By Michael Russell and Peter Wayne
Recently, in Idaho Department of Health and Welfare v. Jonathon L. Hudelson, the Idaho State Supreme Court presumed that the establishment of a qualified settlement fund (“QSF”) under IRC § 468B was a benefit to the claimant in the form of a “receipt” of settlement proceeds. This enabled the Department of Health and Welfare to seek reimbursement from a Medicaid recipient’s personal injury settlement immediately upon the defendant’s transfer of proceeds to a qualified settlement fund. This Court’s interpretation of “receipt” has national implications for both single event and mass tort matters, involving how and when settlement funds are received and how a claimant’s financial needs are affected by a QSF. This in turn affects a claimant’s willingness to settle and everyone’s ability to receive satisfaction.
This practice advisory update is in response to a decision by the Supreme Court of Idaho, which was filed on October 16, 2008. In State of Idaho Department of Health and Welfare v. Jonathon L. Hudelson (“Hudelson”), the Court reversed and remanded a district court decision to affirm the judgment of the original magistrate. In making this decision, the Court presumed the establishment of a qualified settlement fund (“QSF”) under IRC § 468B was a benefit to the claimant in the form of a “receipt” of settlement. Not only does this interpretation threaten the effectiveness of a QSF as a settlement tool for personal injury attorneys, but it also threatens the ability of their clients to properly plan for their receipt of settlement money, which possesses a profound effect on their future health and welfare. QSFs have in the past and continue to be an excellent resource for personal injury attorneys in dealing with cases that involve various post-settlement related issues, such as lien resolution, government benefit preservation, and the tax consequences that result from the financial plan adopted to protect the future interests of their injured client.
Under the Treasury Regulations and Revenue Rulings that set forth the legal basis for QSFs, the Court's interpretation of “receipt” appears to be misguided. While assets are placed in a QSF there is no actual or constructive receipt, via the economic benefit or constructive receipt doctrines on the part of a claimant. “Receipt” occurs only upon the release of funds from the QSF through distribution. QSFs present unique and complex legal and tax issues, such that a cursory analysis of “receipt” by a court, while understandable, may lead to an improper conclusion. A proper analysis of “receipt” based upon the Treasury Regulations and their Congressional intent render QSFs useful tools that provide valuable breathing space to claimants and their attorneys, which in turn helps ensure that proper client counseling can occur after settlement.
1. The Issue: When is a settlement “received?”
The issue of “receipt” and its impact upon QSFs is vital to settlements of all sizes and circumstances. In small settlements where there is a primarily injured claimant and derivatively injured parent, child or spouse, the QSF can be utilized to help properly allocate the funds among all the claimants who possess their own individual or derivative claims under state law. In mass torts where there are numerous claimants with individual claims, the QSF can be used to provide each individual with the appropriate amount of time to address government benefits verification, preservation and lien resolution. Hence the interpretation of “receipt” is essential to QSF utilization for both small and large mass tort settlements.
In Hudelson, the Idaho Supreme Court ruled in favor of the Department of Health and Welfare (“Department”) in its attempt to seek reimbursement from a Medicaid recipient’s personal injury settlement. The individual became eligible for Medicaid benefits as a result of injuries sustained in a car accident. A QSF was established to hold the tortfeasor’s payment and resolve the claims of both the injured individual (“claimant”) and Medicaid. It is important to note that this practice advisory piece does not take issue with the Court’s decision in favor of the Department but rather with the Court’s holding with respect to “receipt.” The Court applied the presumption of I.C. §56-209b(6) which states the following:
If a settlement or judgment is received by the [Medicaid] recipient without delineating what portion of the settlement or judgment is in payment of medical expenses, it will be presumed that the settlement or judgment applies first to the medical expenses incurred by the recipient in an amount equal to the expenditure for medical assistance benefits paid by the department as a result of the occurrence giving rise to the payment or payments to the recipient.
In its application of I.C. §56-209b(6), the Court held that the settlement was "received" under the statute, and that the presumption therefore applied. However, it appears the Court based its finding of receipt by the claimant solely upon the lower court’s simultaneous approval of the settlement allocation and establishment of the QSF in this case. Despite the fact that the settlement proceeds were being held in the QSF and that none of the money was directly payable to the claimant, the Court surprisingly found that the money was applied to the claimant’s benefit and was, thus, constructively received. In sum, the Court held that for purposes of I.C. § 56-209b(6) a settlement is received upon the establishment of a QSF and subsequent payment into it by a liable party. This appears to contradict the Treasury Regulations concerning QSFs, and indeed the very purpose of their creation by Congress in the tax code.
2. Constructive Receipt
QSFs were expressly designed by Congress to avoid constructive receipt issues in the settlement process. Thus, a judicial ruling that a QSF actually creates constructive receipt runs afoul of their declared purpose. The doctrine of constructive receipt is set forth in Treas. Reg. §1.451-2, which states that income, although not actually reduced to a taxpayer’s possession, is constructively received in the taxable year during which it is credited to his account, set apart for him, or otherwise made available so that he may draw upon it any time, or so that he could have drawn upon it during the taxable year if notice of intention to withdraw had been given. The Treasury Regulation further asserts that there is no constructive receipt if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.
