Tax Tips and Traps for Settlement Funds and Settlement Agreements

Taxes: the one word everyone tries to avoid.

But when negotiating a class action settlement and drafting a settlement agreement, not considering the effects taxes have on the fund or on the class member recipients can prove to be disastrous.

Is Your Fund Really a Qualified Settlement Fund?

The Tax Reform Act of 1986 (the Act) made it clear that any fund created as part of a settlement was a taxable entity subject to income tax. The Act even created a new entity called a Qualified Settlement Fund (QSF). However, in order to be a QSF, three conditions need to be met.

• The settlement must be in settlement of a tort
• The funds must be overseen by a court (local, state, or federal)
• The funds must be segregated

Most attorneys and class action practitioners alike are under the assumption that all class action settlement funds are automatically QSFs. This is actually not true, especially if there are reversions of funds back to the defendant or if the funds are deposited prior to the Court’s preliminary approval of the settlement.

Caution: Did You Accidentally Create a Grantor Trust?

Considering the requirements above, have you inadvertently created a Grantor Trust? If you did not meet all three requirements above, and/or if you received the settlement funds prior to preliminary approval, you may not have a QSF. There may be remedies while you are working to meet the conditions. There is a mechanism to qualify as a QSF that makes a Relation-Back Election, but the rules are tricky.

Relation-Back Election is a mechanism set up by the IRS. It allows a fund created prior to preliminary approval to be considered a QSF once approval is obtained, as long as the fund meets all three requirements we listed above.

Don’t Forget About the Fund’s Recipients

What are the tax considerations for class members at the time of distribution? Is it a taxable event? Do the class members need 1099’s? Are there foreign class members? Does the makeup of the class and the potential size of their recovery affect tax treatment and reporting?

Each of these factors should be discussed prior to finalizing the settlement agreement, as they will have an impact on what information you need to obtain from class members and the cost of administration. There is even a potential liability to the fund and counsel if paper tax filings are not made in a timely manner, or at all, with the relevant government entities. Penalties are steep and depending on the class size can easily approach six or seven figures.

Federal and State Rules Can Be Drastically Different From One Another

Once the settlement funds are received and a QSF is formed, the tax consequences become relevant. Federal tax rules mandated by the IRS related to class action settlement funds may be different than the rules imposed by states. A federal money market fund may work for federal purposes but could create tax issues that are many times ignored at the state level.

Unfortunately, states have not followed the federal government in coming up with a solution like the QSF. States take different positions, if they have taken a position at all.

So beware! Not taking the time to discuss tax issues related to your settlement can haunt you for years. Taxation items for a class action settlement should be considered and drafted into the settlement agreement prior to filing for preliminary approval.