To settle mass tort actions, the parties often prefer to structure the settlement payments to take advantage of current tax laws. Section 468B of the Internal Revenue Code permits settlement contributions to be made into certain funds (i.e., accounts or trusts) while the actions continue against other defendants or while the claimants determine an appropriate allocation method. The funds into which these settlement payments are paid are often referred to as 468B settlement funds or QSFs (hereinafter, collectively, 468B QSF). When there is an attempt to create a 468B QSF to effectuate a structured settlement for a single-claimant, it is known as a single claimant 468B QSF.
In a typical structured settlement, personal/bodily injury claimants receive all their funds tax free even though some portion of each payment usually includes earnings on the amount that was invested by the involved insurance company to generate the structured settlement payments. According to the doctrines of constructive receipt and economic benefit, if a claimant has too much control or rights in connection with amounts invested to generate the structured settlement payments, then the claimant must pay tax on the earnings portion of each payment.
In the context of a single-claimant 468B QSF, the claimant may be deemed to be in constructive receipt of (or to have received the economic benefit of) the amount paid into the 468B QSF. This is because, under these circumstances, there are no other claimants, and the single-claimant will essentially have the right to everything that is put into the 468B QSF.
The amount of this tax liability to the claimant can run into the tens or even hundreds of thousands of dollars. In such an event, it is likely that the claimant would seek to pass this liability on to the other parties involved in the settlement negotiations, possibly even to the defendant or the defendant’s insurer.
In addition, this is a potential tax problem for the annuity owner (i.e., the assignee). The Internal Revenue Code provides significant tax benefits for the annuity owner if (among other conditions) the payments at issue are tax free to the claimant. If the payments are not tax free to the claimant, then the annuity owner may lose its tax benefits.
The defendant or the defendant’s liability insurer must provide a statement to the administrator of the 468B QSF and must attach a copy of the statement of the defendant’s tax return or that of the defendant’s insurer. The statement must contain information regarding the transferor and the 468B fund (names, addresses, and taxpayer identification numbers) and the date and amount of the transfer. Unlike 468B structured settlements, typical structured settlements do not have these reporting requirements.
Like any trust, but unlike a typical structured settlement, a 468 QSF must have a trustee or administrator, and will also incur various legal, accounting, and other administrative expenses. These fees and expenses are paid out of the amounts that are originally invested into the 468B fund. Obviously, to the extent that these amounts are used to pay fees and expenses, the amounts paid the claimant are reduced.
Often a 468B QSF is being advocated in a context that involves claims by a husband and wife or by parents and a child, or other close relationships, or when there is a workers’ compensation or medical expense lien. The argument in favor of the 468B QSF in these situations is that the settlement does not involve a single-claimant. However, the practical reality of the situation is that the claimants may not really be adverse to one another like in a mass tort situation), particularly when the claimants are represented by the same lawyer or have already decided how the 468B QSF will be divided between them.
The Background on 468b Settlement Funds
Internal Revenue Code Section 468B, which was enacted in 1986, authorized the creation of a designated settlement fund. Treasury regulations for Section 468B (the “Treasury Regulations”), which became effective in 1993, authorized the creation of a qualified settlement fund. Section 468B and the Treasury Regulations were designed to permit defendants and their insurers in mass tort actions to make agreed upon settlement contributions into designated settlement funds and qualified settlement funds while the actions continued against other defendants or while the claimants determined an appropriate allocation method. The tax benefit to the defendants and their insurers was that there would be an immediate deduction of the amounts paid into the 468B QSF.
Effective in 1993, Revenue Procedure Ruling 93-34 (the “Revenue Procedure”) confirmed that a 468B QSF could enter into a qualified assignment pursuant to Section 130. See 1993-2 C.B. 471.This had the effect of making structured settlements available to claimants to a 468B QSF.
The Background on The Structured Settlement Industry
The structured settlement industry is competitive. The various life insurance companies that sell the annuities that fund the structured settlements compete against each other, as do the various brokers that effectuate these sales.
In some instances, the settlement discussions in a case will include a structured settlement broker that was invited by the defendant and/or its liability insurer. In some other instances, the settlement discussions in a case will include a structured settlement broker that was invited by the plaintiff or the plaintiff’s attorney. Sometimes, the settlement discussions include brokers invited by both sides.
The life insurers that sell the annuities that fund structured settlements typically pay a broker commission in the amount of 4% of the premium paid to purchase the annuity in question. When only one broker is involved in a case, he or she receives the entire commission. When more than one broker is involved in a case, they may have to share that commission.
