It may seem odd to discuss Section 468B trusts, which are at home in the context of resolving litigation. However, given that escrows in M&A deals are common, and that winding up and resolving legal disputes is not infrequently a pre-condition to a seller getting a deal closed, I think there may (finally) be something that the litigators can teach the transactional lawyers.

What is a Section 468B Trust?

Many practitioners are familiar with Section 468B trusts, and the opportunity to defer tax in certain settlements (for a background on qualified settlement funds see Wood, Taxation of Damage Awards and Settlement Payments, Chapter 7 (3rd Ed. 2005)). The IRS regulations generally provide that a fund, an account or trust is a “qualified settlement fund” if it satisfies each of the following three requirements:

• It is established pursuant to an order of, or is approved by, specified governmental entities (including courts) and is subject to the continuing jurisdiction of that entity;

• It is established to resolve or satisfy one or more claims that have resulted or may result from an event that has occurred and that has given rise to at least one claim asserting certain liabilities; and

• The fund, account, or trust is a trust under applicable state law, or its assets are otherwise segregated from other assets of the transferor.

A structured settlement merely calls for periodic payments made over time. The use of periodic payments in personal injury cases was not widespread until the late 1970s. The idea that a tort victim would receive a stream of payments payable over his lifetime as opposed to a lump-sum is no longer novel. Today, structures are increasingly used outside of the traditional personal injury field. See Wood, "Structured Settlements in Non-Physical Injury Cases: Tax Risks?" Vol. 104, No. 5, Tax Notes (Aug. 2, 2004), p. 511.

Interim Status

But what is the status of the funds prior to the time the Section 468B trust is formed?  Most plaintiffs’ attorneys or settlement brokers contact a tax attorney before the settlement agreement is finalized to try to minimize the tax impact of the settlement to the plaintiff. Clearly, that's when tax issues should be addressed. If tax issues are not addressed, and there is no Section 468B trust, the defendant pays the settlement amount to the plaintiff and the plaintiff pays the tax on any taxable portion of the recovery. That lets some significant tax saving opportunities go by the wayside.

Savvy plaintiffs' counsel will ask the tax attorney to form the Section 468B trust before any settlement payment is made, and the settlement funds are transferred directly into the Section 468B trust. However, what happens when the steps occur out of order? The form of a transaction, and the order in which events occur, are extraordinarily important to tax results.

Relation-Back Doctrine

Fortunately, a “relation-back” rule may save you, if you find it deep in the tax regulations. Treas. Reg. Sec. 1.468B-1(j)(2)(i). Under this rule, a fund, account, or trust meets the requirements of paragraphs (c)(2) and (c)(3) of Section 1.468B-1 prior to the time it meets the requirements of paragraph (c)(1) of that section, the transferor and the administrator may jointly elect (a relation-back election) to treat the fund, account, or trust as coming into existence as a qualified settlement fund.

Thus, if the attorneys’ fund, account, or trust is a trust under the state law or the account’s assets are otherwise segregated from other assets of the defendant, and the trust or account is established to resolve or satisfy one or more claims that have resulted, or may result, from the litigation settlement, the relation-back election may apply.

Frequently, an attorney's client trust account will be a trust account under state law. It is important that the attorney segregate the client’s recovery from other moneys. Obviously, where the defendant has paid the money to the plaintiff’s attorney, the defendant has clearly segregated the funds.

The tax attorney may prepare the petition to have a trust created and approved, the order which the judge would sign to approve it, and the Section 468B trust documents themselves, and request the court’s approval. In effect, this gives everyone more time to determine if a structure is a better alternative than cash. In many (if not most) cases, it will be for tax savings, retirement goals, investment returns and even asset protection.

Timing Isn’t Everything

Under the relation-back election, the qualified settlement fund is treated as coming into existence on the later of the date the fund, account, or trust meets the second and third requirements of the regulations (discussed above), or January 1 of the calendar year in which all of the three requirements listed above are met. If a relation-back election is made, the assets held by the fund, account, or trust on the date the qualified settlement fund is treated as coming into existence are treated as transferred to the qualified settlement fund on that date.

A relation-back election is made by attaching a copy of the election statement, signed by each defendant and the trust administrator, to the timely filed income tax return (including extensions) of the qualified settlement fund for the taxable year in which the fund is treated as first coming into existence. Section 1.468B-1(j)(2)(ii). A copy of the election must be attached to the defendant's timely filed income tax return (including extensions), for the taxable year of the payment. The taxable year of the payment is the year in which the qualified settlement fund was formed and accepted by the court. The federal income tax return of a qualified settlement fund (Section 468B trust) must be filed on or before March 15 of the year following the close of the taxable year of the qualified settlement fund. Treas. Reg. Sec. 1.468B-2(k)(3). The due date for filing this return can be extended under Section 6081 of the Code.

But Wait, There’s More...

The flexibility provided by the relation-back election I've discussed here is truly amazing. For plaintiffs mired in the process of litigation and the crush of issues addressed on settlement, it provides a real second chance to address tax issues. So often – in fact nearly all of the time – there is no second chance when it comes to tax issues. So, this relation-back election is pretty remarkable.

But, believe it or not, there's more. Section 301.9100-1(a) of the regulations provides that the IRS Commissioner has discretion, with good cause shown, to grant a reasonable extension of the time fixed by regulations for the making of the election through an application for relief if the plaintiff:

• Requested relief before the failure to resolve the defect is discovered by the Service;

• Failed to make the election because of intervening events beyond his/her control;

• Failed to make the election because, after exercising due diligence, the plaintiff was unaware of the necessity for the election;

• Reasonably relied on the written advice of the Service; or

• Reasonably relied on a qualified tax professional, and the tax professional failed to make, or advise the taxpayer to make, the election.

Close to a Cure-All

Through the ruling process a defective Section 468B trust can be cured of its timing defect beyond the tax year in which it was formed. Thus, the period for saving a Section 468B trust formed after the settlement funds are received extends into the next year (possibly even two years) after the trust was formed. Since frequently the tax benefit of using the Section 468B trust is in the millions of dollars, the ruling process may be an economical way to provide the beneficiaries of the trust resolution to an otherwise disastrous tax problem. While the need to resolve significant extant claims may not be present in many deals, it will occasionally crop up. When it does, the Section 468B trust can be an advantageous way of proceeding.

Handling Claims in and After Deals: Use a Code Sec. 468B Trust?, by Mark A. Muntean, Vol. 13, No. 11, M&A Tax Report (June 2005), p. 4.