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A qualified settlement fund is a fund, account or trust, set up under United States Treasury Regulation section 1.468B-1, that receives settlement money from a defendant before that money is allocated among the people it is owed to. The fund is a taxpayer in its own right: the defendant pays into it and is released, and the claimants are paid out of it later, once liens, shares and payment choices are settled.
This article covers United States federal tax rules. It is general information, not legal or tax advice, and state law, court rules and the facts of each case change the answer.
The regulation sets three requirements, and a fund that meets all three is a qualified settlement fund whether or not anyone calls it one. The regulation calls the paying party the "transferor": in practice the defendant, its insurer, or both.
Rate and estimated tax threshold from the Internal Revenue Service form and instructions for Form 1120-SF; statement date from Treasury Regulation section 1.468B-3.
What are the three requirements of a qualified settlement fund?
A qualified settlement fund must be established or approved by a governmental authority and stay under its continuing jurisdiction, must exist to resolve certain kinds of claims, and must be a trust under state law or hold assets segregated from the payer's other assets. Those are the three tests of paragraph (c) of Treasury Regulation section 1.468B-1, and all three must be met.
The table gives each test with the wording that matters and the usual way it is met.
| Requirement | What the regulation asks | How it is usually met |
|---|---|---|
| Governmental order or approval | Established by, or approved by, the United States, a state, a territory or possession, a political subdivision, or an agency or instrumentality of one of them, a court included, and subject to that authority's continuing jurisdiction | A court order that creates or approves the fund and expressly retains jurisdiction over it |
| Type of claim | Set up to resolve or satisfy contested or uncontested claims from an event that has occurred, with at least one claim asserting liability arising out of a tort, a breach of contract or a violation of law, or under the federal environmental cleanup statute known as CERCLA | A settlement of injury, product, employment, securities, consumer or contract claims |
| Segregation | A trust under applicable state law, or assets otherwise segregated from the other assets of the transferor and related persons | A trust agreement, or a separate bank account in the fund's own name |
Three details in the text deserve attention. First, the regulation says a fund is "ordered by" or "approved by" the authority when the authority issues its initial or preliminary order, even if that order is subject to review or revision. Second, the regulation accepts an arbitration award in place of a court order, provided the award is judicially enforceable, was issued in a bona fide arbitration under rules approved by a governmental authority, and the fund remains under continuing jurisdiction. Third, a separate bank account is enough for the segregation test: the regulation gives cash held in a separate bank account as its own example.
Which claims cannot go into a qualified settlement fund?
A qualified settlement fund cannot be built on workers' compensation liabilities, self-insured health plan liabilities, ordinary product refund or repair obligations, or debts owed to general trade creditors in a bankruptcy or workout. Paragraph (g) of Treasury Regulation section 1.468B-1 excludes those liabilities from the claims the fund may resolve.
A liability to provide services or property, as opposed to money, is generally outside the rules as well. The regulation makes an exception where the transfer to the fund extinguishes the transferor's obligation to provide those services or that property. In the regulation's own example, a trust set up to secure a landfill owner's closure obligation is not a qualified settlement fund, because the owner still has to perform.
One more example in the regulation is worth knowing before anyone drafts documents. A trust created under a private, out-of-court settlement, with no order or approval from any governmental authority, is not a qualified settlement fund. The court's involvement is the first requirement, not a formality added at the end.
Why do defendants and claimants use a qualified settlement fund?
Defendants and claimants use a qualified settlement fund because it lets the defendant pay, be released and take its deduction at once, while the claimants gain time to resolve liens, allocation and payment form before any of them is treated as having received the money.
For the defendant, the tax point is economic performance. An accrual-method taxpayer can generally deduct a liability only when economic performance occurs, and for tort and similar liabilities that normally means payment to the claimant. Treasury Regulation section 1.468B-3 changes the moment: economic performance occurs to the extent the transferor makes a transfer to a qualified settlement fund to resolve or satisfy the liability. The defendant does not wait until the last claimant is paid.
That rule has two limits written into the same regulation. Economic performance does not occur to the extent the transferor, or a related person, has a right to a refund or reversion of the money that it can exercise currently without the agreement of an independent or adverse party. And a transferor that hands the fund its own promissory note, or its own promise to provide property or services later, is treated as performing only as it actually pays or provides. The rule is about timing; whether the payment is deductible at all depends on other provisions of the Internal Revenue Code.
