What Is IRC 468B? Qualified Settlement Fund Taxation and Reporting

A qualified settlement fund under IRC 468B is a court-supervised account that receives settlement money from a defendant, holds and invests it while claims are sorted out, and then distributes it to claimants. The structure gives the defendant an immediate tax deduction for the full contribution, taxes the fund only on the investment income it earns while holding the money, and pushes each claimant’s tax consequences to the moment of distribution, where they are governed by the nature of the underlying claim rather than the fund itself.

What Qualifies as a Fund Under IRC 468B

The statute at IRC 468B actually creates a narrower vehicle called a “designated settlement fund,” which requires a court order fully extinguishing the taxpayer’s tort liability, an affirmative election, independent administration, and a scope limited to personal injury, death, or property damage claims.¹ The “qualified settlement fund” that practitioners actually use comes from Treasury Regulation 1.468B-1, which expanded the framework to cover a wider range of disputes.

Under those regulations, three requirements must be met:

The fund is established by order of, or approved by, a governmental authority (usually a court) and remains subject to that authority’s continuing jurisdiction.
It exists to resolve one or more claims arising from a tort, breach of contract, or violation of law.
It is either a trust under state law or has its assets segregated from the transferor and any related persons.²

Segregation is what gives the structure its force. Once the money is in, the defendant no longer controls it. The QSF gets its own EIN, is treated as a U.S. person for federal tax purposes, and if it would otherwise be classified as a trust under normal entity rules, the QSF classification overrides that.

Timing sometimes runs ahead of the court. A fund may be set up and funded before a court formally approves it. Regulation 1.468B-1(j)(2) provides a “relation-back election”: if the fund already meets the claims and segregation requirements before court approval, the transferor and administrator can jointly elect to treat the QSF as coming into existence on the later of the date those requirements were satisfied or January 1 of the calendar year the court order is obtained.³ The election statement attaches to both the QSF’s and the transferor’s timely filed returns.

Why Defendants Use One

The core benefit is timing. Under the normal rules in IRC 461(h), an accrual-basis taxpayer cannot deduct a liability until “economic performance” occurs, which for a payment liability generally means when the injured party actually receives the money.⁴ The QSF regulations rewrite that rule for these transfers: economic performance is deemed to occur when the transferor makes a transfer to a QSF to resolve or satisfy the liability.⁵

The practical effect: a defendant can write one check to the QSF in December, deduct the full amount on that year’s return, and step away from the litigation, even if the claims administrator will spend the next two years dividing the money among hundreds of claimants. Deduction and release of liability happen together.

If the transferor funds the QSF with property instead of cash, the transfer is treated as a sale or exchange. The amount realized is the property’s fair market value on the transfer date, gain or loss is recognized against adjusted basis, and the QSF takes a basis in the property equal to that fair market value.⁵

How the Fund Itself Is Taxed

A QSF is a separate taxpayer, but it does not pay tax on the settlement money it receives. Those transfers are excluded from the fund’s gross income. What the fund pays tax on is its “modified gross income,” which is essentially what it earns while holding the money: interest, dividends, and capital gains on invested assets.⁶ Three items are pulled back into income even though they might look like transfers: dividends on stock of the transferor or a related person, interest on the transferor’s debt, and payments compensating the fund for late transfers.

The tax rate is set at the maximum rate for trusts and estates under IRC 1(e).¹ For 2026 that top rate is 37% and it kicks in at just $16,000 of taxable income. Even modest investment earnings on a large corpus can produce a real tax bill, so fund administrators typically plan around that compressed bracket.

The fund can reduce modified gross income with deductions measured as if it were a corporation:

Administrative expenses: legal, accounting, and actuarial fees for operating the fund, claimant notice and claims-processing costs, and state and local taxes the fund pays. Claimant legal fees do not qualify.
Investment losses from selling, exchanging, or worthless property held by the fund, to the extent a corporation could deduct them.
Net operating losses when deductible expenses exceed modified gross income in a year.

Distributions to claimants or reversions to transferors are not deductible by the fund. Those payments are the fund’s purpose, not operating costs. The QSF must use a calendar year and the accrual method.

How Claimants Are Taxed on Distributions

Moving money into a QSF is not a taxable event for any claimant. Tax comes when the fund actually pays out, and treatment turns on what the claim was for.

Physical Injury Recoveries

Under IRC 104(a)(2), damages received on account of personal physical injuries or physical sickness are excluded from gross income.⁷ Compensatory amounts for medical expenses, pain and suffering, and lost wages flowing from the physical harm come out tax-free. Emotional distress standing alone is not a physical injury; damages for standalone emotional distress are taxable. Emotional distress stemming directly from an underlying physical injury falls within the exclusion. How the claim is characterized in the settlement agreement and in the fund’s distribution records drives the answer, so precision matters.

