BY: JOHN F. KEARNS III, CELA

You’ve won the case -- but now what?

You have just settled a personal injury claim for $2.5 million dollars for Mary.  She has a Medicare lien and a Medicaid lien.  Mary will need a special needs trust.  You made a derivative claim for loss of consortium on behalf of Mary’s husband, Tom.  The defendant has a structured settlement broker who wants to meet with you and Mary’s family.  How can you quickly tie up the loose ends and get the money?

Mary’s family is stunned and confused.  They waited six years for their day in court and the case settled during jury selection.  The family is anxious and uncertain about the allocation of the settlement between Mary and Tom.  They have questions about a lump sum payout, the use of the structured settlement annuity and the special needs trust.  Tom anxiously asks you, “How much is my loss of consortium claim worth?”  Mary is no longer competent. You will need a Conservator appointed by the probate court.

Negotiations on the Medicare lien and the Medicaid lien have not yet started.  The Conservator application must be filed.  How will the allocation of the settlement between Tom’s consortium claim, the use of the structured settlement annuity and the special needs trust be viewed by the probate judge, Mary’s court appointed attorney, as well as the Assistant Attorneys General for the Department of Administrative Services and the Department of Social Services?

Everyone wants the money to be distributed quickly. Mary loses potential income each day the distribution is delayed.  You know that it will take weeks before the Medicare and Medicaid lien information is updated.

Qualified settlement funds allow for payment of the settlement into a trust. The defendant is released upon payment to the Trustee, and the Trustee can immediately pay the plaintiff’s attorney’s fees and the litigation costs.  This “stops the clock” so that plaintiff’s counsel can carefully evaluate settlement options.  The plaintiff’s attorney can continue to update the lien information and negotiate with lienholders.  When the liens and the allocation of the money is resolved, the Trustee can still use structured settlement annuities and the special needs trust without adverse tax consequences.

As a trial attorney you need to know how to use settlement trusts. 

A Very Brief History

In the mid-1980s, insurance companies and self-insured defendants were reluctant to use settlement trusts.  Payments to such trusts were not deductible until the year in which the Trustee made the distribution to the beneficiary.  Congress enacted Internal Revenue Code §468B in 1986 which created designated settlement funds (DSFs) to resolve the plaintiffs’ and defendants’ concerns.

The Treasury Department expanded DSFs in a 1994 regulatory ruling to include Qualified Settlement Funds (QSFs).  QSFs expanded the range of claims that could be considered, such as tort, environmental, breach-of-contract, violation-of-law and other claims, as designated by the IRS.  Another major distinction is that the court or government entity that creates a QSF must continue oversight of the fund.  There is no such requirement for a DSF.

Everyone has heard of large class action lawsuits or mass tort cases which have resulted in millions or billions of dollars being placed in a settlement trust for plaintiffs.  Settlement trusts such as those created in the Exxon Valdez case, People v. Philip Morris, Inc., the Nasdaq Market-Makers antitrust case, and the Austrian and German Bank Holocaust litigation are Internal Revenue Code §468B trusts.

Please note that §468B trusts are not just for mass tort actions.  These trusts can be used to settle cases of any value involving multiple plaintiffs or the personal injury victim with a derivatively injured spouse, child or parent. 

Advantages of the §468B Settlement Funds

First, funding the §468B trust removes the defendant and their counsel from the litigation.  They can pay and walk.  Once a petition is filed by either party in a court and a Trustee for the fund is appointed, the settlement payment to the Trustee satisfies the economic performance test.  The defendant is out of the case.

Second, the §468B trust removes the defendant from the allocation of the settlement amounts between the various plaintiffs.  The plaintiffs’ attorney does not have to negotiate with the defense counsel about either the allocation of the settlement between the injured parties or the derivative claim for loss of consortium.

Third, the plaintiffs’ attorney’s fees and other expenses can be paid immediately from the §468B fund.

Fourth, the plaintiffs receive the income from the settlement inside the §468B fund.  The plaintiffs can take their time, carefully selecting among the options of a lump sum payment, structured settlement annuity and a special needs trust pursuant to 42 USC §1396p(d)(4)(A).

Finally, time is no longer a pressing factor for the lien negotiations, allocations, and probate proceedings. The settlement can be placed in the settlement trust while you other matters are dealt with, such as waiting for the final figures for the Medicare claim and Medicaid lien, determining allocations between plaintiffs, and deciding on a method of payment.  The plaintiff’s attorney now has additional time to apply for and obtain a Conservator or a Guardian in the local Connecticut probate court, and to establish a special needs trust if appropriate. 