When a QSF is established, a fund administrator is appointed to control and make distributions from the QSF. While money is in the QSF it is not credited to, set apart for, or otherwise made available to an individual claimant. In actuality, a novation occurs whereby the liable party is released from present and future liability despite the cause of action remaining alive to permit the court to maintain its jurisdiction over the case. The novation that occurs adds a new party as substitute obligor (the settlement fund administrator) who was not previously a party to the action, and discharges the original defendant. Upon payment into the QSF the liability on the underlying cause of action transfers from the original defendant to the settlement fund and its administrator. Therefore, the claimant and the fund administrator must come to an agreement on the final distribution and only after executing a fund settlement agreement and release of liability, are the settlement proceeds released. When the settlement proceeds are released, receipt takes place. The operation of the fund administrator as substitute obligor places a substantial limitation on the claimant’s ability to control receipt of the settlement proceeds. Furthermore, a QSF is created to resolve the claims of multiple parties to a single settlement fund. The fund is not simply set aside specifically for the claimant’s benefit but serves as a vehicle to resolve the claims of various involved parties. In Hudelson, both the claimant and the Department possessed claims to the settlement proceeds. Therefore, the settlement proceeds were not specifically set aside or available to any particular person, party or organization.
Additionally, a QSF is a separate taxable entity which is distinct and totally divorced from the claimant. Regs. §1.468B-2(k)(4) requires that a QSF must obtain its own individual employer identification number (EIN). The fund is responsible for quarterly taxes and these tax payments are reported using the EIN and showing the fund as payer as required by Regs. §1.468B-2(1)(2)(ii)(D). The fund administrator is responsible for adhering to the income tax compliance measures. The claimant is not credited with an account and he possesses no tax responsibilities with respect to the QSF. Only after a disbursement is made from the QSF to the claimant, does the claimant need to report the receipt of settlement money to the IRS and be subject to taxation as if the defendant paid the claimant directly. The scheme created for the taxation of QSFs is further support that settlement proceeds in a QSF are not actually or constructively received until they are released from the fund.
The court in Hudelson correctly noted that a QSF was established and an order for settlement was approved. However, it appears from these facts alone that the Court assumed receipt on the part of the claimant. In coming to this conclusion, they omitted an analysis of the mechanics of the QSF, specifically the tax scheme laid out by the Treasury Regulations, the role of the fund administrator and the purpose of QSFs. When taking the aforementioned aspects into account it is clear that the money is not applied to the claimant’s benefit until release from the fund and, thus, there is no constructive receipt by him until then.
3. Economic Benefit Doctrine
The economic benefit doctrine does not apply to the establishment of a QSF because while money is in a QSF there is neither the actual receipt of property nor the right to receive property in the future by any particular claimant to the fund. This receipt is required to confer a current economic benefit upon the claimant. This common law doctrine applies when assets are paid into a trust or fund for the unconditional use and sole benefit of the recipient. In Sproull v. Commissioner, 16 T.C. 244 (1951), aff’d., 194 F.2d 541 (6th Cir. 1952), the court found an economic benefit when a trust was established by an employer to compensate an individual for past services. These settlement proceeds were solely for the individual and receipt was unconditional and irrevocable. While this doctrine exists, it is important to note that not all such payments trigger the economic benefit doctrine. In Rev. Rul. 79-220, 1979-2 C.B. 74, there was no economic benefit where a taxpayer did not receive the lump sum amount to be used to fund an annuity. When there are future conditions or the possibility of forfeiture, the economic benefit doctrine does not apply. Therefore, determining whether or not the doctrine applies to a QSF requires another look at the mechanics of this settlement vehicle.
Settlement proceeds placed in a QSF do not trigger the economic benefit doctrine because the funds are not solely held for the benefit of one claimant and payment is conditioned upon the execution of fund settlement agreements. As mentioned with respect to constructive receipt above, a QSF is established to resolve multiple claims - one of the three requirements for a QSF under Regs. §1.468B-1(c). In Huddelson, the settlement proceeds in the QSF were subject to the claims of both the claimant and the Department; the settlement proceeds were not solely for the benefit of the claimant. Additionally, this case included more uncertainty and the possibility of partial forfeiture. Even after the allocation was approved by the trial judge, it was noted that this decision was not binding on the Department. Thus, because the allocation was not final and binding, the economic benefit was not unconditional. A final, unconditional, allocation does not occur until the money is released from the fund.
Furthermore, while the settlement proceeds are in the QSF the claimant does not possess an unconditional right to them and their receipt is restricted. The claimant must come to an agreement with the fund administrator and execute a release before he gains a vested right in and subsequent access to his allocated portion of the settlement proceeds. Thus, there is no economic benefit or unconditional use of the settlement proceeds until an agreement is executed and the settlement proceeds are released from the fund. In Huddelson, the settlement money was still in the fund and no fund settlement agreement was yet executed. Thus, the claimant did not receive the settlement and there was no economic benefit.
4. Conclusion
We believe that the Court in Huddelson presumed receipt by the claimant without an adequate discussion and analysis of the essential elements of a qualified settlement fund.
Moreover, this presumption from the Court directly conflicts with the Treasury Regulations and Revenue Rulings that stand as the legal authority for QSF establishment and administration. Assets held within a QSF are not received in any form by a claimant, thus, there is no constructive receipt and the economic benefit doctrine does not apply. Receipt takes place only at the time of the execution of any paperwork between the claimant and the fund administrator acknowledging allocation and triggering disbursement from the QSF. In conclusion, the QSF remains an effective tool to create breathing space after a settlement due to its prevention of actual or constructive receipt by any claimant.
We hope that you find this information helpful and please feel free to contact us at any time should you have any questions or comments.
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