The Los Angeles Daily Journal
Oct. 30, 2009
“Stop the Clock with Qualified Settlement Funds”
by Meredith B. Johnson
When a local plaintiff’s attorney reached a seven-figure settlement with General Motors earlier this year, the papers were full of speculation about GM’s bankruptcy future. The papers speculated that unpaid settlements and judgments, along with pending litigation, would be left in “old GM” to be paid with the other GM creditors as another one of GM’s “bad debts.”
A car accident had left the GM plaintiff severely disabled and dependent on Medi-Cal. The attorney’s first thought was to pay the seven-figure settlement to his client trust account before the bankruptcy filing the following Monday, but the client wanted a structured settlement, which cannot be arranged through an attorney trust account. Moreover, the client needed a special needs trust, which requires a 30-day notice to the state of California plus a hearing.
The solution? The attorney got an ex parte order to create a qualified settlement fund. The fund beat the GM bankruptcy filing by a day; the client took all the time needed.
In short, qualified settlement funds are funds into which defendants (or their insurers) can deposit settlement proceeds to obtain a tax deduction and be released from litigation. Funds were created in 1986 by legislation that was intended to fix a tax rule that permitted defendants to deduct settlement payments only in the year in which payment was made to plaintiffs. That rule was, in turn, a Congressional fix of an abuse in which defendants took current deductions for structured settlement liabilities due far into the future, thereby distorting defendant’s current income. In 1986, the Internal Revenue Service and Congress realized that large lawsuits were sometimes settled before all plaintiffs had been identified or had proved their product usage or damages. Thus, the parties to litigation needed a fund to which settlement amounts could be paid when a settlement was reached.
Though funds are most often used in the mass tort context, funds can also be useful in cases with one or a few plaintiffs. An important benefit of a fund, in addition to protection from defendants’ financial problems as in the GM case, is that the interest earned on the fund belongs to the plaintiff. If the defendant holds the settlement money until paid to plaintiff, defendant gets to keep any interest earned, which may equal a 20 percent return on investment. That high return is a strong incentive to slow payment to plaintiffs.
Getting the money out of the hands of the defendant and into a fund permits plaintiffs time to plan for receipt of the settlement. Plaintiffs gain time to arrange for a structured settlement or, if plaintiff is a Medi-Cal recipient, create a special needs trust. With the 30-day statutory notice period to the state of California, payment of liens and a court hearing, a special needs trust typically involves a delay of 45 days. The appointment of a conservator or a guardian also consumes substantial time, as does the approval for the allocation of wrongful-death proceeds among beneficiaries. With the settlement proceeds in a qualified settlement fund, those delays do not prejudice plaintiffs because any accrued interest belongs to plaintiff.
In mass tort cases, putting the money into a fund permits plaintiffs’ counsel time to satisfy the aggregate settlement ethical rules. Often, the plaintiffs’ firm does not know the extent of its pool of clients, some of which come forward during settlement negotiations. The aggregate settlement rules prevent the firm from agreeing to a settlement proposal without notice to and informed written consent from each client. Those rules do not, however, prevent putting the agreed amount into a fund while those rules are satisfied. The penalty if the rule is ignored and a client later complains can be forfeiture by the attorney of his or her fees.
Assuming you have reached agreement with the defense on a settlement amount and the insolvency risk is not present but the plaintiffs are not able to take immediate possession of the settlement amount, shouldn’t you simply pay the money to your trust account? Sometimes the answer is yes. If you are comfortable that your account can pay the interest to the plaintiffs then you should direct the money to your trust account if the delay is attributable solely to court approval of the settlement.
However, there are two disadvantages to distributing settlement proceeds to your client from your trust account rather than a fund. First, you are the agent for the plaintiff as his or her attorney and receipt by an agent is receipt by plaintiff. Thus, the interest earned will be taxable to the plaintiff as ordinary income if received from your trust account. On the other hand, interest received from a fund will be free of tax in a physical personal injury case after the fund has paid its tax on that interest. Second, a plaintiff cannot receive a structured settlement from your trust account, but can do so from a fund.
Now that you have determined that a fund would be beneficial to your clients, how do you form one? Creating a qualified settlement fund is easy; in fact, it is possible to create a fund unintentionally if the three required elements are present. Those three requirements are segregation of the settlement amount from the assets of the defendant, court approval, and a tort or other qualifying claim.
The segregation required is minimal. If the defendant opens a bank account in its own name and deposits the settlement proceeds in that account, then the segregation requirement is satisfied. Few plaintiffs though are willing to agree to permit the defendants to continue to hold the money in a separate account. The customary method is to use a trust administered by a third party.
The second requirement, court approval, typically requires the filing of a petition, along with a statement of the terms of the trust and an order for signature by the court upon approval. Arbitrators, but not mediators can also approve funds, so long as the arbitration is judicially enforceable, bona fide and governed by rules that are approved by a governmental authority.
The third requirement is that the fund is established to resolve or satisfy one or more claims resulting from an event giving rise to at least one claim asserting liability under the Comprehensive Environmental Response, Compensation and Liability Act of 1980, a tort, a breach of contract or a violation of law. The transfer of settlement proceeds to the fund can resolve or satisfy only a portion of the claims arising from the event and does not have to result in a complete discharge of liability. Claims to be made in the future, as in the case of yet unidentified plaintiffs, will also fulfill the resolve or satisfy requirement.
Once the three requirements have been met and the fund has been established, administration of the distributions can begin. When all of the settlement proceeds have been distributed, then the administrator will prepare the final tax return for the fund, pay the tax on any interest earned by the fund and distribute the balance of the interest to plaintiffs. Note that for federal income tax purposes, the fund has no deductions except for trustee fees, legal fees paid by the fund, taxes and claims administration expenses. There are no deductions for California tax purposes. Thus, the administrator must be careful not to spend all of the interest earned by the fund on expenses which would require use of a portion of the settlement proceeds to pay the California tax.
One of the available deductions to a fund is claims administration expenses such as special-master costs to allocate settlements and lien-negotiation expense. The contingent fee payable from the fund to plaintiffs’ counsel is not a claims administration expense and is not deductible. Plaintiffs’ fee agreement typically compensates counsel for obtaining money from a defendant rather than administering claims. However, following recovery by payment to the fund, a plaintiffs’ attorney may perform additional claims administration activities such as creation of payment systems from the fund, location of missing plaintiffs or heirs, negotiation of liens, explanation of settlement options to plaintiffs, etc. All of those claims administration activities could be billed hourly to the fund by plaintiffs’ counsel. That gets more money to the attorney from the fund earnings (not from the settlement proceeds) and reduces the fund’s tax by being deductible for the fund.