At this time of year, tax planning is all about timing. Although it’s late, there’s still (just barely) time to engage in some last-minute planning to make sure you get your deductions by using a Qualified Settlement Fund, unwind any undesirable transactions in a rescission, and to see if you qualify for “open transaction” treatment before the end of the year.
Securing a Deduction: Qualified Settlement Funds
If you’re involved in a legal dispute, whether it is a court case or not, you may be able to accelerate a deduction by using a “qualified settlement fund” (QSF). You can also potentially use a QSF to settle disputes with government agencies or government investigations. I have seen QSFs used to settle everything from public class action lawsuits involving federal legislation to confidential private settlements. They are very flexible and surprisingly easy to set up.
What are the three basic requirements for a valid QSF? First, it must be established pursuant to a court order or government agency. Second, it must resolve or settle one or more contested or uncontested legal or government claims. Third, the defendant (or the party claiming the deduction) must transfer the funds to a separate account or trust to segregate the settlement funds from the defendant’s other assets.
Sometimes a QSF will be established as part of a court order or settlement agreement. But even if that’s not the case, an outside service provider can help you satisfy the first and third requirements.
The second requirement is also easy to satisfy. First, QSFs can be used to satisfy virtually any legal claim, whether or not there is a case filed in court. Second, the funds transferred to the QSF need not satisfy the claim in full. Even if the funds transferred to a QSF only partially satisfy a claim, it will still qualify as a QSF.
The tax advantage of a QSF is that, under certain conditions, a transfer of funds to a QSF is tax deductible at the time of the transfer. Even if the QSF only pays the funds to a plaintiff or to the government at a later time, the transfer to the QSF is deductible at the time of the transfer. However, to qualify for a deduction, the transferor cannot have any right to a return of the funds. Once you transfer the funds to the QSF, there is no turning back. The IRS has issued a ruling relaxing this requirement to qualify for a deduction, but only in very limited circumstances when the taxpayer could demonstrate that it expected to fully spend the QSF funds on satisfying legal claims.
Having Second Thoughts on that Transaction? No Problem, Just Rescind!
Have you ever thought “Oops, I didn’t mean to do that!” after you learn about the tax consequences? As it turns out, you might be able to qualify for the tax equivalent of a “do-over”. It’s called “rescission,” and it allows the parties to a transaction to reverse or cancel a transaction if they restore themselves to the positions they had before entering the transaction.
The classic example of a rescission is the reversal of a sale, but it can also apply to such things as the distribution of a dividend by a corporation or a variety of other transactions. The two critical requirements are: (i) the parties must be returned to their original position they would have had if the transaction had never occurred and (ii) the restoration must take place in the same year.
In case of a sale of property, the seller and buyer can satisfy both requirements when the seller returns the consideration and the buyer returns the property in the same year as the sale. It can be more challenging to determine if the parties are returned to their original position with other transactions.
Rescissions can be particularly helpful when one or both parties to a transaction did not understand the tax consequences of the transaction. It provides you with a rare opportunity to reverse the clock and undo the harm before it’s too late.
Open Transaction?
The open transaction doctrine goes back to a Supreme Court case decided in 1931. The shareholder in that case sold stock in exchange for cash plus a promise to pay 60 cents per ton of ore that the buyer received from the company. The IRS claimed that the buyer’s promise to pay 60 cents per tone of ore could be valued in the year of sale. Therefore, argued the IRS, the value of the promise to pay should be counted as taxable property the shareholder received in the year of the sale. But Mrs. Logan claimed the promise could not be valued and instead she should only be taxed as she received the payments.
Although Mrs. Logan won her case, taxpayers today will face a higher barrier to claiming open transaction treatment. There has been a steady progression of authority in favor of the IRS, finding that various types of contingent payments can be valued and taxed. Equally importantly, many private sales of stock qualify for “installment sale” treatment under statutory rules.
Open transaction treatment is more difficult today because: (i) the installment sale rules provide essentially the same tax benefit in the context of private stock sales and (ii) it’s more difficult to convince the IRS and courts that you can’t value contingent payment rights or stock in private companies. Nevertheless, the open transaction doctrine lives on. For example, it is widely available in the context of corporate liquidations, which can take place over the course of more than one year.
Another example is a prepaid forward contract. In a prepaid forward contract, the buyer pays in the present for the right to receive property in the future. In some cases, a prepaid forward contract is not taxable for the seller until the time when the buyer receives the property in the future. This can be a major benefit for sellers.
Parting Thoughts
It’s worth taking some time to consider if you can benefit from some last-minute tax planning. Three of the most powerful potential techniques include Qualified Settlement Funds to accelerate deductions, rescissions to undo transactions, and the open transaction doctrine to delay a taxable event.
