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