The Qualified Settlement Fund
Should It Be Used in All of Your Employment Class Actions?
By Amy Aiq, Philadelphia, PA
Originally published, Employment Rights Section Newsletter, Vol. 17, No. 1, Fall 2009.
Qualified Settlement Funds (QSFs) have enjoyed popularity for a number of years. While the type of action and terms of your settlement will determine whether a QSF may be established, the nature of the class and award will determine whether it is the appropriate vehicle for managing your employment class action award.
In addition to allowing for more centralized and orderly settlement administration, a QSF offers benefits to both plaintiffs and defendants. In many cases, the use of a QSF as “employer” for the purpose of reporting and remitting taxes may improve efficiency and reduce the overall costs of administration. However, under certain circumstances, this may create costly disadvantages. This article will provide a broad overview of some of the advantages, disadvantages, and sometimes overlooked stumbling blocks encountered with the use of QSFs for employment class action litigation.
QSFs are tax qualified trusts for litigation settlement proceeds created under Section 468B of the Internal Revenue Code. To establish a QSF, three criteria must be met: (1) it must be established by order of a government entity, generally the court, and remain subject to the continuing jurisdiction of that entity; (2) it must be established to resolve one or more claims arising out of a tort; and (3) it must be kept in a segregated trust account under applicable state law. Furthermore, the QSF must also qualify under applicable state law. The QSF is unavailable to all types of cases in the area of employment law, i.e., workers compensation cases.
From the plaintiff point of view, a key benefit of the QSF is that it provides a mechanism for collecting payments from defendants early in the settlement process. Additionally, interest earned on the settlement fund can be used to pay administration fees, and the excess interest may be distributed to the class. Legal fees may be paid out of the QSF in an orderly manner immediately upon receiving court approval and individual plaintiffs are not required to include fees paid to counsel as part of the award that they receive.
Additionally, a little known rule known as the “relation-back rule” allows funding to occur while the parties are still in the process of finalizing the terms of the settlement. This rule provides an added benefit to the plaintiff, i.e., funds deposited are generally insulated from unrelated claims, such as bankruptcy, and defendant since the fund are returned in the event the settlement does not materialize.
The “relation-back rule” under Treasury Regulation Section 1.468B-1(j)(2)(i) makes it possible for defendants to set aside funds in an escrow account with interest accruing for the benefit of the class even before the settlement meets the above criteria. In the event that the settlement breaks down, funds including interest revert to defendants. Once the QSF has been “established by order of a government entity,” the “relation-back rule” can be invoked so that all the interest earned in the current tax year is reportable to—and may belong to—the QSF rather than the defendant.
The QSF is a popular option for defendants because by paying money into a fund the defendant fulfills its obligations to the plaintiff and may receive an immediate tax deduction for payments made. The defendants may also avoid the administrative burden created by tax withholding and reporting requirements as well as the costs associated with the distribution to the plaintiffs by capitalizing on the efficiencies of engaging a claims administrator to perform these functions.
There are a myriad of general tax issues which must be considered when structuring the terms of a settlement. In employment cases, for example, the gross amount of the award is typically allocated to represent wages, damages, interest, and/or penalties. Wages are subject to applicable federal and state tax withholdings and reporting on IRS Form W-2. The employer is typically required to fund the employer’s payroll tax in addition to the gross settlement contribution, unless the settlement agreement specifies otherwise.
Additionally, any allocation of damages, interest, or penalties paid to the class in excess of $600 per class member must be reported on IRS Form 1099. In such instances, it may be beneficial to have the QSF serve as the “employer” for the purpose of paying back wages to claimants and remitting payroll taxes to the taxing authorities. This option allows the class action administrator to handle all tax withholding, remittance, and reporting functions. Parties can then be certain that all taxes have been remitted to the taxing authorities and employers can avoid payroll related complications which may arise in trying to make one-time payments to former employees. However, the QSF is its own tax entity, thus the employer will not get credit for taxes paid on behalf of current employees.
Use of a QSF also allows defendant employers to keep former employees off their employment rolls so that they are not subjected to spurious unemployment or disability claims. However, under some circumstances, it may be more advantageous to the defendant to include employees’ settlement payments on the defendant’s general employment roster. If most class members are current employees, or if the class is small, it may be cost effective to allow the employer to make the payments to class members and thus avoid the costs associated with registering the fund as an “employer” with the IRS and filing in multiple states. Furthermore, both the employer and their current employees may avoid overpayment of taxes by effecting payment through the employer when wages exceed specific tax caps such as the 2009 social security cap of $106,800 per employee.
When back wages are paid through a QSF, the administrator withholds payroll taxes and the burden shifts to the employee to recover excess social security taxes. The employer may also be forced to overpay payroll taxes. This consideration is relevant in cases where the class members were well compensated and/or expect to receive large settlement payments.
Overall, a QSF generally simplifies employment class action settlements. Certainly, the relation-back rule makes it possible for plaintiff attorneys to pre-fund a settlement and accrue additional interest for the benefit of the class even before the settlement is finalized. Often the QSF offers an efficient mechanism for ensuring that all class members are fairly compensated from the negotiated settlement fund and that all other tax obligations are met.
However, under certain circumstances, avoiding a QSF employment structure may be advantageous. Other options, such as bifurcation of settlement administration and employment tax reporting and the grantor trust election may be appropriate in some cases. Given the number of options available, it is prudent to consult a professional administrator in advance of finalizing the terms of your settlement agreement.
Copyright American Association for Justice, formerly Association of Trial Lawyers of America (ATLA®). Reprinted with permission.