Firmwide Qualified Settlement Funds – What Can Go Wrong? (Part 2 of 2)

In part 1 of this series, we explored the question of what is a Firmwide Qualified Settlement Fund (FWQSF) - sometimes also referred to as a Master Qualified Settlement Fund. We concluded that such arrangements are not supported by the regulations, the IRS comments, or the IRS’ rulings in Private Letter Rulings. As noted in part one, this analysis of FWQSF schemes is not singular. Multiple tax law firms and industry commentators have long chronicled the array of issues with FWQSFs.¹

Now, in part 2 of this series, we turn our focus to what could be the potential consequences upon disqualification of an FWQSF as a Qualified Settlement Fund (“QSF”).

• Section One analyzes likely IRS actions, including tax penalties, interest, and potential tax fraud claims
• Section Two explores potential Civil Actions that might arise from a disqualified FWQSF
• Section Three examines possible State Bar actions against the law firm related to the disqualification of an FWQSF

Section One

If the IRS disqualifies an FWQSF for failing to meet the related claims requirement under section 1.468B-1(c)(2), or for any other reason, there would likely be various tax consequences and potential penalties. These may include:

Tax Consequences for the Transferring Parties

Loss of Tax Deduction: If an FWQSF is disqualified, the transferring parties (typically defendants) may lose their tax deductions for contributions made to the fund. Generally, a defendant can claim a tax deduction for amounts transferred to a QSF in the year the transfer occurs. However, the IRS may disallow the defendant’s deduction if the fund is disqualified as a QSF.

Constructive Receipt: If an FWQSF is disqualified, the transferring parties may be considered to have made direct payments to the claimants, leading to potential constructive receipt issues for the claimants. The constructive receipt would result in immediate tax liability for the claimants, even if they have not yet received the funds. In such a scenario, disqualification for treatment under Section 130 could arise or disqualify the attorney fee structure or assignment.

Tax Consequences for the Claimants

Accelerated Tax Liability: Upon disqualification of an FWQSF, claimants may face immediate tax liability on the amounts allocated, as they could be in constructive receipt of the funds. They may have to pay taxes before receiving the funds or in a tax year when unprepared for the tax liability. The accelerated tax liability may create an unfavorable financial and tax situation for the claimants.'

Tax Consequences for the FWQSF

Trust Taxation: If an FWQSF is disqualified, it may be treated as a regular trust for tax purposes, subject to additional and adverse tax treatment.

Penalties and Interest

Penalties: If the IRS determines that an FWQSF or the parties involved have not complied with the tax laws, it may impose penalties, such as failure to file, late payment, or failure to pay fines and penalties, depending on the specific situation.

Interest: The IRS may also assess interest on any unpaid taxes or underpayments resulting from the disqualification of an FWQSF, which could further increase the financial burden on the parties involved.

Potential Tax Fraud Claims

In cases where the IRS suspects intentional wrongdoing or fraud in the establishment or administration of an FWQSF, it may pursue tax fraud claims against the parties involved. This could lead to significant financial penalties and potential criminal liability, depending on the severity of the fraud.

Section One Conclusion

In conclusion to Section One, the disqualification of an FWQSF by the IRS can lead to various tax consequences, penalties, interest, and potential tax fraud claims. The parties involved in establishing and administrating an FWQSF should ensure compliance with the related claims requirement and other tax laws to avoid these unfavorable outcomes.

Section Two – Civil Claims and Litigation

If the IRS disqualifies an FWQSF, the law firm responsible for its establishment and administration may face civil claims and litigation. These claims may include:

Legal Malpractice

Suppose the law firm fails to properly advise clients about the related claims requirement, tax consequences, or the risks of establishing an FWQSF. In that case, clients may pursue legal malpractice claims against the firm. Clients would need to prove that the law firm breached its duty of care, which caused them harm through financial losses, tax liabilities, or other damages.

Breach of Fiduciary Duty

Attorneys owe a fiduciary duty to their clients, which includes duties of loyalty, competence, and diligence. Suppose the law firm failed to advise clients properly, failed to comply with the related claims requirement, or otherwise acted negligently in establishing or administering the FWQSF. In that case, clients may assert breach of fiduciary duty claims against the firm.

