In class and collective actions, settlement agreements carry important tax consequences for the settling parties. Included below are best practices to adhere to in drafting class action settlement agreements, to (1) ensure minimization of negative tax consequences for class members and (2) provide clarity to the parties, courts and distribution agents on the correct reporting required.
Drafting Agreements to Minimize Negative Tax Consequences
Defendants funding a settlement agreement in a class action using a qualified settlement fund (QSF) receive a tax benefit on the day the funding occurs if they would otherwise be entitled to a benefit. Given that settlements may be tax deductible, it is valuable to all the parties to negotiate the timing of the funding so as to maximize the value of settlement dollars. Allowing the defendant to take a deduction earlier by timing the defendant’s payment within its tax year, for example, may reduce the overall after-tax cost to that defendant and may thereby increase the money available for settlement. The tax character of the money paid to fund a settlement—i.e., the origin of the claim or claims leading to the settlement amount—also carries tax consequences. Some punitive remedies, for example, are not deductible. This means that while the payment for a settlement resolving a consumer pricing issue will be deductible by the defendant, the additional portion of the payment attributable to punitive damages may not be. Clarifying in the settlement agreement that settlement moneys are attributed solely to appropriate claims, therefore, has considerable tax consequences. Examples of how settlement funds may be treated based on their allocation include:
- Punitive or exemplary damages are not tax deductible
- Remediation of claims for excessive charges may be tax deductible
- Damages for personal physical injuries are likely tax deductible but may have insurance funding limitations
Making Taxes Clear for the Parties, Courts, and Distribution Agents
Those responsible for paying out a settlement need to be able to read a settlement agreement and have a clear understanding of the parties’ intent to determine the tax consequences of the settlement. Intent along with the origin of the claims in the complaint will determine the tax character of the payments flowing from a QSF and therefore the reporting and withholding obligations of the QSF in making payments. For example, interest is always interest, and it is always income. U.S. Supreme Court precedent and IRS pronouncements make it clear that regardless of the tax character of the underlying claims, settlement money allocated to interest retains its character as interest income as it flows out to the claimants.
Using a meaningful checklist, like the following, will help in the drafting process:
- What are the available remedies under the settled claims?
- What is the intent of the parties with respect to the payments being made?
- What are the tax consequences of the types of recovery available?
- Is it possible to allocate recovery among the available remedies flowing from the settled claims to a more tax favored recovery and still retain an agreement reasonably related to the underlying facts and circumstances of the case?
- Is the allocation of settlement dollars to prejudgment or post judgment interest necessary to the settlement if it negatively impacts the after-tax value of the payments to plaintiffs or class members?
- While punitive or penalty damages may be available, can the parties agree to allocate the payments to the underlying recovery and minimize the settlement dollars allocated to the punitive damages?
Julia Damasco is a tax attorney with Miller Kaplan Arase LLP in San Francisco, California.
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