Taxation of a Qualified Settlement Fund - Never Establish a QSF in California
California is known for many things; great beaches, vivid scenery, award-winning wines, and high taxes. Often overlooked when creating a Qualified Settlement Fund (“QSF”) is that California applies its confiscatory tax policy and rates to QSFs operating in California or established by a governmental authority residing therein.
California’s maximum marginal corporate income tax rate of 8.840% is the 9th highest in the United States. Thus, Legal Ruling 1993-4 makes establishing a QSF in California an expensive mistake that can result in high taxation.
Background of Legal Ruling 1993-4
In its Legal Ruling 1993-4 issued November 15, 1993, the State of California Franchise Tax Board’s - Legal Division established California’s position regarding the “Taxation of a Qualified Settlement Fund”.
The Franchise Tax Board (“FTB”) ruling outlined the following:
- A QSF is subject to tax under the Revenue and Taxation Code (“RTC”) §24693.
- The taxation applies if a “California Court” establishes a QSF.
- RTC §24693 n1 incorporates IRC §468B by reference and AMENDS the 1.468B-1 et seq. definition of Modified Gross Income with modifications to provide that a tax shall be imposed upon the Gross Income of the fund at a rate equal to the rate in effect under RTC §23501.
- In general, RTC §23040 provides that - income derived from or attributable to sources within California includes income from tangible or intangible property located or having a situs in California and income from any activities carried on in California, regardless of whether carried on in intrastate, interstate, or foreign commerce.
- Under RTC §23040, income received by such a QSF is taxable under RTC §24693. The FTB takes the position that the situs of intangible property for California tax purposes is the commercial domicile of the QSF unless the intangible property has acquired a business situs elsewhere. This means, the default commercial domicile of a QSF (including a designated settlement fund) shall be presumed by the FTB to be at the court or the governmental authority which ordered or approved the establishment of the QSF and which exercises continuing jurisdiction over the QSF.
The final holding of the FTB is as follows:
“FUND [sic QSF] income (other than interest on obligations of the United States) from California sources is taxable under RTC §24693. Income from intangible property (other than interest on obligations of the United States) received by a QSF which was established or approved by, and subject to the continuing jurisdiction of, a court or government agency located in California is attributable to California sources and taxable under RTC §24693, unless the QSF has established a commercial domicile elsewhere or the intangible property has acquired a business situs elsewhere.”
Conclusion
While some states have higher taxes than California, many have lower taxes or apply trust or no taxation to a trust-based QSF. Carefully consider in which jurisdiction you create a QSF and consider QSF 360 to manage your QSF tax liabilities.
