Qualified Settlement Funds (QSFs), which can be an LLC or a Trust, are the unsung heroes of many legal settlements, offering significant potential tax advantages for both plaintiff parties and defendants.
QSFs have an interesting history rooted in tax legislation and the need for more efficient handling of complex legal settlements. Over time, the use of QSFs has expanded from class action and mass tort cases to environmental claims, breach of contract cases, and other legislation involving multiple claims or complex settlement structures.
As Tax Analyst Robert W. Wood states, “Defendants love QSFs, for they get their tax deductions immediately. Plaintiffs love QSFs, for they can determine when and how to be paid, structure, cash or both. Plaintiff Lawyers love QSFs, for they can structure their fees, or get paid immediately [or deferred], even while their clients are still negotiating.”
Tax Benefits for Defendants
One of the primary advantages of QSFs for defendants is the ability to take an immediate tax deduction, if available, when depositing funds. This is a notable exception to the general tax rule that only allows deductions when the recipients receive and recognize the payment as income.
By using a QSF, defendants can secure their tax deduction and obtain a full release of liability, even if plaintiffs have not yet received their settlement funds. That being said, it’s important to note that a QSF itself is a separate taxable entity. Income earned by the fund—usually through interest and dividends—is taxed at the highest tax rate (so plan accordingly).
Tax Benefits for Plaintiffs and Their Attorneys
For plaintiffs and their attorneys, QSFs are particularly useful in structured settlement arrangements. Structured settlements provide a stream of payments over time, allowing for a measured approach to tax planning. Plaintiffs can take the time to resolve liens, determine appropriate allocations among multiple claimants, and make informed decisions about lump sum versus structured settlement options.
Plaintiff attorneys, too, can benefit from QSFs. Income can be deferred, and earnings can be spread over multiple tax years. There’s also no waiting for full resolution among plaintiff parties for the representing attorneys to be paid.
Proper Administration is Key
While the tax benefits of QSFs are substantial, they are contingent upon proper administration. This responsibility is handled by the QSF administrator supervised by the court. The QSF administrator files the tax return and issues any required 1099 forms to claimants. They make agreed-upon payments and satisfy any outstanding liens. The fund must also meet specific requirements set forth by the IRS and are subject to court or government agency supervision and/or applicable state trust law requirements.
The complexity of QSF administration and the associated tax implications underscore the importance of working with experienced professionals. When properly established and managed, QSFs can significantly enhance the financial outcomes and tax opportunities for each party involved.