For the claimants, the benefit is time without tax consequence. The money has left the defendant, but no claimant yet has an unrestricted right to a fixed amount, so the usual reading among practitioners is that no claimant is in constructive receipt while the fund holds the money and the allocation is still open. During that period the claimants and their counsel can:
- negotiate and pay medical, insurer and government liens, so the amount each claimant keeps is known before it is paid;
- agree or litigate how the total is divided among claimants, with a special master or the court deciding where they cannot agree;
- have attorney fees and costs approved where court approval is required;
- decide, claimant by claimant, between a lump sum and periodic payments.
That last choice is the reason structured settlement planners care about the fund. Revenue Procedure 93-34 of the Internal Revenue Service treats a qualified settlement fund as a party to the suit or agreement for the purposes of a qualified assignment under section 130 of the Internal Revenue Code, if five conditions are met: the claimant agrees in writing to the assignment, the claim is for physical injury or physical sickness, each funding asset relates to periodic payments owed to a single claimant, the assignee is not related to the transferor, and the assignee neither controls nor is controlled by the fund. A claimant can therefore arrange periodic payments after the defendant has paid and left, which is not possible once money has been paid to the claimant outright.
Who is taxed on what when a qualified settlement fund is used?
When a qualified settlement fund is used, the defendant deals with its deduction when it funds the fund, the fund pays tax on what the money earns while it is held, and each claimant is taxed as if the defendant had paid that claimant directly. The first position is set by Treasury Regulation section 1.468B-3, the second by section 1.468B-2 and the third by section 1.468B-4.
The claimant rule comes with two examples in the regulation: a distribution that satisfies damages on account of personal injury or sickness may be excludable under section 104(a)(2) of the Internal Revenue Code, and a distribution that satisfies a claim for foregone taxable interest is includible in gross income. The fund does not change the character of what a claimant receives.
How is a qualified settlement fund taxed on its income?
A qualified settlement fund pays federal income tax on its modified gross income at the maximum rate in effect under section 1(e) of the Internal Revenue Code, the rate schedule for trusts and estates, and it reports that tax each year on Form 1120-SF. The Internal Revenue Service form, in its revision of December 2025, computes the tax by multiplying modified gross income by 37%. There are no lower brackets: the top rate applies from the first dollar.
Modified gross income starts from ordinary gross income, and the settlement money itself is left out. Under Treasury Regulation section 1.468B-2, amounts transferred to the fund by or on behalf of a transferor to resolve the claims are excluded. What remains is mostly what the money earns: interest, dividends and capital gains. The regulation keeps a few items in income even though they come from the transferor, among them payments made in compensation for a late or delayed transfer, so interest that a defendant owes for funding late is income to the fund.
The deductions are narrow, and the form lists them on its own lines:
- trustee or administrator fees;
- taxes, state and local taxes included;
- accounting and legal services for operating the fund;
- the expenses of notifying claimants and processing their claims;
- certain losses on fund property and net operating losses, to the extent a corporation could deduct them.
Two things are never deductible. Distributions to claimants are not, so paying everyone out does not reduce the tax on a year's interest. Legal fees incurred by or on behalf of claimants are not administrative costs of the fund either, and the form's instructions add that expenses incurred by or on behalf of claimants or transferors, and expenses allocable to tax-exempt income, cannot be deducted.
The regulation closes off the rest of the income tax system. The fund's tax replaces any other income tax under subtitle A, cannot be reduced by tax credits, and the fund is not subject to the alternative minimum tax. Its taxable year is the calendar year and it must use an accrual method of accounting.
A related decision exists for a fund with a single transferor. Paragraph (k) of Treasury Regulation section 1.468B-1 lets that transferor elect to treat the fund as a grantor trust that it owns, in which case the fund's income is reported by the transferor instead of being taxed to the fund.
What does the administrator of a qualified settlement fund have to do?
The administrator of a qualified settlement fund obtains the fund's employer identification number, files Form 1120-SF every year the fund exists, pays the tax, and carries out the information reporting and withholding that go with each distribution. Treasury Regulation section 1.468B-2 treats the fund as a corporation for the procedural rules of the Internal Revenue Code, and the administrator is the person who answers for them.
