Qualified Settlement Funds (QSFs) offer a practical solution for parties involved in litigation (and non-litigation disputes) to fulfill monetary settlements. Notably, their formation and operation as trusts falls under the scope of regulation §1.468B-1 in the U.S. federal tax code [1][2].
Under §1.468B-1, QSFs are treated as trusts for federal income tax purposes [1]. These entities are deemed to be owned by the transferor as dictated by section 671 and its subsequent regulations. This regulation holds, except for paragraph (b) of the section and §1.468B-4, which deal with different aspects of the fund.
Importantly, if a fund, account, or trust classified as a QSF aligns with the definition of a trust under §301.7701–4, it is classified as a QSF for all purposes of the Internal Revenue Code [2]. This classification provides additional legal and financial protection for the parties involved in the settlement.
The trust formed as a QSF constitutes a separate taxable entity per section 1.468B-1(c) of the Income Tax Regulations [3]. Being separate from the parties involved, the fund can independently manage the financial obligations associated with the settlement.
The IRS’s EIN system additionally classifies a QSF under the Trust Section of the online EIN system, notwithstanding that investment income is taxed at the corporate rate and a QSF files an IRS Form 1120-SF.
Note: The settlement payments transferred in a QSF are not taxable income to a QSF. Only investment income (interest) earned by the QSF is taxable.
Moreover, the QSF trust is taxed on its modified gross income, a term defined under section 1.468B-2(b) of the Income Tax Regulations [3]. This taxation is equivalent to the maximum corporate rate, underscoring the fund's distinctness as a taxable entity.
In summary, forming QSFs as trusts provides a structured method for handling settlement funds, aligns with federal tax obligations, and offers protection for all parties involved in the legal proceeding. Adhering to regulations such as §1.468B-1 allows for a consistent, statutorily established approach to managing and distributing funds arising from settlements.
[1] “However, this section (except for paragraph (b) of this section) and §1.468B-4 apply to the qualified settlement fund; (ii) The qualified settlement fund is treated, for Federal income tax purposes, as a trust all of which is treated as owned by the transferor under section 671 and the regulations thereunder;”
https://www.law.cornell.edu/cfr/text/26/1.468B-1
[2] “If a fund, account, or trust that is a qualified settlement fund could be classified as a trust within the meaning of §301.7701–4 of this chapter, it is classified as a qualified settlement fund for all purposes of the Internal Revenue Code.”
https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR53de09ff5f206e9/section-1.468B-1
[3] “(1) The Trust will constitute a qualified settlement fund under section 1.468B-1(c) of the Income Tax Regulations. The Trust will be treated as a separate taxable entity. (2) The Trust will be subject to tax on its modified gross income as defined in section 1.468B-2(b) of the Income Tax Regulations at a rate equal to the maximum rate in effect for that taxable year under section 1(e) of the Internal Revenue Code.”
https://www.irs.gov/pub/irs-wd/0149013.pdf
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