Episode 307: Qualified Settlement Funds Trusts

Episode 307: Qualified Settlement Funds Trusts

Qualified Settlement Funds: Their Purpose and Their Advantage

Qualified settlement funds (QSFs), or 468B trusts, are a tool for businesses to use to deduct the cost of any payments made to settle lawsuit or bankruptcy claims, even if the claims and amounts owed are contested. QSFs are an alternative to an escrow account and are employed for strategic reasons. We will address what QSFs are and why businesses might want to use them.

What is a Qualified Settlement Funds Trust and When Are They Needed?

Qualified settlement funds are termed such because they must meet certain qualifications to be recognized by the IRS as a vehicle for deducting the costs of settling certain legal claims. According to IRC 468B(2), there are three criteria to meet in order to qualify as a QSF.

  1. The trust must be formed pursuant to a court order or the authority of a governmental agency, and the trust must remain under that court or agency’s jurisdiction. In other words, a QSF cannot be established and funded without court or agency oversight.
  2. The trust must be established to resolve certain civil claims against the defendant, such as torts and breach of contract.
  3. The trust must satisfy state laws governing trusts in the state that the QSF is formed.

QSFs are often used to pay off a company’s creditors during bankruptcy or pay off mass tort claims. If a company needs a QSF, it has likely determined that future settlement payments will be necessary. If done properly, any transfers of payments to the fund will be deductible as expenses paid in the course of business.

It’s important to note, though, that transfers to QSFs must be non-reversionary. Once funds are placed in the QSF, they cannot be returned to the business under any circumstance – even if it is later determined that the business is not liable for the claims. In order to effectively claim a deduction for money paid to the trust, the company must give up any right to a refund of the money.

One might wonder why should a business irrevocably transfer funds if there is a possibility there will be no financial liability pending the outcome of a trial or appeal? In some cases, setting up a simple escrow account might be the more logical option, until the dispute has been settled. There are, however, specific reasons why a business might want to employ a QSF.

The Advantages of Setting up a Qualified Settlement Fund Trust

When a business faces civil claims or files bankruptcy, it must consider possibilities for paying creditors and judgment holders. Forming a QSF as a payment vehicle is an option to consider for a few reasons.

  • A QSF provides a tax deduction for any funds transferred to the trust – In order for a business to claim a tax deduction, it must meet the “all events test” under IRC 461. In order to meet this test, there must be “economic performance”, meaning the costs have actually been paid. Treasury Regulation 1.468B-3(c) states that any money transferred to a QSF for the purpose of satisfying a liability meets the economic performance test and is therefore a deductible business cost.

  • A QSF releases the defendant from continuing liability as to those payments – A QSF assumes responsibility for a defendants’ payments to creditors and judgment holders related to the claims the trust was specifically created for. If the defendant satisfies payment requirements to a QSF, the Trust Agreement that creates the QSF can call for the defendant to be released from further liability for the claims the payments are intended to satisfy. Once a QSF is created, it releases the defendant from the responsibility of paying claimants directly, and judgment holders and creditors must take up any further grievances relating to payments of their claims with the Trust. The Trustee in charge of the Trust would then be the one to handle those issues. The Trust and the Trustee would also be in charge of allocating payments to multiple claimants, even if the claimants are all owed differing amounts or the amounts owed are contingent, uncertain, or unverified.
  • A QSF allows companies to organize their finances in the wake of litigation – Litigation can take months, even years to resolve. QSFs allow businesses to quickly and precisely allocate funds to potential judgment holders and creditors. When facing the costs of paying innumerable judgement holders and creditors, there can be budget and logistical concerns. How many claimants will there ultimately be? What amounts must they be paid? How is the company going to manage that uncertainty? The creation of a QSF is a way to manage the concerns. Once a QSF trust is created and funded, the company can write off any transfers as an expense. Decision makers won’t have to worry about who all will be paid or how much each person must ultimately be paid. All that matters for the business is the year end amount that is transferred to the fund, regardless of the total judgment award or claim value each creditor may have.

