The QSF Regs.A Double-Edged Sword

Generally, the treatment of a settlement fund as a qualified settlement fund (QSF) benefits the transferor, because a transferor who contributes funds to a QSF may be able to take a deduction that would otherwise not be allowed (under the economic performance rules) until the funds are distributed to claimants; see Regs. Sec. 1.468B-3(c). However, QSF treatment is not elective, in contrast to the QSFs progenitor, the designated settlement fund (DSF); see Sec. 468B(d)(2)(F). This distinction is a trap for the unwary, as evidenced by the Tenth Circuits decision in Brown, 334 F3d 1197 (10th Cir. 2003).

Background

In Brown, the issue before the Tenth Circuit was whether a trust established to provide restitution to foreign investors (Investors) was a QSF liable for income taxes on its earnings. The Investors were defrauded when they attempted to invest in U.S. securities sold by a domestic company (Transferors) that had misrepresented the securities. The Transferors entered into stipulations with the U.S. under which they released their claims to certain property and placed it in a fund (Fund) designed to provide the In-vestors with restitution. The total Fund assets, however, were worth less than one-fourth of the total claims filed against the Fund.

Nearly two years after the Fund was established, the IRS identified it as a QSF, submitting a proof of claim stating that the Fund owed taxes. The tax effect on the Investors was considerable; under a treaty, they would not otherwise have been subject to U.S. taxes on Fund distributions. The Investors raised several arguments against QSF treatment, including challenging (1) the statutory authorization for the QSF regulations as an unconstitutional delegation of authority under the nondelegation doctrine; and (2) the QSF regulations as a misuse of delegated power.

Regulations

Regs. Sec. 1.468B-1(c) defines a QSF as a fund, account or trust if:

(1) It is established pursuant to an order of, or is approved by, the United States, any state (including the District of Columbia), territory, possession, or political subdivision thereof, or any agency or instrumentality (including a court of law) of any of the foregoing and is subject to the continuing jurisdiction of that governmental authority;

(2) It is established to resolve or satisfy one or more contested or uncontested claims that have resulted or may result from an event (or related series of events) that has occurred and that has given rise to at least one claim asserting liability[a]rising out of a tort, breach of contract, or violation of law;and

(3) The fund, account, or trust is a trust under applicable state law, or its assets are otherwise segregated from other assets of the transferor (and related persons).

After finding that the Fund qualified as a QSF, the Tenth Circuit addressed the validity of the QSF regulations. The courts opinion in Brown is the first circuit court decision addressing the constitutionality of these rules. The rest of this item focuses only on the Investors challenges to the validity of the QSF regulations and the Tenth Circuits conclusions.

Nondelegation Doctrine

Given practical limits on time and the specialized expertise necessary to enact tax laws that effectively carry out the Codes intent, Congress will often delegate to Treasury the authority to provide rules for the operation of a given provision. Although the Constitution vests all legislative powers in Congress, the Supreme Courts nondelegation clause permits Congress to delegate rulemaking authority to administrative agencies (such as Treasury), provided that it establishes an intelligible principle to which the agency is to conform; see, e.g., Mistretta, 488 US 361 (1989). Sec. 468B(g) provides as follows:

Nothing in any provision of law shall be construed as providing that an escrow account, settlement fund, or similar fund is not subject to current income tax. The Secretary shall prescribe regulations providing for the taxation of any such account or fund whether as a grantor trust or otherwise.

The Tenth Circuit did not consider Sec. 468B(g) to be an unconstitutional delegation. Rather, in that provision, Congress (1) expressed its general policy to permit taxation of settlement funds not then taxed under the DSF regulations, (2) expressly directed Treasury to promulgate regulations and (3) limited the exercise of Treasurys authority to escrow accounts, settlement funds and similar funds. The court determined that this was an intelligible principle to which Treasury was to conform and that the delegation under Sec. 468B(g) was not out of line with other delegations upheld by the Supreme Court.

Misuse of Delegated Power

The Investors argued that Treasury had exceeded its authority under Sec. 468B(g), because the QSF regulations rendered other parts of the original statute obsolete. Specifically, they argued that, under the statute, DSF status is elective. Under the QSF regulations, however, a fund that has not elected DSF status, but otherwise meets the DSF requirements, is a QSF and is taxed similarly.

The court, however, found that the Investors argument ignored the scope of the authority granted under Sec. 468B(g), which allows Treasury to prescribe regulations providing for the taxation of an escrow account, a settlement fund or any such fund. Under a plain reading of the statute, Congress left the taxation of settlement funds to Treasurys discretion, and the latter had not misused the delegated power.

Conclusion

Brown serves as a reminder that beneficiaries of a fund, account or trust need to consider the applicability of the QSF rules; see Regs. Sec. 1.468B-1(c). Otherwise, the beneficiaries may unknowingly fall under the QSF rules and have the income generated therefrom taxed at the maximum rates applicable under Sec. 1(e); see Sec. 468B(b)(1).

From Agahi Goodarz, Washington, DC