This article discusses Qualified Settlement Funds (QSFs) as pivotal for resolving legal disputes like personal injury and property damage claims, focusing on their tax-efficient nature under Section 1.468B-1 et seq. of the Internal Revenue Code, including Form 1120-SF filing and payment obligations.
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Originally posted on: https://www.easternpointtrust.com/articles/understanding-qualified-settlement-funds-taxation-and-tax-reporting#:~:text=A%20QSF%20is%20taxed%20on,from%20a%20QSF's%20gross%20income.
Qualified Settlement Funds (QSFs) have increasingly become pivotal in resolving lawsuits, particularly for personal injury, wrongful death, and property damage claims. QSFS provide a tax-efficient vehicle for the settlement of claims, facilitating smoother and more efficient resolutions. However, the taxation rules surrounding QSFS are intricate, necessitating a comprehensive understanding for practical usage. This guide sheds light on the pertinent aspects of QSF taxation and the associated reporting.
Introduction to QSFs
QSFs have emerged as a crucial instrument for resolving various types of claims in legal settlements. QSFs, established under Section 1.468B-1 et seq. of the Internal Revenue Code, manage the proceeds from a legal settlement (or judicial award) and offer substantial benefits to both plaintiffs and defendants. These benefits include tax deferral opportunities and the ability to structure payments over time.
QSF Treated as a Corporation
Except as provided for in §1.468B-5(b), a QSF is considered a corporation for tax treatment purposes. Any tax imposed under §1.468B-2(a) is thus levied as a tax imposed by §11.
Modified Gross Income
A QSF is taxed on its "modified gross income." The term modified gross income is generally comprised of the investment income generated by a QSF. Moreover, settlement payment amounts transferred to a QSF to resolve or satisfy a liability for which a QSF is established are excluded from a QSF's gross income.
A deduction against modified gross income is allowed for administrative costs and other incidental costs and expenses incurred in administrating the operation of the QSF. Deductible expenses may include administrative costs, such as accounting, legal, and other ministerial expenses as well as state and local taxes, relating to the QSF. Also, the costs associated with the determination and notification of claimants and claims administration are deductible.
Note: Administrative costs and other miscellaneous expenses do not include legal fees incurred by or on behalf of claimants and are thus not deductible.
The Emergence of Form 1120-SF
IRS Form 1120-SF is an essential component in the taxation process of a QSF. It is used to report the transfers received, income generated, deductions claimed, and distributions made; and to calculate and report the income tax liability of a QSF.
Filing Due Date
The QSF trustee or administrator must prepare and file the income tax return Form 1120-SF not later than the 15th day of the 4th month following the end of its tax year. There are exceptions for QSFS with a fiscal tax year ending on June 30 and for QSFs with a short tax year ending in June. In those cases, the QSF must file its 1120-SF by the 15th day of the 3rd month following the end of their tax year.
Private Delivery Services (PDSs) can meet the "timely mailing as timely filing/paying" rule for tax returns and payments. However, it's essential to note that PDSS cannot deliver items to P.O. boxes, necessitating the use of the U.S. Postal Service for such deliveries.
Signature Requirements
The return must be signed and dated by the trustee or administrator of the QSF. If an employee completes Form 1120-SF, the paid preparer's space should remain empty. Anyone who prepares the form but doesn't charge the QSF should not complete that section.
Paid Preparer Authorization
If a QSF wants to permit the IRS to discuss its tax return with the paid preparer, it can check the "Yes" box in the signature area of the return. This authorization applies only to the individual whose signature appears in the "Paid Preparer Use Only" section of the QSFs return and does not apply to the firm.
The authorization allows the IRS to contact the paid preparer to answer any questions that may arise during the processing of the return, provide any missing information from the return, get information about the processing status of the return, and respond to IRS notices about errors, offsets, and return preparation.
This authorization, however, does not allow the paid preparer to receive any refund check, bind the QSF to anything, or otherwise represent the QSF before the IRS. The authorization automatically ends on the due date (excluding extensions) for filing the QSF's tax return.
Assembling the Return
To ensure correct processing, include all schedules alphabetically and other forms in numerical order after Form 1120-SF. If the return requires more space for forms or schedules, separate sheets are allowable if the pages are the same size and format as the printed forms.
Where and How to File
The Form 1120-SF return should be filed at the applicable IRS address, which (as of this writing) is as follows:
Department of the Treasury
Internal Revenue Service Center
Ogden, UT 84201-0012
Tax Payment Obligations
The taxes are due and payable in full no later than the 15th day of the 4th month after the end of the tax year. QSFS must use electronic funds transfers to make all federal tax deposits. These transfers are payable using the Electronic Federal Tax Payment System (EFTPS). However, the QSF can also arrange for a tax professional, financial institution, payroll service, or other trusted third party to make the deposits.
Estimated Tax Payments
Generally, a QSF must make installment payments of estimated tax if it expects its total tax for the year (less applicable credits) to be $500 or more. The installments are due by the 15th day of the tax year's 4th, 6th, 9th, and 12th months.
Note: If the QSF overpaid estimated tax, it may file Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax.
Accounting Method
A QSF must use the accrual method of accounting. The accrual method records income and expenses when earned or incurred, regardless of when payment is received or made.
Recordkeeping
Keeping accurate and detailed records is essential for any QSF. These records support items of income, deductions, or credits on the return. The tax records must be kept for three years from the date the return is due
or filed, whichever is later. Records that verify the QSF's basis in property should be kept as long as needed to determine the basis of the original or replacement property.
Recordkeeping
Keeping accurate and detailed records is essential for any QSF. These records support items of income, deductions, or credits on the return. The tax records must be kept for three years from the date the return is due or filed, whichever is later. Records that verify the QSF's basis in property should be kept as long as needed to determine the basis of the original or replacement property.
Definitions
In the context of QSFs, certain terms are of particular importance:
• Administrator: The person who manages the QSF, which can include a trustee if the QSF is a trust.
• Transferor: A person who transfers money or property to a QSF to resolve or satisfy claims against that person.
Conclusion
Understanding the taxation of QSFs can be a complex task.
However, platform such as QSF 360 provided by Eastern Point Trust Company provide a turnkey service which includes all of the critical aspects of tax reporting such as Form 1120-SF, filing requirements, tax payments. As always, seeking professional advice when dealing with such intricate financial matters is advisable.
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