  • A QSF trust can help companies recover their reputation – Along with monetary damages, mass tort claims may bring reputational harm as well. By establishing a QSF, businesses demonstrate good faith and can rightly claim to be a cooperative party during settlement. Further, once payments are made to plaintiffs, any leftover funds may then paid out to a charity of the company’s choice. This can provide a reputation boost to the company if it’s framed and communicated properly.

Together, these advantages make a compelling case for using QSF trusts to pay legal claims.

If your business is facing litigation and considering a QSF trust for settlement purposes, it’s worth consulting with a Houston tax and accounting expert first. Taxation laws and timelines related to QSF trusts are complex, governed by treasury codes that dictate rates, reporting, and how distributions are treated. A Houston tax professional can forecast these details for their clients and help advantageously position businesses facing settlement proceedings.

Episode 306: Title Repair, Liens and Strategic Property Investment

Title Repair, Liens and Strategic Property Investment

The title status of property is important to real estate purchasers and sellers. In many instances, when there are blemishes on a title, it’s because of one or more liens on the property. Depending on the nature and number of liens, these title issues can greatly complicate a real estate transaction, which makes the assistance of a reputable Houston real estate attorney invaluable.

What is a Clean Title and Why is it Crucial for Real Estate Investors?

If a title is “clear” then it is free from any liens or other claims that would cast doubt on who owns or has interest in the property. Most purchasers prefer a clear or “clean” title for a few reasons, including:

  • No additional tax or creditor obligations

  • No additional risk of foreclosure or other legal actions
  • Lower risk of future claims to the property by unknown third parties

For real estate buyers and sellers, it’s advantageous for a property to be free of any title issues. Sometimes, despite some title issues, a would-be buyer has enough interest in the property and is willing to navigate the title repair process to take sole ownership.

Liens and Lien Priority: Who Gets Paid First?

A single property may have various liens, often in a certain order of priority. The first-in-time, first-in-right rule is used to determine lien priority – the order in which lien holders are paid if the property is ever sold.

There are different types of liens, including tax liens, mortgage liens, mechanic’s liens, judgment liens and more. The first lien levied against a property is often, though not always, the “senior” lien, while those lower in priority are “junior” liens.

Here’s what lien priority may look like for a real estate property:

  • Tax liens – Tax liens are placed against a property by a government agency, and they may concern property taxes or income taxes. In either case, tax liens take priority over all other liens, regardless of when they were levied.

  • Mortgage liens – When homebuyers take out a mortgage through a lender for the purchase of property, the lender (usually a bank) will place a lien on the home as collateral for facilitating the buying process. Mortgage liens are senior liens and are typically first in priority.

  • Junior liens like second mortgages and mechanic’s liens – Junior liens may be second or third liens, levied against the property when taking out a second mortgage, a home equity line of credit (HELOC), or for improvements to a property (a mechanic’s lien). Junior liens are considered riskier because they are paid off last if the property is ever sold or foreclosed on. If the total debts exceed the property’s value, there may not be enough sale proceeds to pay junior lien holders. If that happens, those lien holders receive nothing.

Prior to a real estate transaction, a title search will reveal if there are any liens against the property. This service can be provided by an attorney or a title company.

Leveraging Liens When Buying or Selling Real Estate Properties

When purchasing a property, the buyer assumes responsibility for any liens attached to it. That means the debt attached to those liens is passed to the new owner. For buyers, this obviously represents an undesirable liability, as lien holders may force the sale of a property if debt obligations aren’t met.

Some real estate investors, though, use liens to their advantage when acquiring properties. Here are some examples of how would-be buyers can make liens work for them:

  • Forcing a foreclosure sale – Lien owners have the right to force foreclosure procedures should the property owner default on debt payments. This process can take months to complete, and it involves many steps, but it may be necessary if the owner can’t be located or if liens can’t be resolved otherwise.

    Following the foreclosure process, the property is put up for bid and sold. If a junior lien holder has the resources, they may purchase the property outright in this way. Based on market data, foreclosed properties typically sell for about 70 percent of their fair market value, so there’s room for a good deal.

