468B QUALIFIED SETTLEMENT FUNDS IN SINGLE-PLAINTIFF PHYSICAL INJURY SETTLEMENTS

By John J. Campbell, Esq., CELA, MSCC

 

Introduction

 

          Section 104(a)(2) of the Internal Revenue Code (IRC) provides that proceeds from the settlement of a claim involving physical injury or sickness (except for punitive damages) are not taxable.  However, income earned by plaintiffs on lump sum settlements of such claims is taxable.

 

          In 1982, Congress passed the Periodic Payment Act, amending the IRC to grant statutory authority for the use of periodic payments in physical injury (PI) settlements.  The Act most notably created §130 of the IRC, which provides a means whereby a settling defendant can fulfill his or her obligation to make periodic payments of settlement proceeds through a qualified assignment. Under IRC §130, the income from a qualified annuity that makes periodic payments as part of a settlement of a PI claim is exempt from income tax if there is a qualified assignment of the obligation to make the annuity payments.

 

          In addition to income tax concerns, there is an inherent risk that a lump sum settlement designed to provide for the plaintiff's lifetime medical and support needs may be dissipated prematurely.  Unwise investments, poor money management or even the volatility of the economy can result in the exhaustion of the plaintiff's settlement funds, leaving the plaintiff with no means to provide for his or her care and support.

 

          As a result, it is now common practice to structure all or part of a PI settlement with a qualified annuity and a qualified assignment under IRC §130. The advantages to the settling plaintiff are clear: income earned by the annuity is exempt from income tax; and the plaintiff has the security of a future stream of income to provide necessary funds for the plaintiff's lifetime.

 

          IRC §130 requires that a qualified assignment be made by a party to the suit or agreement having liability to the plaintiff.  (IRC §130(c)(1).)  If the plaintiff were to obtain actual or constructive receipt of the settlement funds, the ability to take advantage of the tax savings under §130 would be lost.  Therefore, structured settlements under §130 have traditionally been funded directly by the defendant or the defendant's insurance carrier.

 

          Increasingly, settling plaintiffs and their attorneys have expressed serious dissatisfaction with the traditional arrangement in which the defendant has complete control over the purchase of the annuity which will fund the qualified assignment.  Plaintiffs are forced to agree to a specified income stream rather than the lump sum amount with which the annuity will be funded.  Defendants' insurance carriers often use "preferred" brokers who may be under an agreement to split commissions with the carrier.  Fees, commissions and the actual commuted value of the annuity are seldom, if ever, disclosed.  Many times, the future payments the plaintiff will receive are less than what the plaintiff might have been able to obtain from another annuity issuer for the same premium payment.

 

          Plaintiffs may thus be deprived of the ability to enjoy the fullest benefit of the settlement; and may even feel that they have been duped into settling for less than the agreed-upon amount.  Further, there is at least a perceived conflict of interest involved where the plaintiff's financial settlement planning is in the hands of the opposing party. 

 

    As a result, many plaintiffs who are interested in receiving their settlements in the form of a structure are insisting on a different procedure that will allow them more control.  Qualified Settlement Funds under IRC §468B and the corresponding IRS regulations provide an alternative to the traditional, defendant-directed structured settlement arrangement. 

         

Qualified Settlement Funds under IRC §468B

 

          In 1986, Congress enacted the Tax Reform Act, which added IRC §468B to allow a defendant to extinguish his or her liability by paying settlement proceeds into a "designated settlement fund."  (IRC §468B is codified at 26 U.S.C. §468B.)  Initially, designated settlement funds (DSF's) were used in the settlement of large class action PI[1] suits, where the individual shares of the settlement to the various class members had not yet been determined.  However, §468B contains no language restricting the use of DSF's to the settlement of suits or claims involving multiple plaintiffs. 

 

          A DSF is defined as any fund:

 

                    (A) which is established pursuant to a court order and which extinguishes completely the tort liability of the defendant or the defendant's insurance carrier to the plaintiff,

(B) with respect to which no amounts may be transferred other than in the form of qualified payments,         

(C) which is administered by persons a majority of whom are independent of the defendant or the defendant's insurance carrier,

(D) which is established for the principal purpose of resolving and satisfying present and future claims against the defendant (or any related person or formerly related person) arising out of personal injury, death, or property damage,

(E) under the terms of which the defendant (or any related person) may not hold any beneficial interest in the income or corpus of the fund, and

(F) with respect to which an election is made by the defendant.

 

IRC §468B(d)(2).

 

          In 1992, the Treasury Secretary introduced regulations governing the treatment of DSF's.  (26 C.F.R. §§1.468B-1 through 1.468B-5.)  Under these regulations, the Secretary provided for the creation and use of "qualified settlement funds" (QSF's).[2]  Although QSF's are not specifically mentioned in IRC §468B, they are clearly intended to meet the definition of a DSF.

