At its most basic, a Qualified Settlement Fund (“QSF” or “468B trust”) is a temporary holding tank for settlement funds. Its purpose is to allow both parties to wrap up the settlement at the speed that works for them while taking advantage of certain tax benefits.
When a case is settled, the defendant may want to issue payment quickly and move on, while the plaintiff may need more time to negotiate claims with lienholders, handle allocation issues, and/or make post-settlement arrangements such as setting up structured settlements and trusts. If funds are disbursed to the plaintiff attorney’s IOLTA, constructive receipt will occur, preventing the client from creating tax-free structured settlements and possibly creating issues with the client’s means-tested public benefits such as Supplemental Security Income (SSI) and Medicaid. The QSF allows both parties to get what they want, when they want it, because the defendant can disburse funds quickly without causing constructive receipt issues for the plaintiff or attorney. QSFs are generally short-lived, many lasting a year or less, although there is no limit on how long they can exist, and some do last for years.
QSFs are governed by IRS Code § 468B and Income Tax Regulation § 1.468B. QSFs have their own Employer ID Number (EIN) and only the interest or dividends earned, minus deductions, is taxed at a rate up to 35% (the deposits from the defendant remain tax-free). Because constructive receipt is avoided, the plaintiff can elect to do a structured settlement with their recovery and the attorney has the ability to do tax-planning such as fee-deferrals. Both of these options have tax benefits for the plaintiff and the plaintiff attorney. There is also a tax benefit to the defendant because, under the tax code, the defendant’s payment to the QSF counts as economic performance. This releases the defendant from the case and allows them to take a tax deduction in the current year.
Creation & Administration
A QSF must meet three requirements: 1) it must establish pursuant to an order and subject to continuing jurisdiction by a court or agency; 2) it must be created to resolve “one or more” legal claims; and 3) it must comply with the requirements of a valid trust for the state in which it is created and administered. The QSF can be created before the case begins or at settlement. Once creation of the QSF is approved and the case is settled, the defendant assigns its liability to the QSF and a full and final release of the defendant is executed. The defendant’s obligation is satisfied upon funding the QSF. The trustee disburses funds as agreed upon by the parties or by order of a court and files annual tax returns. When the funds in the QSF have been exhausted, the QSF is closed, a final tax return is filed, and a court order terminates the court or agency’s jurisdiction over the QSF.
A pooled QSF is a unique solution appropriate for certain cases. It can be a more expeditious and less costly solution because the master trust is already established and simply needs to be joined, creating a sub-QSF trust in the pool. Once the plaintiff’s sub-QSF trust is exhausted, it is closed without further intervention from the court.
While not appropriate or necessary for every case, there is no downside to using a QSF when timing presents an issue between the parties. It allows the defendant to satisfy their obligation, take a tax deduction, and move on, while the plaintiff can take their time with important post-settlement arrangements and tax-planning. Ultimately it helps the parties make a smooth transition after what was likely a contentious and hard-fought battle, giving everyone peace of mind and space.