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.
- 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.
- The trust must be established to resolve certain civil claims against the defendant, such as torts and breach of contract.
- 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.
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