 

          Under 26 C.F.R. §1.468B-1, a fund, account or trust is a QSF if:

 

(1) It is established pursuant to an order of, or is approved by, the United States, any state (including the District of Columbia), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority;

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

(i) Under the Comprehensive Environmental Response, Compensation and Liability Act of 1980 (hereinafter referred to as CERCLA), as amended, 42 U.S.C. 9601 et seq.; or

(ii) Arising out of a tort, breach of contract, or violation of law; or

(iii) Designated by the Commissioner in a revenue ruling or revenue procedure; and

(3) The fund, account, or trust is a trust under applicable state law, or its assets are otherwise segregated from other assets of the transferor (and related persons).

 

26 C.F.R. §1.468B-1(c) (emphasis added).  Although the regulations define a QSF in broader terms than the statute's definition of a DSF, the regulations are valid.  United States v. Brown, 334 F.3d 1197 (10^th Cir. 2003). 

 

          The proceeds of a PI settlement used to fund a QSF continue to receive favorable tax treatment under IRC §104(a)(2), but income earned on the proceeds are taxable to the QSF for so long as the QSF continues to hold the funds.  Under 26 C.F.R. §1.468B-2, QSF's are taxed at the maximum rate applicable to trusts, but are otherwise treated as corporations under the IRC.  

 

          Like the governing statute, the regulations do not contain any language restricting the use of QSF's to settlement of suits or claims involving multiple plaintiffs.  Moreover, the regulations state specifically that a QSF can be used to settle "one or more" claims.  There can be little serious doubt that the regulations permit QSF's to be used in the settlement of single-plaintiff physical injury claims.

 

QSF's and Qualified Assignments

 

          The question still remains whether a QSF holding funds from a PI settlement involving a single plaintiff can accomplish a qualified assignment under IRC §130.  Many defendants, liability carriers and structured settlement professionals have argued for years that it cannot, based upon the common law doctrine of "economic benefit," as defined in the landmark case of Sproull v. Commissioner, 16 T.C. 244 (1950), aff'd, 194 F.2d 541 (6th Cir. 1952). 

 

          In a nutshell, the Sproull case held that when a fund is placed irrevocably with a third party for the sole benefit of the taxpayer and the taxpayer has a vested right in the fund, the taxpayer has received an economic benefit. This, the argument goes, is exactly what happens when a QSF is funded with the proceeds of a single-plaintiff PI settlement, since the amount to which the plaintiff's vested interest applies is immediately determinable. 

 

          Under Sproull, if the taxpayer has received an economic benefit, the fund is immediately includable in the taxpayers gross income.  Therefore, if the plaintiff has an economic benefit from PI settlement funds, the principal settlement amount is excludable under IRC §104(a)(2), but any income earned on the funds is includable in the plaintiff's gross income.  This would arguably prevent the QSF from being able to accomplish a valid §130 qualified assignment, since all of the periodic payments from the qualified funding asset, including the income portion, must be excludable from the plaintiff's gross income under §104(a)(1) or (2).  (IRC §130(c)(2)(D).)   

 

          Proponents of this argument often cite an IRS Private Letter Ruling (PLR 0138006) as authority for the application of the economic benefit doctrine to single-plaintiff QSF's.  While that particular PLR did involve an analysis of a QSF under the economic benefit doctrine, the QSF discussed in PLR 0138006 was not funded with the proceeds of a PI settlement.  Therefore, the case discussed in PLR 0138006 did not involve the issue of whether a QSF holding funds from a single-plaintiff settlement could accomplish a valid §130 qualified assignment.

 

          The real issue is whether the economic benefit doctrine applies to bar a single-plaintiff QSF, funded with PI settlement proceeds, from making a qualified assignment under IRC §130.  To rely solely upon PLR 0138006 as authority for the application of the economic benefit doctrine in such cases ignores the content of IRC §130, the Congressional intent and legislative history behind IRC §130, and the IRS' Revenue Procedure 93-34.

 

          When §130 was originally enacted in 1982, the statute provided that the party making a qualified assignment could not assign payment rights "greater than those of a general creditor."  (IRC §130(c)(2)(C), 1982.)   The legislative history behind the original 1982 statute states Congress' intent at the time that payments of damages from PI claims be "excludable from income only if the recipient taxpayer is not in constructive receipt of or does not have the current economic benefit of the sum required to produce the periodic payments.  S. Rep. No. 97-646; H.R. Rep. No. 97-832, 97th Cong., 2d Sess. 4 (1982) (emphasis added).  