The regulation also says who the administrator is, in order of priority: the person designated or approved by the governmental authority that ordered or approved the fund; failing that, the person designated in the escrow or settlement agreement; failing that, the escrow agent, custodian or other person in possession or control of the assets; and last, the transferor. A trustee may be the administrator where the fund is a trust.
The filing duties, read on the regulation and on the Internal Revenue Service instructions for Form 1120-SF, are these:
- A return every year. The fund files for each taxable year it exists, even a year with no gross income. The administrator signs and dates the return.
- Estimated tax. A fund that expects its total tax for the year to be $500 or more pays it in installments, due by the 15th day of the 4th, 6th, 9th and 12th months of the year.
- Electronic payment. All federal tax deposits are made by electronic funds transfer.
- The transferor's statement. Each transferor must give the administrator a statement, headed with the legend the regulation prescribes, listing each transfer, its date, the cash amount and a description and value of any property. It is due no later than February 15 of the year following the transfer, and the transferor attaches a copy to its own return.
- Reporting on the way out. The fund must file an information return for, or withhold on, a distribution to a claimant whenever the transferor would have had to do so had it paid the claimant directly.
The fund's existence for tax purposes begins when it first meets the three requirements. It ends when it no longer meets them, or when it has no assets and will receive no more transfers. The regulation lets a fund keep a reasonable reserve for its tax liabilities and related professional fees and still be treated as wound up when it asks for a prompt assessment.
Can a qualified settlement fund have only one claimant?
Whether a qualified settlement fund can be used for a single claimant is debated among tax practitioners, and the regulation does not settle the point in express terms. The three requirements speak of claims, not of a number of claimants, and nothing in their wording requires more than one person to be paid.
Those who consider a single-claimant fund valid rely on that text: a fund approved by a court, set up to resolve a tort claim and held in a segregated trust meets every test as written. Those who are cautious do not usually dispute that reading of the three requirements. Their concern is a different doctrine. When only one person can ever receive the fund's assets, and no allocation among claimants remains to be made, the argument for saying that person already has the economic benefit of the money, or is in constructive receipt of it, is stronger than in a case with many claimants and an open allocation. If that argument prevailed, the claimant could lose the ability to arrange periodic payments with the intended tax treatment.
Practice differs from one adviser to the next. A reader facing this decision should treat it as an open question to be resolved with tax counsel for the specific case, not as a rule to be taken from a general article.
How do you set up a qualified settlement fund?
Setting up a qualified settlement fund means obtaining a court order that creates or approves the fund and keeps jurisdiction over it, putting the trust or segregated account in place, and funding it only then. The order of the steps matters, because the tax treatment follows the date on which all three requirements are met.
- Provide for the fund in the settlement agreementThe agreement says that payment will be made to a qualified settlement fund, that the transfer releases the defendant, and that the defendant keeps no right to a refund except on terms the parties accept with the deduction limit in mind.
- Choose the administrator and the trusteeThe parties propose the person who will administer the fund and the institution that will hold the assets. Naming the administrator in the court order places that person first in the regulation's order of priority.
- Draft the trust or account documentsA trust agreement under state law, or the terms of a segregated account, sets the permitted investments, who may instruct distributions, how expenses and taxes are paid, and how the fund ends.
- Ask the court to establish or approve the fundA motion or petition asks for an order creating or approving the fund, appointing the administrator and stating that the court retains continuing jurisdiction. A preliminary order is enough to meet the first requirement.
- Obtain the identification number and open the accountThe administrator obtains an employer identification number for the fund and opens the account in the fund's own name.
- Fund it and collect the transferor's statementThe defendant or its insurer transfers the settlement amount. The transferor delivers its statement to the administrator by February 15 of the following year.
- Allocate, distribute, file and closeLiens are resolved, shares are fixed and approved, distributions are made with the required reporting, Form 1120-SF is filed for each year, and the court is asked to close the fund once nothing remains.
If the money moves before the order is signed, the regulation has a default and a remedy. By default, until the governmental approval and segregation requirements are both met, the assets are treated as still owned by the transferor, and the transferor is treated as transferring them on the date all requirements are met. As a remedy, where the claims and segregation tests were met first, the transferor and the administrator may jointly make a relation-back election, which treats the fund as coming into existence on the later of the date those two tests were met and January 1 of the year in which all three were met. The election is a signed statement attached to timely filed returns.