Breach of Contract

If the law firm fails to fulfill its contractual obligations to its clients in relation to an FWQSF, clients may pursue breach of contract claims against the firm. For example, suppose the firm agreed to establish and administer an FWQSF in compliance with all applicable tax laws and regulations but failed to do so. In that case, clients may have a claim for breach of contract.

Negligent Misrepresentation

Suppose the law firm provided false or misleading information to clients regarding an FWQSF, tax consequences, or the risks related to potential failing to satisfy the related claims requirement. In that case, clients may bring a claim for negligent misrepresentation. To succeed, clients would need to prove that the firm made false or misleading statements that the clients reasonably relied upon, resulting in damages.

Contribution and Indemnification

Suppose the law firm’s actions or omissions related to an FWQSF cause other parties, such as defendants or claimants, to incur losses. In that case, these parties may bring claims for contribution or indemnification against the firm. Depending on the circumstances, they may seek to recover a portion or all of their losses from the law firm.

Class Actions

In some cases, a group of similarly situated claimants or defendants affected by the disqualification of an FWQSF may file a class action lawsuit against the law firm. The class action could involve claims such as legal malpractice, breach of fiduciary duty, breach of contract, or negligent misrepresentation.

Section Two Conclusion

In conclusion, the disqualification of an FWQSF may expose the responsible law firm to various civil claims and litigation, including legal malpractice, breach of fiduciary duty, breach of contract, negligent misrepresentation, contribution, indemnification, and class actions. Law firms should diligently advise clients about FWQSFs, ensure compliance with the related claims requirement, and manage the associated risks to avoid potential civil claims and litigation.

Section Three

Suppose the IRS disqualifies an FWQSF; the law firm responsible for its establishment and administration will likely have acted negligently or unethically. In that case, the state bar may take disciplinary action against the firm or the attorneys involved. The specific steps that the state bar might take may depend on the jurisdiction and the nature of the misconduct but could include the following:

Investigation

The state bar may investigate the law firm or the attorneys involved in an FWQSF’s establishment and administration. A complaint from a client, another attorney, or the state bar itself could trigger this investigation.

Reprimand or Censure

Suppose the state bar concludes that the law firm or its attorneys acted negligently or unethically but that their misconduct was not severe enough to warrant suspension or disbarment. In that case, the state bar may issue a reprimand or censure. This formal rebuke serves as a warning and becomes part of the attorney’s disciplinary record.

Probation

The state bar may impose a probationary period on the attorneys involved in an FWQSF’s disqualification. During probation, the attorneys may be required to meet certain conditions, such as attending continuing legal education courses, submitting to periodic audits, or reporting regularly to the state bar.

Suspension

In the event the state bar determines that the misconduct was more severe, it may suspend the attorneys involved for a specified period. During the suspension, the attorneys cannot practice law, and their licenses are temporarily inactive.

Disbarment

In the most severe cases, where the state bar finds that the attorneys engaged in serious misconduct, such as fraud, intentional misrepresentation, or willfully ignoring the law, the attorneys may be disbarred. Disbarment is the most severe disciplinary action resulting in permanent revocation of the attorney’s license to practice law.

Restitution

The state bar may also order the law firm or its attorneys to pay restitution to clients or other parties who suffered financial harm due to an FWQSF’s disqualification. Restitution may involve reimbursing clients for fees paid, compensating for tax liabilities, or other economic losses.

Mandatory Continuing Legal Education

The state bar may require the attorneys involved in an FWQSF’s disqualification to complete additional continuing legal education courses, particularly in areas such as ethics, tax law, or Qualified Settlement Funds.

Section Three Conclusion

In conclusion, the state bar may take various disciplinary actions against a law firm or its attorneys if an FWQSF is disqualified due to negligence or unethical conduct. These actions may include reprimands, probation, suspension, disbarment, restitution, or mandatory continuing legal education, depending on the severity of the misconduct and the jurisdiction’s attorney discipline rules.