  • Negotiating with leverage – Once an investor holds a lien, they can negotiate with other lien holders with leverage. For example, if a second lien holder indicates that they may force a foreclosure sale, they can convince third (and fourth, etc.) lien holders to release a lien for less than full payment on the debt. In this way, a junior lien holder can reduce debt liabilities before acquiring the property.

An emerging investment concept is purchasing junior liens, such as underperforming second mortgages. It may seem counterintuitive to do so, as these lien holders are exposed to additional risk, but there are several ways that junior lien holders can recoup their investment. For example:

  • Forcing a foreclosure sale – Forcing a sale can work for many second lien holders, as property values have soared in some markets. If the property’s value exceeds the value of the senior lien, the second lien holder stands to profit if the property is sold.

  • Servicing debt tied to the lien – Lien owners are debt owners, which means they can modify the debt’s terms as they see fit. For example, they may reduce the debt’s principal, stretch out terms, modify interest rates – anything to ensure the borrower can continue making payments to the lien holder.

  • Acquiring debt for pennies on the dollar – Second liens are risky investments, but this risk is priced into the debt’s purchase. It’s possible for investors to acquire junior liens for 10 percent (or less) of the initial debt, so it’s common for investors to purchase many underperforming second liens and sift through them to see which ones may be profitable.

    For the original lien owner, selling the debt for pennies often makes sense because it can be costly and time consuming to service debt. Selling off the debt at a deep discount shifts that debt servicing burden to someone else.

It takes experience and skill to make junior liens work as an investment, which is why it’s highly recommended that investors consult with a real estate attorney before moving forward with a transaction. An experienced real estate attorney can help interested investors make intelligent transactional decisions and ensure they aren’t surprised by taxes or other process-related concerns when buying a property.

Liens: Obstacle or Opportunity?

Real estate has long been a profitable option for investors, but the presence of one or more liens can quickly complicate the process. If you’re considering purchasing or selling a property or a lien attached to a property, it’s worth consulting with an expert in the area before moving forward. A real estate lawyer can advise individuals on how to best acquire a property with liens attached, and how to minimize the cost-related impact of those liens.

Episode 305: RMDs and IRAs

RMDs and IRAs

RMDs and IRAs: What to Consider from a Tax Perspective

IRAs are popular retirement savings vehicles, largely because they offer tax advantages to individual Houston investors. Those advantages differ depending on the IRA. Traditional IRAs defer tax on any money or assets invested until you take distributions upon retirement. Roth IRAs tax income into the account upon transfer at your current tax bracket, and no additional tax is taken at distribution. This matters when you consider that any growth on your investments will be taxed accordingly in a traditional IRA, but not so in a ROTH.

Another worthwhile consideration with traditional IRAs is the required minimum distributions (RMDs). Here, we’ll address what RMDs are and how they may affect a Houston individual’s tax planning strategy.

What are Required Minimum Distributions and When are They Required?

Beginning at an age specified by the IRS (and adjusted based on current life expectancy), owners of a traditional IRA account must begin taking RMDs. Currently, the age one must begin taking RMDs is 72 – or 73 if the taxpayer turned 72 after December 31, 2022.

RMDs are a check put in place by the IRS to prevent people from using their traditional IRA as a way to avoid taxes. Because traditional IRAs provide upfront tax benefits in the form of a deduction, taxpayers might avoid paying taxes on their IRA earnings if there wasn’t a requirement in place to prevent this.

RMDs are that incentive. If required minimum distributions are not withdrawn from an IRA account, an additional excise tax will be levied against the account. Starting in 2023, this tax is equal to 25 percent of the RMD not removed from the account. If the issue is corrected within two years, the tax may drop to 10 percent.

How to Calculate Required Minimum Distributions

Calculating RMDs can be complex, as taxpayers must be aware of what’s in their IRA account to accurately assess their RMD. The math isn’t too difficult, though, and it looks like this:

Value of the IRA account (as of December 31 of the preceding year), divided by a “distribution factor” that’s published on its Uniform Lifetime Table (Publication 590-B). Distribution factors range from 1.9 to 27.4, depending on the taxpayer’s age. As a taxpayer ages, their distribution factor drops. In other words, as the taxpayer gets older, their RMD increases.

