Taxation and reporting of qualified settlement funds.

• Author: Damasco, Jude P.

EXECUTIVE SUMMARY

Qualified settlement funds, which are generally established to administer a litigation judgment or settlement to a class of plaintiffs, are subject to a myriad of income tax paying, reporting and withholding requirements. Final regulations appear to explain how the fund administrator is to discharge such obligations, but leave some unanswered questions. This article analyzes and illustrates the operation of Sec. 468B and the regulations and tackles some of the thornier administrative issues.

One of the duties arising from class action litigation is the administration of the court-controlled settlement fund created as part of an attendant judgment or settlement. In addition to the responsibility for validating claims submitted by class members and disbursing settlement funds to the class, the settlement fund administrator (SFA) must also be concerned with Federal and state tax paying and reporting requirements. The Tax Reform Act of 1986 (TRA '86) expanded the complexity of settlement fund administration by imposing, for the first time, an income tax on fund earnings and a requirement that the SFA file an annual income tax return on the fund's behalf. This article examines the tax and reporting rules imposed on SFAs.

Background

Historically, a court-controlled class action settlement fund was not subject to tax at the fund level(1); rather, individual claimants were subject to income tax on their respective distributive shares of fund earnings when such earnings were paid to them.(2)

TRA '86 added Sec. 468B, "Special Rules for Designated Settlement Funds," effective generally for settlement funds established after July 18, 1984.(3) The thrust of Sec. 468B, from an SFA's viewpoint, is to require the fund to file an annual income tax return reporting the fund's earnings and paying any tax due. As initially enacted, Sec. 468B appeared to affect only "designated settlement funds" (DSFs). Under Sec. 468B(d)(2), a DSF, in addition to other requirements, is a settlement fund established by a defendant who elects to be governed by Sec. 468B. The treatment of a settlement fund in the absence of a DSF election was unclear.

Congress clarified the taxation of settlement funds in the Technical and Miscellaneous Revenue Act of 1988 (TAMRA), which incorporated into the Code a provision taxing income earned on such funds. Although this specific provision had been included in TRA '86, it was omitted from the Code. TAMRA Section 1810(f)(5)(A) added Sec. 468B(g), which clarified Congress's intent to subject a settlement fund to current taxation regardless of whether a DSF election was made:

Nothing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. The Secretary shall prescribe regulations providing for the taxation of any such account or fund whether as a grantor trust or otherwise.

Sec. 468B (g), effective for funds established after Aug. 16, 1986, grants the Treasury Secretary broad administrative power to devise a scheme of taxation for settlement funds. (Although beyond the scope of this article, Sec. 468B (g) also applies to "escrow accounts.")

Pursuant to that authority, in early 1992, the IRS issued proposed regulations(4) under Sec. 468B. Final regulations(5) were issued in late 1992 and, subject to certain transition rules in Regs. Sec. 1.468B-5 (b), were generally effective Jan. 1, 1993. The final regulations mandate similar tax treatment for all settlement funds, regardless of whether a DSF election is made; accordingly, Regs. Secs. 1.468B-1 through -5 govern the treatment of all settlement funds meeting the regulations' criteria.

Classification

The regulations create a taxable entity called a "qualified settlement fund" (QSF). Regs. Sec. 1.468B-1 (c) defines a QSF as a fund that meets the following criteria:

1. Is established pursuant to an order of, or is approved by, a governmental authority and is subject to its continuing jurisdiction. "Governmental authority" is defined by Regs. Sec. 1.468B-1 (c) (1) as the U.S., any state, territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing.(6) An order or approval, under Regs. Sec. 1.468B-1 (e) (1), occurs when the governmental authority issues its initial or preliminary approval of the fund, even if such order is subject to review or revision.

2. Is established to resolve or satisfy one or more claims (contested or uncontested) that have resulted or may result from an event (or related series of events) that has occurred and has given rise to at least one claim asserting liability:

   * Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (CERCLA).

   * Arising out of a tort, breach of contract or violation of law.

   * Designated by the IRS in a revenue ruling or procedure. Under Regs. Sec. 1.468B-1 (g), QSFs cannot be used to resolve or satisfy claims arising from:

   * An obligation for provision of services or property, unless such obligation is extinguished by a transfer or transfers to the fund. (Regs. Sec. 1.468B-1 (f) (2) provides an exception for CERCLA obligations.)

   * A workers' compensation act.

   * An obligation 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.

   * A self-insured health plan.

   * An obligation to make payments to general trade creditors or debt holders pursuant to a Title 11 or similar case, or a workout.

   * A liability designated by the IRS in a revenue ruling or procedure.

3. Is a trust under applicable state law, or its assets are physically segregated from other assets of the "transferor" and related persons. (Under Regs. Sec. 1.468B-1 (d), a transferor is a person who transfers (or on behalf of whom an insurer or other person transfers) money or property to a QSF to resolve or satisfy qualified claims; generally, the defendant or defendant's insurer.) Cash held by a transferor in a separate bank account satisfies the segregation requirement. Although there would not be a trust, such an arrangement meets the physical segregation requirement of Regs. Sec. 1.468B-1 (h).

   According to Regs. Sec. 1.468B-1 (j), if a fund, account or trust established to resolve or satisfy claims does not meet the criteria described in 1,2 and 3 above, the fund's assets are treated as owned by the transferor and the earnings thereon are taxable to him.

   Example 1:(7) On June 1, 1996, corporation Y establishes a fund to resolve certain securities law claims. On that date, Y transfers $10,000,000 to a segregated account. On Dec. 1, 1996, a Federal district court approves the fund. Y is treated as the owner of the $10,000,000 and is taxed on any income earned on such funds from June 1 through Nov. 30, 1996. The fund is a QSF beginning on Dec. 1, 1996.

   The final regulations do not provide guidance for...