Attorney Client Alert:
The Pitfalls of Qualified Settlement Funds
in Single Plaintiff Cases

by Martin Jacobson, Esq., General Counsel, Creative Capital Inc.

This is offered to Creative Capital Inc.'s (CCI) clients, counsel (involved in prior and existing cases which CCI handled), and colleagues at the Bench and Bar as an alert regarding the potential tax risk associated with single plaintiff (or single family) Qualified Settlement Funds [or trusts] (QSF) under Internal Revenue Code Section 468(B).

The Concept
Create a QSF in a case where the plaintiff attorney desires to obtain a structured settlement for his/her client. Pursuant to court order (required) 100% of the funds paid by the defendant are deposited into the QSF. The defendant receives a complete release and has no further involvement. The plaintiff's attorney, using the plaintiff's structured settlement broker, then "negotiates" the terms of the structured settlement with the trustee of the QSF. The trustee, acting on behalf of the QSF, enters into a Qualified Assignment transferring the future payment obligation to a Qualified Assignee, just as in a vanilla structured settlement where the defendant assigns its future payment obligation to a Qualified Assignee. The plaintiff ends up with the same structured settlement he/she would have had, but the plaintiff's broker gets all the commission and does not need defense cooperation.

The Risk
Like many things in life that sound too good to be true, so too may be this. If the plaintiff is audited in the future by the IRS and loses the tax-free advantages of a proper structured settlement, the plaintiff will owe back taxes, interest and penalties on the interest portion of every payment he/she has received. The now failed structured settlement would be treated in exactly the same way as an ordinary (tax deferred, but not tax-free) annuity purchased by a plaintiff who settled for cash. However, interest and penalties will also be applied for back taxes owed unless the audit took place immediately after settlement (not a likely occurrence). On even a moderate size case (several hundred thousand dollars into the structure), the back taxes, interest and penalties (to say nothing of the cost of defending a potentially indefensible audit) would threaten to wipe out the settlement. (I leave the discussion of potential legal malpractice claims to another time.)

Why There is Risk
First, there is no question that 468(B) may be used in single plaintiff cases. However, the real question is whether a single plaintiff QSF may enter into a structured settlement with the plaintiff and execute a Qualified Assignment under Internal Revenue Code (Code) section 130 (c).

For purposes of this memo, suffice it to say that I believe that a QSF (trustee) acting as an assignor under Code section 130(c) may have rights equal to, but no greater than, the original defendant. In other words, if the defendant cannot execute a Qualified Assignment under Code section 130(c), then neither may the QSF.

In 1983 the IRS was asked whether knowledge of the cost of a structured settlement would deprive a plaintiff of the tax benefits provided by such a settlement. The IRS answered in the negative stating that having knowledge only is ok, but that having the unqualified availability of the cost of the annuity would deprive the plaintiff of the tax free advantages of a structured settlement. Hence, if a settlement were documented on the record in court as follows: "case settled for $500,000 - plaintiff to let defendant know how much, if any, of the $500,000 he wants to structure and how much he wants to take in a single lump sum" it is too late to do a structured settlement. Why? Because the plaintiff had the unqualified right to take the cash. Knowledge is ok. Availability is not!

By analogy, in a single plaintiff 468(B) QSF, the plaintiff knows exactly how much is unqualifiedly available to him/her. There is no dispute with other unrelated plaintiffs (who have competing interests) who are claiming entitlement to the same settlement dollars [the real reason for the existence of Code section 468(B)]. To conclude that the QSF (trustee) may enter into a Qualified Assignment in these circumstances leads to the inescapable (and unsupportable) conclusion that the QSF has the ability to do what the defendant itself cannot do i.e. enter into a Qualified Assignment notwithstanding the fact that the plaintiff had the unqualified right to take everything in cash.

The Search for Disputes
The attempted solution in single plaintiff QSF cases has been to search for and identify purported disputes. Are liens in issue? How much of a quantified settlement a spouse will get on his derivative claim, as opposed to his wife who wants a structure, but cannot determine the net amount available, and other disputes which the IRS will likely claim are feigned, are among the techniques currently being used by some structured settlement brokers to justify the QSF. However, the IRS need not and likely will not accept any of these "disputes" and, in my opinion, will likely reject them all.

Economic Benefit Doctrine Violation
If the economic benefit doctrine has been triggered (thus charging the plaintiff or the plaintiff family with having received the economic benefit of the cost of the settlement), it is too late to accomplish a structured settlement (with or without a qualified assignment). Hence, if there is only one claimant, an ipso facto prior allocation exists at the time of the creation of the Qualified Settlement Fund, since all of the money is paid on behalf of the sole claimant. This prior allocation would trigger economic benefit and thus taxation on the gain, and an inability to do a Qualified Assignment, under the requirement that all of the periodic payments must be entirely excludable, pursuant to IRC 130(c)(2)(D).

Further, if the plaintiffs have already agreed among themselves on the allocation of the settlement proceeds prior to creation of the QSF - or where that allocation is determined by statute or by court precedent as it often is in death cases (e.g. New York State's Kaiser formula), a structured settlement may not be "negotiated" with a QSF. A plaintiff who manipulates a structured settlement under such circumstances does so at his/her own peril. So too, plaintiff's counsel who moves the court for the establishment of a QSF to steer the structure to his/her own broker imperils not only the plaintiff, but also himself/herself, if the plaintiff is ultimately audited by the IRS and is found to owe taxes, interest and penalties on a structured settlement that would have been tax free if only it had been accepted when offered by the defense.

Position of Life Companies
Many major life carriers will not accept an assignment under Section 130 of the Internal Revenue Code from a Section 468(B) Qualified Settlement Fund (QSF) if there is a single claimant or single claimant family. Important issues of allocation and economic benefit preclude them from accepting assignments on single claimant 468(B) funds.

Conclusion
Until there is a definitive ruling by the IRS, single plaintiff (and single plaintiff family) QSFs should be avoided. If the defense has offered to negotiate a structured settlement, every effort should be made to work with the defense consultant, in a spirit of cooperation with plaintiff's broker, to achieve a settlement that is satisfactory to all. This will accomplish the defendant's goal of settling the case and closing the file and the plaintiff's goal of achieving a tax-free and risk free structured settlement.

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