1099 or withhold any tax had the defendant made the distribution directly to the claimant. 37 A QSF must fulfill reporting and withholding obligations on distributions from the QSF as if the QSF was the original defendant. As a result of this obligation, it is always important that the settlement administrator require that the defendants provide to them the necessary information to make the appropriate withholding and reporting determinations. The failure of which to do so could prevent the settlement administrator from having the information necessary to meet their QSF obligations. Failing to report or withhold the right information or money may subject the QSF to large IRS penalties that the settlement administrator may not even become aware of until 36 months later. 38 For example, failing to prepare and file a Form 1099, when one is required, may subject the fund to a penalty of at least $100 per document, which in the case of a large class action, where hundreds of 1099s may be necessary, is an overwhelming mistake. 39 Thus, it highly important that a QSF administrator pay close attention to both the tax requirements of a QSF and those that would have applied had the defendant paid the claimant directly. 37 Id. 38 The IRS uses a standardized calendar to address EIN related issues. 39 Jude P. Damasco and Todd F. Taggart, Taxation and reporting of qualified settlement funds, The Tax Adviser (1996 American Institute of Certified Public Accountants Inc.). CONCLUSION In a world where the average individual believes the IRS is rarely on his or her side, QSFs are the exception. Regardless of whether or not you are an attorney for a class of claimants or a single injured claimant with derivatively injured spouse, parents, or chrildren, QSFs can be an excellent resource for an attorney s practice. Resolving liens is a complicated and convoluted aspect of tort law and demands significant attention and the same can be said for government benefit preservation and advising a claimant about the tax ramifications of their settlement. It highly important that a QSF administrator pay close attention to both the tax requirements of a QSF and those that would have applied had the defendant paid the claimant directly. All of these aforementioned areas of law are often not a part of the general expertise of an attorney s practice and this is only compounded during a lawsuit where a defendant is trying to avoid liability and resolve their case as soon as possible. Because of this, it is advisable to become the tortoise and not the hare. Counsel should provide himself or herself with the opportunity to focus on the areas of law the client hired him or her to advocate and let the QSF serve as a safety net. The client that receives his settlement award first only to later lose government benefits or be subject to litigation as a result of an ERISA lien is far worse off than the client that receives their settlement award second, but free and clear of any further claim or litigation. November/December 2007 Vol 21 / No 2 QUALIFIED SETTLEMENT FUNDS: A LEGAL AND FINANCIAL ANALYSIS 79 tfi-2102-s2-garretson.indd Sec2:79 10/14/2007 1:36:46 PM

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