Requirements for the Designated Settlement Fund:

IRC §468(B)(d)(2) sets out the requirements for a Designated Settlement Fund:

1. The fund is established pursuant to a Court order and completely extinguishes the tortfeasor’s tort liability;
2. No amounts may be transferred other than in the form of qualified payments;
3. The majority of the administrators of the fund are independent of the tortfeasor;
4. The fund is established to satisfy present or future claims against the tortfeasor; and
5. The tortfeasor and related parties may not hold any beneficial interest in the income or corpus of the fund.

Requirements for the Qualified Settlement Fund:

Pursuant to Treasury Regulations §1.468B-1(c), a Qualified Settlement Fund must meet the following requirements:

1. It must be a trust, account or fund, which is established or approved by order of a court of law (or government agencies) and is subject to continuing jurisdiction of that authority;
2. It is established to resolve contested or uncontested claims asserting liability for a tort, breach of contract or a violation of law;
3. It must be a trust under applicable state law, or the assets must be kept separate from the assets of the tortfeasor, insurance carrier or other related parties.

A Qualified Settlement Fund cannot be created for liabilities under a Worker’s Compensation Act claim or self-insured health plan.  A fund is not considered a Qualified Settlement Fund until the court has approved the trust fund and the assets have been paid into it by the tortfeasor (referred to in the statute as the “Transferor”).  This payment meets the economic performance test.

The QSF must be approved by a court or a governmental agency.  This approval occurs when the governmental authority issues its preliminary order to establish the fund even if the order is subject to review or revision.  An arbitration award granted by an arbitration panel will suffice as long as the award is judicially enforceable, the award is issued pursuant to a bona fide arbitration proceeding and the fund is subject to the arbitration panel’s continuing jurisdiction.

The QSF must be established to satisfy a claim.  This requirement has been strictly interpreted in United States v. Brown, 2:95-CR; 245 B (D. Utah May 23, 2001) wherein funds used to reimburse victims of a stock fraud were not held to be a QSF because the fund was created to provide restitution, not to resolve or satisfy a requisite claim.

QSFs are subject to the “relation-back rule”, which says that if the fund meets all the statutory requirements with the exception of obtaining governmental approval, then the transferor and fund administrator may treat the fund as being created either when the last two (of the three) statutory requirements are met, or on January 1st of the year in which all three statutory requirements are met, whichever occurs later.  If a relation-back election is made, the funds are treated as being transferred to the fund on this date.

No Constructive Receipt

The economic performance test allows the defendant to pay a settlement into a §468B trust and deduct the claim even though the payout to or for the benefit of the plaintiff occurs later.  However, the §468B trust does not constitute constructive receipt to the plaintiff because of the restrictions placed upon the §468B trust.  The plaintiff’s attorney does not have custody of the fund. An independent Trustee owns the funds.  This arrangement preserves the opportunity to use the structured settlement annuity option.

The Tax Reporting Details

The DSFs and QSFs are treated as corporations and they are liable for taxes on their modified adjusted gross income.  Earnings (dividends, interest, capital gains and losses, carryovers, etc.) are subject to taxation in a manner similar to corporate earnings at the maximum trust tax rate in IRC §1(e).  Settlement trusts are also allowable deductions for administration costs and related expenses, losses sustained in connection with the sale or exchange of property, and net operating losses.  Trust distributions to the plaintiffs are not deductible and liability cannot be reduced with tax credits.  Qualified payments to DSFs and QSFs are not included in the gross income of the funds.

Settlement trusts must use the calendar year and the accrual method of accounting.  These trusts are treated like corporations for tax reporting purposes, and distributions are subject to the Internal Revenue Code’s corporate reporting requirements. 

Conclusion

When a settlement has finally been obtained after years of litigation, the plaintiff’s attorney usually feels pressured to tie up loose ends quickly.  In the rush to finalize the settlement, important planning opportunities can be missed.  By creating a Qualified Settlement Fund trust, the plaintiff’s attorney can take a careful and deliberate approach in evaluating the client’s options in distributing settlement funds, while the defendant can be released from the case quickly.  The plaintiff’s attorney can be paid immediately from the trust, while the liens for Medicare and Medicaid are tabulated and negotiated to lower amounts.  Based on these benefits, the Qualified Settlement Fund trust is an important tool for the trial attorney’s arsenal.