Tax Treatment of a Qualified Settlement Fund

A Qualified Settlement Fund, or QSF, is a specialized account or trust created to hold and distribute settlement proceeds in legal disputes. These funds are established under a court order to manage payments in cases involving numerous claimants, such as class-action lawsuits. A QSF allows the defendant in a legal case to make a single payment into the fund, resolving their obligation. The fund’s administrator then takes on the responsibility of managing the assets and distributing them to the individual claimants according to the settlement agreement.

Establishing a Qualified Settlement Fund

To be recognized as a Qualified Settlement Fund for tax purposes, an arrangement must satisfy three tests detailed in Treasury Regulation § 1.468B-1. Failing to meet any of these criteria means the fund will not qualify for the specific tax treatment afforded to QSFs. The process involves adherence to these regulatory standards.

The first requirement is that the fund must be established pursuant to an order from, or have the approval of, a governmental authority. This authority, often a court, must also maintain continuing jurisdiction over the fund.

A second condition is that the fund must be created to resolve or satisfy one or more claims arising from a tort, breach of contract, or violation of law. This links the fund directly to the resolution of a specific legal dispute.

The final test mandates that the fund’s assets must be segregated from the other assets of the entity paying into the fund, known as the transferor. This is achieved by establishing the fund as a formal trust under state law, which makes it clear that the transferor has relinquished control over the money.

Tax Treatment of the Transferor

From the perspective of the defendant paying into a Qualified Settlement Fund, the primary tax consideration is the timing of the deduction. The transferor can claim an immediate tax deduction for the entire amount transferred. This deduction is available in the year the payment is made to the fund, not when the claimants ultimately receive their individual distributions.

This ability to take a current deduction is based on the principle of “economic performance.” Internal Revenue Code Section 468B provides a special rule stating that economic performance is deemed to occur when a “qualified payment” is made to a QSF. This exception allows the transferor to accelerate the deduction.

The transferor’s payment into the fund effectively ends their involvement in the financial administration of the settlement. Once the funds are transferred, the defendant is released from further liability to the claimants. The responsibility for managing and distributing the assets shifts to the QSF and its administrator.

Taxation of the Fund Itself

A Qualified Settlement Fund is a distinct taxable entity, separate from both the transferor who funds it and the claimants who will receive distributions. The initial transfer of the settlement principal into the fund is not considered taxable income to the QSF. The fund’s tax liability is based on the investment income it generates while holding and managing the assets.

The QSF is taxed on its “modified gross income,” which consists of earnings like interest, dividends, and capital gains. The fund can take deductions for administrative expenses, such as trustee and accounting fees, legal fees, and state and local taxes. However, payments made to claimants are not deductible by the fund.

The income of a QSF is taxed at the maximum rate applicable to trusts under Internal Revenue Code Section 1(e), which is 37 percent for 2025. The fund must file its own annual income tax return using Form 1120-SF, U.S. Income Tax Return for Settlement Funds, to report its income, deductions, and tax liability.

In certain situations, a QSF administrator can make a “relation-back election.” This election allows the fund, with the transferor’s consent, to be treated as having been established on an earlier date. This can be useful if there is a delay between when the fund is established and when it receives court approval, simplifying tax compliance.

Tax Consequences for Claimants

The tax implications for claimants receiving money from a Qualified Settlement Fund are determined by the nature of their original legal claim. The “origin of the claim” doctrine dictates whether the funds are taxable. Payments received for physical injuries or sickness are excluded from a claimant’s gross income under Internal Revenue Code Section 104. Conversely, payments for claims such as lost wages, lost profits, or punitive damages are considered taxable income.

The timing of income recognition for a claimant is an important consideration. A claimant must include a taxable settlement payment in their income in the year their right to the funds becomes fixed and determinable. This right is established when the fund makes a final determination on their specific award amount.

The administrator of the QSF is responsible for handling tax reporting to both the claimants and the IRS. When taxable payments are made, the administrator will issue an appropriate information return, such as Form W-2 for lost wages or Form 1099-MISC for other awards. This reporting provides claimants with the necessary documentation to report their settlement income.