ATTORNEYS SAY TAX-EXEMPT ENTITIES WITH QSFs SHOULD REPORT AS GRANTOR TRUSTS.

We are sending this letter (an original and six copies) for the purpose of providing comment on the proposed regulations which have been issued under Section 468B and on which the Service is having hearings beginning May 27, 1992.

Beginning in 1993, the proposed regulations provide that every settlement fund will be subject to taxation currently. The Service has invited comment as to whether this practice may be appropriate in situations where the settlement fund is funded by a tax-exempt organization and the proceeds will be paid to personal injury claimants who will exclude the proceeds under Section 104 for federal income tax purposes.

In situations where the fund is established by a tax-exempt entity, we believe that the proposed regulations are inappropriate and work a hardship on the entity. The more appropriate regulation would be to provide that for tax years beginning in 1993 and after, settlement funds established by a tax-exempt entity may report as a grantor trust. This treatment should also be accorded to funds established by governmental entities where the income will be excludable under Section 115.

The reason for this recommendation is two fold. First, when Section 468B was amended in 1988 to add subsection (g), Congress obviously intended that settlement funds be placed on a current year reporting basis. It is appropriate that the interest income be reported currently and taxed on a different basis than the corpus of the settlement fund. We believe that current taxation of earnings on the settlement fund should be consistent with the manner in which the earnings would be taxed if the corpus were retained by the payor and the corpus paid directly to the claimants without having to utilize a settlement fund. In the case of a tax-exempt entity or governmental instrumentality, the income will be exempt from tax if held by the payor and the same result should follow until the funds are disbursed to the claimants.

The second aspect of the recommendation is that it is more appropriate for the income to be reported by the payor than by the claimants. The claimants are receiving sums in liquidation of their claims and past rulings of the Service have not treated the claimants as if they were earning income on their funds while the funds are held by the settlement fund. This position by the Service (which seems most apparent in the Agent Orange ruling) seems to us to be appropriate because the claimants do not have an identifiable interest in the settlement fund until the fund is disbursed. Therefore, in dealing with the question of who may be the proper reporting entity prior to the funds being disbursed, the resolution would seem to be either the settlement fund or the payor. In instances where the payor is a tax-exempt organization or a governmental instrumentality, we believe that it is more appropriate for the payor to report the income as the income will normally accrue to the benefit of the payor (either by reason of being payable to the payor or by reason of covering additional claims which the payor is responsible to cover).

If you would like to discuss any aspect of our comment, please feel free to call either of us.

Very truly yours,