Group Suggests Guidance on Tax Treatment of Single-Claimant Qualified Settlement Fund

We are writing with respect to guidance under consideration under Code¹ section 468B regarding the tax treatment of a single-claimant qualified settlement fund.² We are counsel to and administer many qualified settlement funds. We are writing in our individual capacity, however, and not on behalf of any client or on behalf of any of those funds.

Summary. For the reasons set forth below, we believe that application of the economic-benefit doctrine to treat claimants of a single-claimant qualified settlement fund as in receipt of settlement proceeds upon their transfer from a defendant or its insurer to a qualified settlement fund will nullify the statute and regulations and make inoperative Rev. Proc 93-34, 1993-2 C.B. 470. First, the designated settlement fund statute, which is intended for "classes" of claimants, will become a nullity.³ Second, the Qualified Settlement Fund regulations, which do not currently limit themselves to "classes" of claimants, will also be unusable. We reach that conclusion because the ethical rules applicable to attorneys considering an aggregate settlement require allocation to individual clients in advance of acceptance of an aggregate settlement offer. Such an allocation turns a multiple-claimant Designated Settlement Fund or Qualified Settlement Fund into an aggregation of single-claimant Designated Settlement Funds or Qualified Settlement Funds for purposes of applying the economic-benefit doctrine.⁴

We describe first below the legislative history of the Designated Settlement Fund enactment confirming that the statute is intended for "classes" of claimants, which intent will be frustrated by application of the economic benefit doctrine. We describe second below the application of the ethical rules causing the adverse result. We acknowledge that non-tax factors such as ethical rules should not normally be determinative of tax policy results. We suggest that where those non-tax factors cause statutes to be nullities and regulations to be inoperative, the non-tax factors may be appropriate to consider in setting tax policy.

The accrual method and abuses. Designated Settlement Funds were enacted in 1986 as part of Public Law 99-514, 99^th Cong. 2d Sess., to provide taxpayers relief from the economic performance requirement enacted as section 461(h)(2)(C)⁵ of the Tax Reform Act of 1984. Section 461(h)(2)(C) was needed to stop abuses of the accrual method of accounting that had arisen since the Revenue Act of 1916.⁶ The Revenue Act of 1916 permitted taxpayers to use for tax reporting the method of accounting taxpayers used to keep their books, which evolved through Court decisions into the accrual method of accounting.⁷ Section 446(b), prohibiting accounting methods that do not clearly reflect income, was inadequate to stop such abuses. To stop such abuses, Congress was faced with either putting certain taxpayers on a cash basis or time valuing deductions for future expenses. For ease of administration, Congress chose the cash basis of section 461(h)(2)(C).

The cure for accrual abuses in section 461(h)(2)(C ). Section 461(h)(2)(c), however, prohibited deductions before payments were made to claimants. Thus, no deductions were available for large settlements in which the total number of claimants was not yet known or in which the known claimants had not completed proving the amount of their individual damages. Such settlements could otherwise be made because the attorneys were satisfied that the defendants had provided all of the cash, stock and insurance that was available to meet the liabilities asserted.

Technically correcting the cure in section 468B. Given the public policy in favor of settling litigation, Congress enacted section 468B as a technical correction to the economic performance requirement of the Tax Reform Act of 1984. The technical correction permitted deductions for payment to a Designated Settlement Fund. The original enactment of section 468B did not contain statutory language limiting funds to "classes." As enacted the statute simply said that a fund must be established "pursuant to a court order." Former section 468B(d)(2)(A).

The Senate Report, however, made clear that a class of claimants was intended, as follows:

The legislative regulations. The regulations authorized in 1988 and published in 1993 do not address either single-claimant qualified settlement funds or the economic benefit doctrine. The regulations, however, are not limited by the legislative history of section 468B. That is so because the legislative grant of authority to Treasury is broader than the statute,⁹ and goes to any provision of law providing for escrow accounts, settlement funds, or similar funds,¹⁰ as follows:

When the lawyer has received the consents, then the lawyer may accept the offer and fund the Qualified Settlement Fund with the pre-allocated shares. If the economic benefit doctrine¹⁵ is applied for a single-claimant fund, then it must also be applied by the pre-allocation of multi-claimant funds.