For example, at age 78, a taxpayer’s distribution factor is 22 – derived from the IRS’s Uniform Lifetime Table. A 78-year-old has a traditional IRA that, as of December 31 of the previous tax year, was worth $100,000.

The RMD, in this example, is $100,000 divided by 22. That comes out to $4,545. So, this taxpayer would need to withdraw at least $4,545 out of their traditional IRA to avoid paying an excise penalty.

It is worth noting that RMDs are calculated for each account and must be withdrawn from each account to avoid penalties.

Want to Avoid RMDs? Consider Investing in a Roth IRA

The surest way to avoid RMDs is to invest in a Roth IRA instead. Roth IRAs provide their tax benefits upon withdrawal, not investment. As such, there is no need for the IRS to pressure Roth IRA holders into paying taxes on account funds as they’ve already been paid for.

The tradeoff is no immediate tax deduction, but many people are okay with this, as they assume their income bracket at retirement will be lower.

Taxpayers have the option to transfer, convert, or “rollover” their traditional IRA funds to a Roth IRA to avoid paying RMDs, but one must be aware of the tax consequences of this. Taxes must be paid on traditional IRA distributions into a ROTH account, and these distributions may temporarily kick an individual into a higher tax bracket that year.

A tax expert can help their clients make this traditional-to-Roth transition without overwhelming them with additional tax burdens.

When an IRA is Inherited: How RMD Rules are Applied

RMD rules also apply to inherited IRAs, as defined in the SECURE and SECURE 2.0 Act. These rules depend on whether there is a named beneficiary attached to the IRA, and what the beneficiary’s age is. Here are some common scenarios:

  • If the deceased spouse died before RMDs were required – One of the most common situations is for a spouse to inherit an IRA following their husband or wife’s death.

    If the spouse is the only beneficiary named in the IRA, they may transfer the IRA assets to their own IRA, or they may open an inherited IRA in their own name. If the assets are transferred, the surviving spouse’s age is what’s considered for early withdrawal and RMD purposes.

    If the assets are included in a newly opened IRA in the spouse’s name, RMDs start the year when the decedent would’ve turned 73 (so, the year RMDs would have kicked in for the deceased spouse) or on December 31 of the year after the decedent passed away. The later of these two dates is used for RMD purposes.

    The above rules apply only if the surviving spouse chooses to take distributions using their life expectancy as the guide. There are other options, though. For example, an inherited IRA in the beneficiary’s name may be liquidated immediately as a lump sum – and taxes will need to be paid out in the process. Or the beneficiary may opt into the 10-year rule, which requires the account to be completely liquidated at the 10-year mark following the decedent’s death. In this instance, distributions can be taken out right away without an early withdrawal penalty.

  • If the deceased spouse died after RMDs were required – If the decedent was old enough that IRA distributions were required, those requirements are passed on to the inheriting spouse.

    Inheriting spouses may transfer the IRA’s assets to their own IRA, or they may open up an inherited IRA in their own name. In the former’s case, the spouse must be the only named beneficiary. If an inherited IRA is opened in the spouse’s name, they may name additional beneficiaries for the account.

    However, RMDs are required and must be taken out starting the year of the decedent’s death if they would have needed to take an RMD for themselves.

    Alternatively, the surviving spouse may liquidate the IRA. Again, though, taxes must be paid on the assets immediately, and this may kick the inheriting spouse into a higher tax bracket for that year.

RMDs and IRAs Can Be Complex, So Work with a Reputable Tax Professional

As you can see, RMDs are a tricky subject for IRA holders. It’s even trickier when an IRA is passed to a beneficiary. If RMDs aren’t taken out on time, there may be severe penalties for failing to do so, but distributions can also move a taxpayer into a higher tax bracket – and burden them with additional tax obligations in the process.

There are a lot of moving parts where IRAs and RMDs are concerned, so it’s highly recommended that IRA holders consult with a trusted tax professional before taking distributions or naming beneficiaries. An experienced Houston tax expert can help their clients plan out their distribution schedule and ensure their tax burden remains minimal when handling account assets.