Taxable Categories

Punitive damages are always taxable as ordinary income, even in a physical injury case.⁸
Lost wages and business income are generally taxable unless received as compensation for income lost due to a physical injury.
Emotional distress damages without physical injury are taxable, though amounts used to pay medical expenses not previously deducted may be excludable.
Pre-judgment or post-judgment interest on the settlement is taxable regardless of the underlying claim.

Attorney Fees

Attorney fees paid from the QSF can create a tax trap. In many contingency arrangements the entire gross settlement, including the attorney’s share, is treated as income to the claimant, who then deducts the fees. IRC 62(a)(20) provides an above-the-line deduction for attorney fees in claims involving employment discrimination, civil rights violations, whistleblower protections, and similar federal and state causes of action. Outside those categories the deduction picture is worse, and claimants generally work through the math with a tax advisor before agreeing to allocation language.

Structured Settlements Through a Qualified Assignment

Claimants with physical injury or physical sickness claims can use the QSF as the launching point for a structured settlement, receiving tax-free periodic payments instead of a lump sum. The mechanism is a “qualified assignment” under IRC 130, in which the QSF’s obligation to pay the claimant is assigned to a third-party assignment company that funds the payments through an annuity.⁹ The payments must be fixed as to amount and timing, cannot be accelerated or deferred by the recipient, and must be excludable under IRC 104(a)(1) or (2). The annuity has to be purchased within 60 days before or after the assignment date. Done right, the claimant receives a future income stream that stays entirely tax-free.

Filing and Reporting Obligations

Compliance sits with the fund administrator, not the defendant.

Every QSF files Form 1120-SF, the U.S. Income Tax Return for Settlement Funds, reporting transfers received, income earned, deductions claimed, distributions made, and the resulting tax.¹⁰ Because the fund must use a calendar year, the return is generally due April 15 of the following year. An automatic extension is available by filing Form 7004 by the regular due date.¹¹ Estimated tax payments follow the standard quarterly schedule.

When the QSF pays out taxable amounts, the administrator issues the appropriate Forms 1099. Gross proceeds paid to an attorney go on Form 1099-MISC; other taxable payments to claimants may go on Form 1099-MISC or Form 1099-NEC depending on their nature. Distributions excludable under IRC 104(a)(2) for physical injury claims do not require information reporting. Once the money is in the QSF, the defendant has no 1099 obligation; the duty shifts entirely to the fund administrator.⁶

Late filing carries the corporate-style failure-to-file penalty of 5% of unpaid tax per month or partial month, capped at 25%. For returns due after December 31, 2025, the minimum penalty when a return is more than 60 days late is the lesser of $525 or 100% of the unpaid tax.¹² The penalty can be waived for reasonable cause, but that’s a high bar when the fund has professional management.

Winding the Fund Down

A QSF ends when all claims are resolved and distributions are complete. The administrator files a final Form 1120-SF covering the short tax year ending on the termination date and pays any remaining tax.

Residual amounts raise a distinct issue. In class actions, courts sometimes direct leftover money to charitable or public-interest recipients through cy pres distributions, particularly when remaining class members can’t be identified or amounts are too small to distribute economically. If residual amounts revert to the transferor instead, the fund cannot deduct those payments, and the transferor may need to adjust the deduction previously claimed for the original transfer, since the full contribution was deducted in the year it went in.⁶ Settlement agreements are the right place to spell out how any reversion will be handled, before the wind-down phase, when attention and leverage have both dropped.

1
Office of the Law Revision Counsel. 26 U.S.C. 468B – Special Rules for Designated Settlement Funds
2
eCFR. 26 CFR 1.468B-1 – Qualified Settlement Funds
3
GovInfo. 26 CFR 1.468B-1 – Qualified Settlement Funds
4
Office of the Law Revision Counsel. 26 U.S. Code 461 – General Rule for Taxable Year of Deduction
5
eCFR. 26 CFR 1.468B-3 – Rules Applicable to the Transferor
6
eCFR. 26 CFR 1.468B-2 – Taxation of Qualified Settlement Funds and Related Administrative Requirements
7
Office of the Law Revision Counsel. 26 U.S. Code 104 – Compensation for Injuries or Sickness
8
Internal Revenue Service. Tax Implications of Settlements and Judgments
9
Office of the Law Revision Counsel. 26 U.S. Code 130 – Certain Personal Injury Liability Assignments
10
Internal Revenue Service. About Form 1120-SF, U.S. Income Tax Return for Settlement Funds
11
Internal Revenue Service. Instructions for Form 1120-SF
12
Internal Revenue Service. Failure to File Penalty