Relatively recently, certain brokers that are more closely associated with plaintiffs and plaintiffs’ lawyers (as opposed to defendants and defendants’ insurers) have been arguing in favor of the use of a 468B QSF in the context of a structured settlement involving a single claimant. These brokers have also been arguing that the annuity issued to fund that structured settlement must be one that is solely determined by the plaintiff and their attorney.
The argument that a 468B Fund could be utilized in the context of a single claimant arises out of language in the Treasury Regulation that explains that a requirement of a 468B Fund is that it be “established to resolve one or more contested or uncontested claims ...” See Treasury Regulation 1.468B -1(c) (emphasis added). This argument, however, is unpersuasive - since the text of Section 468B refers does not contain a similar phrase and indeed refers only to “claims,” which is plural. See Section 468B(d)(2). The distinction is significant of course because Section 468B is a statute that was drafted by Congress and signed into law by a President, whereas a regulation is mere guidance issued by the Internal Revenue Service (the “IRS”). The argument that the annuity must come from an unrelated life insurance company arises out of language in the Revenue Procedure that sets forth a requirement that “the assignee ... not [be] related to the transferor (or transferors) to the [468B Fund]...There is a counter-argument to this; however, the counter-argument is somewhat complicated and not necessary. Accordingly, for the purposes of this memorandum, it is assumed that the assignee in a 468B Fund must not be affiliated with the defendant or the defendant’s liability insurer.
These brokers have also been arguing that the annuity issued to fund the structured settlement must come from a life insurance company that has no affiliation with either the defendant or the defendant’s insurer, while the defendant and defendant’s insurer stress the need to mitigate the risk of life company rating strength and to reduce the risk of reopening a settled claim.
While there is an arguably broader array of annuities to choose from, the primary benefit of a 468B QSF in the context of a single claimant may be very much to the advantage of the promoting broker. This is because, if the promoting broker is able to have the annuity issued by a life insurance company that does not involve negotiating with the defendant or the defense broker, then that promoting broker may have also succeeded in securing the entire commission for themselves. Of course, insurers may become reluctant to settle matters if they are forced to pay into a single claimant 468B QSF.
Unfortunately, however, the use of a 468B QSF in the context of a single claimant appears to be very much not to the advantage of the claimant. The problems associated with a 468B QSF in the single claimant context are summarized in the next section of this memorandum.
The Problems with Single Claimant 468b Settlement Funds
Constructive Receipt and Economic Benefit
If a taxpayer is not in actual possession of certain funds, but nevertheless has unrestricted control over those funds or has the right to receive or withdraw those funds, then the doctrine of “constructive receipt” will treat the taxpayer as if he or she was in actual receipt of those funds. See Treasury Regulation 1.451 -2(a), which provides that income not yet in possession of the taxpayer “is constructively received by him in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw on it at any time….” Similarly, according to the “economic benefit” doctrine, a taxpayer must include in gross income any economic or financial benefit that he or she has received - regardless of the form or mode by which it was effected. See Commissioner v. Smith. 324 U.S. 177, 181 (1945).
The doctrines of constructive receipt and economic benefit are applicable to Section 130. See S. Rept. N. 646,97th Cong., 2d Sess. 1983-1 C.B. at 15 (express stating that these doctrines apply to Section 130). More importantly, there is also nothing in Section 468B or the Revenue Procedure that states that the doctrines of constructive receipt and economic benefit do not apply to a settlement under Section 468B. In fact, the Revenue Procedure states that, “[i]n addition to the requirements provided by the revenue procedure, an assignment by a [468B QSF] of a liability to make periodic payments must also satisfy all the other requirements of section 130 to be a qualified assignment.” See Revenue Procedure 93-34.
Significantly, in the context of a single claimant 468B settlement, the claimant may be deemed to be in constructive receipt of (or to have received the economic benefit of) the amount paid into the 468B QSF. This is because, under these circumstances, there are no other claimants, and the single claimant will essentially have the right to everything that is put into the 468B QSF. (Often a 468B QSF is being advocated in a context that involves claims by a husband and wife or by parents and a child, or other close relationships, or when there is a workers’ compensation or medical expense lien. Of course, the argument in favor of the 468B QSF in these situations is that the settlement does not involve a single claimant. However, the practical reality of the situation is that the claimants may not really be adverse to one another (like in a mass tort situation), particularly when the claimants are represented by the same lawyer or have already decided how the 468B QSF will be divided between them. Indeed, if the 468B QSF in such a situation is distributed soon after its commencement, that may constitute strong evidence that there was no real adversity among the claimants. Under these circumstances, the claimants will have the same constructive receipt and economic benefit problems that would befall a single claimant.)
