Tax Traps in Class Action Settlements: Avoiding Overtaxation of Plaintiffs and Nondeductibiliy for Defendants

Description

The primary tax concern for a class member is the hidden "contingency fee trap." The combination of Commissioner v. Banks and recent tax legislation is that the plaintiffs cannot report their recovery net of attorney fees, and there is no corresponding tax deduction for attorney fees. Thus, the plaintiffs stand to lose a substantial percentage of their damages recovery to taxes and legal fees.

The defendant will also want to maximize the tax deductibility of settlement payments. In documenting a settlement agreement, plaintiff and defense counsel must be aware of which categories of payments are deductible for each side. In consumer class actions, for example, the portion of a defense settlement attributed to compensating plaintiffs for excessive charges is likely to be deductible. Payments by the plaintiffs for punitive or exemplary damages are generally not deductible.

An oft-used tool is a qualified settlement fund (QSF) under 26 CFR 1.468B-1. A QSF, which is established by agreement and court order, transfers liability from the defendant to the QSF. The QSF stands in the defendant's shoes and enters into and pays the settlement with plaintiffs. This creates an accelerated deduction for the defendant and ample time for plaintiffs and their counsel to mitigate tax consequences.

Listen as this panel of attorneys, experienced with the intersection of tax and class action law, provides guidance for crafting tax-advantageous outcomes.