 

          However, Congress amended §130(c)(2)(C) in 1988 by removing the "greater than a general creditor" language, so that  "[r]ecipients of periodic payments under structured settlement arrangements should not have their rights as creditors limited by provisions of the tax law." H.R. Rep. No. 100-795, at 541 (1988).  When Congress repealed §130(c)(2)(C), it also added the following  language to §130(c):

 

"The determination for purposes of this chapter of when the recipient is treated as having received any payment with respect to which there has been a qualified assignment shall be made without regard to any provision of such assignment which grants the recipient rights as a creditor greater than those of a general creditor." 

 

IRC §130(c) (emphasis added).

 

          The legislative history behind the 1988 revisions to §130(c) states that "no amount is currently includable in the recipient’s income solely because the recipient is provided creditor’s rights that are greater than the rights of a general creditor."  H.R. Conf. Rep. No. 1104, 100th Cong., 2d Sess. at II-171(1988). 

 

          A settling plaintiff with vested rights to a settlement fund has rights "greater than those of a general creditor" and would normally be considered to have an "economic benefit" under Sproull.  Thus, the effect of the 1988 amendments to §130(c) was to make the "economic benefit" doctrine inapplicable to qualified assignments in PI settlements. 

 

          Whenever the parties to a PI case reach an agreement to settle for a specified amount, the plaintiff obtains a vested right to the proceeds of settlement.  When the defendant or the defendant's insurance carrier provides the funds through a qualified assignment for the purchase of a qualified annuity, the funds are irrevocably placed with a third party for the sole benefit of the plaintiff.  In spite of this, qualified assignments are routinely and successfully employed in structured PI settlements for individual plaintiffs.  (To prevent constructive receipt, the settlement terms will not permit the plaintiff the option to receive the settlement in a lump sum; and will provide that the assignment will be made directly by the defendant or the defendant's insurance carrier.) 

 

          It seems clear that the economic benefit doctrine is no longer applicable to bar a qualified assignment under IRC §130 after the 1988 revisions to that section.  Indeed, the IRS has interpreted the 1988 revisions as allowing qualified assignments of periodic payment liabilities without regard to whether a plaintiff has the current economic benefit of the settlement proceeds or the qualified funding assets purchased with those settlement proceeds.  (PLR 9703038.)  Assuming the requirements of IRC §130 are met, the plaintiff's economic benefit does not bar a successful qualified assignment.

 

          Therefore, a party to the suit or agreement with liability to the plaintiff can accomplish a valid qualified assignment, regardless of whether the settlement proceeds are placed irrevocably with a third party in a separate fund, account or trust for the sole benefit of the plaintiff and the plaintiff has a vested right in the fund, account or trust.  So long as the plaintiff is not in constructive receipt of the settlement proceeds, a qualified assignment is still possible.

 

          It is very important to note that IRC §130(c) requires only that the assignment be made by a "party to the suit or agreement" having liability to the plaintiff.  That section does not require that the assignment be made by the original defendant or its insurance carrier.  Thus, any  party with liability to the plaintiff can make a valid qualified assignment.

 

          In 1993, the IRS enacted Revenue Procedure 93-34.  This procedure "provides rules under which a designated settlement fund described in section 468B(d)(2) of the Internal Revenue Code or a qualified settlement fund described in section 1.468B-1 of the Income Tax Regulations will be considered 'a party to the suit or agreement' for purposes of section 130."  (Rev. Proc. 93-34, Section 1.)   

 

          Specifically, Rev. Proc. 93-34 provides that:

 

. . .  a qualified settlement fund will be treated as "a party to the suit or agreement" within the meaning of section 130(c)(1) of the Code if each of the following requirements is satisfied:

(1) the claimant agrees in writing to the assignee's assumption of the . . . qualified settlement fund's obligation to make periodic payments to the claimant;

(2) the assignment is made with respect to a claim on account of personal injury or sickness (in a case involving physical injury or physical sickness) that is . . .:

          (b) a claim [under CERCLA ; or arising out of a tort, breach of contract, or violation of law; or designated by the Commissioner in a revenue ruling or revenue procedure];

(3) each qualified funding asset purchased by the assignee in connection with the assignment by the designated or qualified settlement fund relates to a liability to a single claimant to make periodic payments for damages;

(4) the assignee is not related to the transferor (or transferors) to the designated or qualified settlement fund within the meaning of sections 267(b) or 707(b)(1); and

(5) the assignee is neither controlled by, nor controls, directly or indirectly, the designated or qualified settlement fund. . .

 

Rev. Proc. 93-34, Section 4 (emphasis added).

 

          Rev. Proc. 93-34 does not contain any provisions which would restrict its application to settlements involving multiple plaintiffs.   On the contrary, it speaks in terms of qualified assignments relating to "a claim" and "liability to a single claimant."  This language, like the language of IRC §468B itself, is consistent with situations involving either a single plaintiff or multiple plaintiffs.