This is a big problem for the claimant. Under these circumstances, although the lump sum (that is invested to purchase the annuity that generates the periodic payments) will still not be taxable to the claimant in accordance with Section 104(a)(2), the earnings portion of each of the future periodic payments (that are generated by the annuity) may be taxable to the claimant. The value of this tax liability to the claimant can run into the tens or even hundreds of thousands of dollars. In such an event, it is likely that the claimant would seek to pass this liability on to the other parties involved in the settlement negotiations, possibly even to the defendant or the defendant’s insurer. Whether a claimant would be successful in this regard would depend on the claimant’s allegations and the facts. However, the only way to guarantee that this is not a threat is to avoid the use of a 468B QSF in any context other than in a mass tort context.
Some authors posit that a 468B, by virtue of the phrase “one or more” in the regulations creates an automatic override of such timing of income doctrines such as constructive receipt or economic benefit. Although the 468B regulations do discuss the taxation of the claimant-recipient, they only address the character of the income received. (Treas. Reg. Sec. 1.468B-4.) The regulations are conspicuously silent on the timing of income recognition for the payees and nothing like an automatic override exists. To assume it does on the basis of the lack of a prohibition carries significant risk.
To the contrary, in at least one ruling, the IRS specifically states that economic benefit doctrine applies to a 468B. In PLR 200138006, the IRS addressed tax issues related to the establishment and funding of a qualified settlement fund, including the issue whether the fund beneficiaries were currently taxable on the amounts transferred to the fund under the economic benefit doctrine. PLR 200138006 (May 7, 2001). Although the IRS ruled that the economic benefit did not apply under the facts of the ruling, it nonetheless stands for the proposition that an arrangement’s status as a 468B does not override or nullify in any respect the application of the economic benefit doctrine.
These are not the only tax doctrines that plaintiffs and their attorneys should be aware of. Given the short duration of some 468B’s, some lasting only for a day or two in order to allow for the plaintiff to structure their settlement or the attorney to structure their fees without dealing with a defendant, can give rise to the application of both the economic substance and step transaction doctrines, which would allow the IRS to disregard the existence of the 468B and tax the plaintiff or their attorney despite the structured settlement.
The defendant or the defendant’s liability insurer must provide a statement to the administrator of the 468B QSF and must attach a copy of the statement to the defendant’s tax return or that of the defendant’s insurer. The statement must contain information regarding the transferor and the 468B QSF (names, addresses, and taxpayer identification numbers) and the date and amount of the transfer. Treas. Reg. Sec. 1.468B-3(e).
Like any trust, but unlike a typical structured settlement, a 468 QSF must have a trustee or administrator, and will also incur various legal, accounting, and other administrative expenses. All these fees and expenses will necessarily be paid out of the amounts that were originally invested into the 468B QSF. Obviously, to the extent that these amounts are used to pay fees and expenses, these amounts will not be used to acquire an annuity that will maximize the plaintiffs future periodic payments.
Neither the IRS nor the Department of Treasury have issued any rulings or regulations on the issue of single claimant 468B QSF, nor are there any on-point cases. Some commentators have cited North Carolina Department of Revenue v. The Kimberley Rice Kaestner 1992 Family Trust. 139 S. Ct 2213 (2019), as support for the proposition that, for tax purposes, a trust is distinct from its beneficiary. However, in a single- claimant QSF, that control is illusory. Plaintiff, through her attorney, has absolute and sole discretion over the funds. For a time, it appeared as though Treasury would provide guidance on the topic, as the question of whether single claimant 468B's were valid was on Treasury’s Priority Guidance Project List beginning in 2008. Priority Guidance Project List 2008-2009, page 19, item 27. Further, the American Bar Association agreed the issue was unresolved and requested that Treasury provide guidance. ABA Letter to Treasury, June 10, 2008.
Perhaps Robert Wood, author of “Qualified Settlement Funds and 468B” said it best when he said, “with ruling posture unresolved, do you want to take the risk?” National Structured Settlement Trade Association, Regional Meeting, Friday, January 24, 2003.
Stephen R. Harris is a member with Cozen O'Connor in Philadelphia, Pennsylvania.
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