To apply the economic benefit doctrine would, of course, make funds earnings taxable to the claimants instead of to the fund. That taxation of income would be inconsistent with section 468B, which taxes earnings to the fund, and with the Qualified Settlement Fund regulations, which also do so. It would also make Rev. Proc 93-34, supra, inoperable. The consideration for the settlement would be the lump sum amount in the allocated Qualified Settlement Fund determined under the economic benefit doctrine, rather than periodic payments required for the exclusion of section 104(a)(2).

We would appreciate the opportunity to discuss this issue with you or others if that would be of interest.

Post-2002 rule. The Model Rule was amended in 2003 to add the requirement of a writing signed by the client to reflect informed consent and detailing the lawyer's disclosure, as follows:

² That guidance project is item 27 in the Tax Accounting section of section H (Other) of the Priority Guidance Plan dated September 10, 2008 issued by The Office of Tax Policy and The Internal Revenue Service.

³ The law disfavors interpretation that cause statutes to be nullities. While here we are dealing with a legislative regulations, rather than a statute, we assume that such interpretation are also to be avoided if logically possible.

⁴ The only exception to this results would be those aggregate settlements in which the attorney obtains the advance approval of each claimant to permit the aggregate settlement to be allocated by a Court or by a Special Master following its transfer to a fund. In those cases, the economic benefit doctrine would presumably be triggered upon such allocation if the doctrine were applied to single-claimant qualified settlement funds.

⁵ Section 461(h)(2)(C) limits economic performance to the time when payments are made to plaintiffs. Thus, payment to an attorney trust account or to a trust for the benefit of plaintiffs would not be deductible by the defendant. Subchapter L probably permits an insurer to take that deduction since the paid claim of the statutory filing would flow through to the insurer's tax return under Subchapter L.

⁶ The Revenue Act of 1916 permitted a taxpayer to use make its return "upon the basis on which its accounts are kept, in which case the tax shall be computed upon its income as so returned." Revenue Act of 1916, c. 463, section 13(d), 39 Stat. 756.

⁷ Treasury Decision 2433 (January 18, 1917) first used the term "accrual" in permitting reserve deductions for future expenses. United States v. Anderson, 269 U.S. 422 (1925) seems to be the source of the "all events" test ("all the events must occur which fix the amount of the tax and determine the liability of the taxpayer to pay it") that determined the accrual method deduction. The test first appeared in the Solicitor's General's brief, authored by Solicitor General Mitchell but probably written by John B. Milliken, Esq., the Special Attorney for the Bureau of Internal Revenue, and was adopted by the Court in its opinion.

⁸ In a footnote to The Joint Committee Explanation of the 1986 enactment of section 468B the Staff observed that "n12 [a] technical correction may be necessary to clarify that a designated settlement fund must completely extinguish the taxpayer's tort liability with respect to a class of claimants." Joint Comm. On Taxation, Explanation of Technical Corrections to the Tax Reform Act of 1984 and Other Recent Tax Legislation (Part I of 17 Parts), JCS-11-87 (1987).

⁹ The 468B regulations are legislative, rather than administrative regulations. They may go far beyond what would be permitted in administrative regulations and are given controlling weight by courts. The standard of review for legislative regulations is "arbitrary, capricious, or manifestly contrary to statute," as follows:

¹¹ A brief description of the evolution of the Model Rule is attached as an Appendix.

¹²In the Matter of Disciplinary Proceedings Against Jeffrey D. Berlin, 306 W.2d 288,290, 743 N.W.2d 683 (2008) ("by participating in making an aggregate settlement of both C.B.'s individual claims and the claims of D.B.'s estate without consulting with and obtaining the informed consent of C.B. and someone authorized by the probate court to act on behalf of D.B.'s estate, Attorney Berlin engaged in a prohibited transaction, in violation of former SCR 20:1.8(g).")

¹³Burrow v. Arce, 997 S.W. 2d 229, 240 (Texas Sup. Ct. 1999) ("An attorney's compensation is for loyalty as well as services, and his failure to provide either impairs his right to compensation.")

¹⁴Berlin, supra note 11.

¹⁵ That doctrine was developed by the Tax Court in Sproull v. Comm., 16 T.C. 244, aff'd per curiam, 194 F.2d 541 (6^th Cir. 1952). The economic benefit doctrine held an employee liable for tax on an amount set aside by his employer in a trust, as follows: