Is This a Qualified Settlement Fund?
Understand the criteria that determine if a fund for legal claims operates as a distinct, taxable entity and the administrative consequences of this IRS classification.
When parties in a legal dispute agree to a settlement, the money designated to resolve the claims is often placed into a specific fund. Under Treasury Regulation § 1.468B, if a fund meets a specific set of criteria, it is considered a “Qualified Settlement Fund,” or QSF. This classification triggers a unique set of tax rules and administrative duties that differ from other types of accounts. Understanding whether a fund qualifies as a QSF is the first step in navigating its financial and reporting obligations.
The Three Required Tests for a Fund
For any fund, account, or trust to be recognized as a Qualified Settlement Fund, it must satisfy three tests outlined in federal tax regulations. Failure to meet even one will prevent the fund from gaining QSF status. The tests are designed to ensure the fund is under proper oversight, serves a specific legal purpose, and maintains financial separation from the party that established it.
Government Jurisdiction
The first test requires that the fund be established pursuant to an order from, or have its creation approved by, a governmental authority, such as a federal, state, or local court or government agency. The regulation stipulates that the fund must remain under the continuing jurisdiction of that same authority. For example, if a federal district court orders a defendant to place settlement money into an account to resolve a class-action lawsuit, this test is met. This requirement ensures the fund is subject to official supervision rather than being a private, unregulated arrangement.
Resolving Specific Claims
The second test mandates that the fund must be established to resolve or satisfy one or more contested or uncontested claims. These claims must arise from an event or series of events that led to a liability claim resulting from a tort, a breach of contract, or a violation of law. For instance, a fund created by a company to compensate customers affected by a data breach would meet this test.
Asset Segregation
The final test requires the fund’s assets to be financially independent. The fund must be structured as a trust under state law, or its assets must be segregated from the other assets of the transferor, who is the defendant in the legal case. This means the transferor cannot have access to the funds or treat them as their own property once the transfer is made. The money must be held in a separate account or trust, ensuring it is used solely for satisfying the legal claims.
Tax Treatment of the Fund
Once a fund is identified as a QSF, it is treated as a distinct entity for federal income tax purposes, separate from the defendant and the claimants. The QSF itself is responsible for paying taxes on its earnings. The fund’s taxable income is its “modified gross income,” which consists of income generated from its assets, such as interest or dividends. The initial settlement amount transferred into the QSF is not considered income to the fund and is excluded from taxation.
The income of a QSF is taxed at the maximum rate applicable to trusts. To report and pay these taxes, the fund’s administrator files Form 1120-SF, U.S. Income Tax Return for Settlement Funds. This form is used to calculate the tax owed on the fund’s modified gross income after deducting allowable administrative expenses, such as legal and accounting fees.
Administrator Duties and Reporting
The administrator of a Qualified Settlement Fund has several responsibilities dictated by tax regulations. The administrator can be the defendant, a third party appointed by the court, or a person agreed upon by the involved parties. Their duties include managing the fund’s investments and handling specific tax reporting obligations to both the IRS and the claimants.
A primary duty is the timely filing of the fund’s annual income tax return using Form 1120-SF. This return must be filed for each taxable year the fund is in existence, regardless of whether it generated income. The tax payment is due by the 15th day of the fourth month after the end of the fund’s tax year and must be paid via the Electronic Federal Tax Payment System (EFTPS).
The administrator must also provide a statement to any claimant receiving a distribution from the QSF. Furthermore, the administrator may be required to file information returns with the IRS, such as Form 1099-MISC, for certain distributions, mirroring the reporting that would have been required if the defendant had paid the claimant directly.