 

          The logical conclusion is that the provisions of IRC §§130 and 468B, and §§1.468B-1 through 1.468B-5 of the IRS regulations, as interpreted by the IRS itself, permit QSF's in single-plaintiff PI settlements to make qualified assignments under IRC §130, so long as the QSF is made a "party to the suit or agreement" in compliance with Rev. Proc. 93-34.

 

How Does a QSF Make a Valid Qualified Assignment?

 

          It should not be difficult to comply with all of the applicable requirements of IRC §§130 and 468B, §§1.468B-1 through 1.468B-5 of the IRS regulations, and Rev. Proc. 93-34 when settling a PI claim.  The parties would first petition the court with jurisdiction over the claim to create a QSF trust and appoint an independent trustee, with the court having continuing jurisdiction over the QSF trust until it terminates.  The plaintiff would not have any rights to revoke or modify the terms of the QSF trust, or to compel any distributions from the QSF trust other than to fund a qualified assignment.

 

          The parties would then enter into a "novation," in which the plaintiff, defendant, the defendant's insurance carrier and the QSF trustee would all agree that the defendant's liabilities to the plaintiff be assigned to and fully assumed by the QSF.  As consideration, the defendant and/or the defendant's insurance carrier would agree to pay the QSF an agreed upon lump sum, to be used only to fund a qualified assignment with the plaintiff as payee.

 

          The QSF would then be substituted for the original defendant as a party to the case; the QSF would be funded by the defendant or the defendant's insurance carrier; and the defendant and/or its carrier would be granted a full release by all parties.  The QSF trustee, now a party standing in the shoes of the original defendant, would then enter into a full and final, court-approved settlement agreement with the plaintiff.  The settlement would extinguish all liabilities assumed from the original defendant and require payment of the settlement proceeds to the plaintiff through a qualified assignment.  The plaintiff would not have the option of receiving any portion of the settlement in a lump sum; and the obligation to make and fund the qualified assignment would fall solely to the QSF.

 

          The QSF, as a "party to the suit or agreement," should then be able to accomplish a §130 qualified assignment, giving the plaintiff favorable income tax treatment of all income earned on the qualified annuity.  Since the QSF would be funded with an agreed lump sum, representing the commuted value of the qualified annuity, the plaintiff would be assured of receiving the full value of the settlement. 

 

          The plaintiff would also have the ability to choose the structured settlement broker; to direct the trustee to purchase a qualified annuity that would provide the most valuable income stream; and to ensure that all fees and commissions are fully disclosed.  At the same time, the settlement would be protected from premature depletion; and the plaintiff would be assured a secure, future stream of income for life to meet his or her needs for support and medical care.  In short, the plaintiff would be able to enjoy all of the advantages of a tax-free structured settlement without the negative aspects of the traditional, defendant-directed structured settlement arrangement.

 

          Use of a QSF may be particularly useful in situations where the distribution of settlement proceeds need to be delayed to allow planning for the plaintiff's SSI or Medicaid eligibility.  The QSF's prohibition on distributions other than to fund a qualified assignment and its restrictions on the plaintiff's authority to compel distributions of principal or income would prevent the assets in the QSF from being treated as available resources or income to the plaintiff for purposes of SSI and Medicaid.  The qualified assignment could then be drafted to name an SSI/Medicaid exempt special needs trust as the payee (so long as all payments are made before the plaintiff reaches age 65).

 

Conclusion

 

          Defendants, liability carriers and their structured settlement brokers have historically argued that QSF's cannot be used in single-plaintiff PI structured settlements involving qualified assignment.  This argument, based on the theory that the economic benefit doctrine somehow bars the plaintiff from taking advantage of the favorable tax treatment in IRC §130, is not persuasive.  It is based solely on a common law doctrine that has been superceded in this context by federal statutes and regulations; and upon a private letter ruling that is not on point.   

 

          An in-depth analysis of IRC §130 and its legislative history, IRC §468B and the corresponding IRS regulations, and Rev. Proc. 93-34 all support and lead to the opposite conclusion: the economic benefit doctrine is not applicable to the use of qualified assignments in PI settlements.  The IRS' own interpretation of the law on this issue is in agreement. 

 

          The IRS has not said whether its stated position in this regard might somehow depend on the number of plaintiffs involved.  Of course, it is possible that the IRS could draw a distinction and treat the economic benefit doctrine as a bar to use of qualified assignments by QSF's in single-plaintiff settlements only.  However, this seems like a remote possibility at best. 

 

          There is simply no cogent basis in the IRC, the IRS regulations and procedures, or in the IRS' own previously-stated interpretations of the law to support such a distinction.  It is far more likely that the IRS will remain consistent and adopt the position that QSF's may successfully make qualified assignments in PI settlements, regardless of the number of plaintiffs, so long as there is compliance with the requirements of  IRC §130, IRC §468B; §§1.468B-1 through 1.468B-5 of the IRS regulations; and Rev. Proc. 93-34.