Affected Investor Fund QSF: What Investors Need to Know

When investors are harmed by financial fraud, such as a Ponzi scheme, an affected investor fund may be established to manage and distribute recovered assets. These funds are often structured as a Qualified Settlement Fund (QSF), a specific designation under the U.S. tax code. A QSF acts as a court-supervised entity designed to hold settlement money from defendants before it is paid out to harmed investors. This structure provides an orderly process for resolving claims and has distinct tax rules for the fund and the investors.

The primary purpose of a QSF is to create a clear separation between the party paying the settlement and the recipients. This allows the defendant to resolve their liability, while the fund’s administrator takes on the task of verifying investor claims and distributing the money. For investors, it provides a centralized process for recovering a portion of their losses, governed by federal regulations.

Establishing a Qualified Settlement Fund

To be recognized as a Qualified Settlement Fund for tax purposes, a fund must meet three requirements detailed in Treasury Regulation § 1.468B-1. Failure to satisfy these criteria would prevent the fund from operating under the special QSF tax rules. Each requirement serves a purpose in ensuring the fund is a legitimate vehicle for resolving legal claims.

The first requirement is that the fund must be established with the approval of a governmental authority, like a federal court or the Securities and Exchange Commission. This authority must maintain continuing jurisdiction over the fund, overseeing its administration to ensure it operates according to the settlement agreement. This oversight confirms the fund is managed by a court-appointed administrator or trustee.

A second condition is that the fund must be created to resolve one or more claims arising from a tort, breach of contract, or a violation of law. The fund must be tied to a specific event or series of related events that gave rise to the legal action, ensuring it is dedicated to compensating a specific group of claimants.

Finally, the fund’s assets must be segregated from the other assets of the defendant who paid the settlement. The assets can be held in a formal trust or a distinct bank account, but they cannot be commingled with the defendant’s money. This segregation protects the settlement proceeds from the defendant’s creditors and ensures the money is available for distribution to investors and for paying administrative expenses.

Taxation of the Fund

A Qualified Settlement Fund is a distinct taxable entity, separate from the defendant who funded it and the investors who will receive payments. The fund itself is responsible for paying taxes on any income it generates. The initial settlement amount is not considered taxable income to the fund; instead, the fund is taxed on its earnings, such as interest or capital gains from investing the assets before they are distributed.

The fund’s modified gross income is taxed at the highest rate applicable to trusts, which is 37%. This prevents the fund from being used as a tax-sheltered investment vehicle. The fund can deduct administrative expenses, such as legal and accounting fees, trustee fees, and other costs related to its operation.

The fund’s administrator must file an annual income tax return with the IRS using Form 1120-SF, U.S. Income Tax Return for Settlement Funds. This form is used to report all income earned, deductions taken, and the final tax liability. The fund must use a calendar tax year and the accrual method of accounting, and the return is typically due by the 15th day of the fourth month after the tax year ends.

Information Required for Investor Claims

To receive a distribution from a QSF, an investor must file a formal claim with the fund’s administrator. This process requires submitting detailed documentation to prove the existence and amount of their loss. The administrator uses this evidence to validate each claim and calculate the investor’s pro-rata share of the settlement funds.

Investors must provide comprehensive documentation to establish their claim, including:

• Proof of identity and ownership of the investment account.
• Brokerage or account statements showing the dates and amounts of all investments.
• Records of any funds already received, such as withdrawals or redemptions.
• Transaction confirmations for both purchases and sales to establish a timeline.
• Any correspondence with the fraudulent entity or broker concerning the investment.

This documentation is necessary for the administrator to perform a “recognized loss” calculation. The administrator subtracts the total amount of funds the investor withdrew from the total amount invested to determine the net loss. This calculated loss figure is then used to determine what portion of the total settlement pool each investor is entitled to receive.

Tax Consequences for Investors

The tax treatment of distributions from a QSF is determined by the principle of basis recovery. An investor’s basis is the amount of their original investment, plus any additional contributions, less any amounts they withdrew before the fraud was discovered.

Distributions from a QSF are first treated as a non-taxable return of the investor’s basis. An investor will not owe any tax on the payments until the total amount received from the fund exceeds their calculated investment basis. For example, if an investor’s basis was $100,000, they would not report any income for the first $100,000 of distributions they receive.

If an investor’s total recovery from all sources, including the QSF, exceeds their investment basis, the excess amount is considered a taxable gain. The character of this gain mirrors the character of the original investment, which for most investors would be a capital gain.

If an investor’s total recovery is less than their basis, they are left with a final, unrecoverable loss. This loss may be deductible, and its character is an important consideration.

For losses from Ponzi-type schemes, the IRS provides a “safe harbor” in Revenue Procedure 2009-20 that allows investors to treat the loss as a theft loss. A theft loss from an investment is not subject to the strict limitations placed on capital losses. Under the safe harbor, a qualified investor can deduct either 95% or 75% of their net loss in the year the fraud is discovered. The 95% deduction is available if the investor is not pursuing recovery from third parties, while the 75% deduction applies if they are. To claim this deduction, investors must complete Section C of Form 4684, Casualties and Thefts.