What does a qualified settlement fund look like on a timeline, with the tax worked out?
On a timeline, a qualified settlement fund runs from a court order, through one transfer in, to staged distributions out, with one tax return for each calendar year in between. The worked example below is illustrative: twelve claimants injured in one accident settle with a defendant's insurer for $6,000,000, the fund earns simple interest at an illustrative annual rate of 4%, and every amount other than the 37% rate is an assumption chosen for the example.
| Stage | When | What happens |
|---|---|---|
| Order | Before funding | The court approves the fund, appoints the administrator and retains jurisdiction; the administrator obtains the identification number and opens the account |
| Funding | Start of January | The insurer transfers $6,000,000; the defendant is released |
| First distribution | End of June | $4,500,000 leaves the fund: approved attorney fees and costs, resolved liens, lump sums, and the cost of periodic payments chosen by some claimants |
| Final distribution | End of December | The last lien disputes are resolved and the remaining balance is paid out, less a reserve for the year's tax |
| Transferor's statement | By February 15 of the following year | The insurer gives the administrator its statement of the transfer |
| Return | By the due date in the form instructions | The administrator files Form 1120-SF for the year and pays any balance of tax |
The fund holds $6,000,000 for the first six months and $1,500,000 for the next six. Interest is computed on those two balances, without interest on interest, to keep the arithmetic visible.
| Line | Calculation | Amount |
|---|---|---|
| Interest, first six months | $6,000,000 × 4% × 6/12 | $120,000 |
| Interest, last six months | $1,500,000 × 4% × 6/12 | $30,000 |
| Gross income | $120,000 + $30,000 | $150,000 |
| Administrator fee | Illustrative | $18,000 |
| Accounting and return preparation | Illustrative | $6,000 |
| Claimant notices and claim processing | Illustrative | $4,000 |
| Total deductions | $18,000 + $6,000 + $4,000 | $28,000 |
| Modified gross income | $150,000 − $28,000 | $122,000 |
| Federal income tax | $122,000 × 37% | $45,140 |
| Net earnings left for claimants | $150,000 − $28,000 − $45,140 | $76,860 |
Three things follow from the numbers. The tax of $45,140 is about 30.1% of the $150,000 of interest, lower than the 37% rate only because the fund's own expenses are deductible; without the $28,000 of deductions the tax would be $55,500. The claimants as a group receive $6,076,860 in total, the $6,000,000 of principal plus the $76,860 of net earnings. And because the expected tax is far above $500, the administrator pays it through the year in estimated installments; spread evenly, that is four payments of $11,285.
Before the final distribution, the fund holds $1,622,000: the remaining $1,500,000, plus $150,000 of interest, less $28,000 of expenses. Setting aside the $45,140 of tax leaves $1,576,860 to distribute. How the net earnings are shared among the twelve claimants follows the allocation approved by the court.
How does a qualified settlement fund differ from an attorney trust account or an escrow?
A qualified settlement fund differs from an attorney trust account or an ordinary escrow in that the fund is itself a taxpayer under its own regulation, created or approved by a governmental authority, while a trust account or an escrow is a holding arrangement governed by professional rules or by the parties' agreement. Each arrangement does a different job, and a case may use more than one.
An attorney's client trust account receives settlement proceeds on behalf of identified clients. It is governed by state bar rules and is the normal route where the claimants and their shares are already known. An escrow holds money or documents under the parties' agreement until stated conditions are met.
The qualified settlement fund answers a narrower need: money that must leave the defendant now, for claims that qualify, when the division among claimants is not yet known and a court is prepared to supervise it. The regulation makes the classification exclusive where it applies: a fund that meets the three requirements is a qualified settlement fund for all purposes of the Internal Revenue Code, even if it could also be classified as a trust, an association or a partnership.
Once the fund exists and the allocation is approved, paying out is a separate exercise. The administrator pays lienholders, counsel and claimants under the court-approved plan, issues the information returns that the transferor would have owed, and keeps a reserve for the fund's final tax and expenses before asking the court to close it.
The rules described here are federal. State income tax on the fund's earnings, state trust law, court approval requirements for minors and protected persons, and the lien rules of public health programs all sit alongside them, and each can change the timetable.
