PLR 1045001: State-required escrow contributions were deductible qualified settlement fund payments

Plain-English summary

The IRS ruled that escrow accounts established under state legislation to resolve claims related to a manufacturer's products were qualified settlement funds. The taxpayer's contributions were tied to its sales and were held separately for potential claims. The IRS concluded that the contributions were ordinary and necessary business expenses and could be deducted in the year transferred when the all-events and economic-performance requirements were met. Any later distributions from the escrow accounts, including refunds or interest, had to be included in gross income.

Ruling snapshot

• Question: Are the escrow accounts qualified settlement funds, and may the taxpayer deduct its contributions in the year deposited?
• Outcome: Approved
• Key authorities: IRC §§ 162, 461, and 468B; Treas. Reg. §§ 1.461-1 and 1.468B-1 through 1.468B-3

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 201045001 [Third Party Communication:
Release Date: 11/12/2010 Date of Communication: Month DD, YYYY]
Index Number: 468B.06-00, 162.00-00,
461.00-00 Person To Contact:
--------------------------------, ID No. ----------
------------------------ -----------------------------------------------------

------------------------ Telephone Number:
-------------------------------------- ---------------------
Refer Reply To:
CC:ITA:B06
PLR-104391-10
Date: July 26, 2010

LEGEND

Taxpayer = ------------------------

Company = -----------------------------------

Business Entity = -------------------------

Predecessor = -----------------

Date 1 = ---------------------------

Date 2 = ---------------------------

Date 3 = -------------------

Date 4 = --------------

Year 1 = -------

Year 2 = -------

Year 3 = -------

Time Period = ------------

Bank = -------------------------------------------------
PLR-104391-10 2

$x = -------------------

a = ------------

b = --------------

C = -------

A = ----------------------------------------

E = -------------------------

D = ------------------

Dear ----------------:

This letter responds to your letter postmarked January 27, 2010 requesting certain
rulings on behalf of Taxpayer, d/b/a Company, concerning the application of various
sections of the Internal Revenue Code to transfers made by Taxpayer to various escrow
accounts. By letter postmarked June 3, 2010, the administrator of the escrow accounts
joined Taxpayer’s request for these rulings.

FACTS

Taxpayer is the sole owner of Company, a Business Entity that develops, manufactures,
advertises, markets, sells and distributes a products, including b. Taxpayer uses an
accrual method of accounting and a taxable year that ends on December 31.
Taxpayer’s Year 3 tax return was filed in Date 4.

The Cs filed suit against the major manufacturers of a products. The suits sought
monetary, equitable, and injunctive relief under various laws, including consumer
protection and/or antitrust laws. Taxpayer was not a party defendant in this lawsuit.

On Date 1, the Cs entered into a settlement agreement, A, to resolve litigation against
the major manufacturers of a products. Under the A, the party defendant manufacturers
of b and other a products are required to establish escrow accounts and make annual
payments into escrow for the benefit of the Cs. The party defendants’ ongoing
payments to the escrow accounts are determined based on their sales of b. In
exchange for these payments, the A releases the defendant manufacturers from all
past, present, and certain future claims stemming from the use, sale, distribution,
manufacture, development, advertising, or marketing of b. Under the A, these escrow
accounts are intended to be treated as qualified settlement funds for federal income tax
purposes.
PLR-104391-10 3

The party defendant manufacturers contended, and the Cs agreed, that the
manufacturers of a products not named as party defendants in litigation should be
required to make annual contributions similar to those required of the party defendants.
Accordingly, the A directs the Cs to require that certain nonparty manufacturers, of
which Taxpayer is one, either abide by the terms of the A or establish escrow accounts
and make contributions thereto for the benefit of the Cs. Nonparty manufacturers who
do not elect to abide by the terms of the A are referred to as “non-participating
manufacturers.” Accordingly, each C has enacted E that requires non-participating
manufacturers to make annual deposits into escrow accounts for the benefit of the C, to
the extent the non-participating manufacturer’s a products were sold in the C.

The E is identical or substantially similar to a D attached to the A. According to the D,
the financial burdens created by the use of b should be borne by the a manufacturers
rather than by the Cs. The amount of a non-participating manufacturer’s annual
deposits into the escrow accounts required by the D is based on the manufacturer’s
sales of b within a C during the year in question. The escrowed funds may be used only
to satisfy claims arising from the manufacture, sale, etc. of b by the nonparticipating
manufacturer. Any funds that remain in the escrow after Time Period from the day on
which they were contributed will be refunded to the non-participating manufacturer.

Pursuant to the D, the Cs may use civil litigation to enforce the escrow contribution
requirement. In addition to ordering a non-compliant non-participating manufacturer to
make the required contribution, a court may impose civil penalties. In certain cases the
non-participating manufacturer may be prohibited from selling b in the Cs for up to a
two-year period.

Predecessor was the sole owner of Company until Date 2. On that day, Taxpayer
purchased Company. Predecessor was a non-participating manufacturer, and
Taxpayer is a non-participating manufacturer. Thus, pursuant to E, Predecessor and
Taxpayer are required to establish escrow accounts to the extent they sold b within a C.

During Year 1, Predecessor entered into an escrow agreement with Bank. The escrow
agreement sets forth terms and conditions relating to the contributions required by the
legislation enacted by the Cs pursuant to the A. During Year 2, after Taxpayer
purchased Company, the escrow agreement was amended to reflect Taxpayer’s
ownership of the business. As of Date 3, Taxpayer has deposited a total of $x into the
escrow accounts.

Taxpayer expects that the Cs in which Taxpayer does business will make claims
against Taxpayer, that all of the contributed funds will be used to satisfy the Cs’ claims if
the claims are successful, and accordingly, that Taxpayer will not receive a refund of
PLR-104391-10 4

any of the contributed funds. This expectation is based on Taxpayer’s belief that the
Cs’ will be as successful with respect to Taxpayer as with the defendant manufacturers.
REQUESTED RULINGS

                          Escrow Account Classification

The first requested ruling is that the escrow account established pursuant to the A with
Bank is a qualified settlement fund within the meaning of § 1.468B-1 of the Income Tax
Regulations.

Section 468B(g) provides, in part, that nothing in any provision of law shall be construed
as providing that an escrow account, settlement fund, or similar fund is not subject to
current income tax. Pursuant to the authority of section 468B(g), the Secretary has
published §§ 1.468B-1 through 1.468B-5 regarding qualified settlement funds.

Section 1.468B-1(a) provides that a qualified settlement fund is a fund, account, or trust
that satisfies the requirements of § 1.468B-1(c). First, § 1.468B-1(c)(1) requires that the
fund, account, or trust is established pursuant to an order of, or it is approved by, the
United States, any state (including the District of Columbia), territory, possession, or
political subdivision thereof, or any agency or instrumentality (including a court of law) of
any of the foregoing and is subject to the continued jurisdiction of that governmental
authority. Second, § 1.468B-1(c)(2) requires that the fund, account, or trust is
established to resolve or satisfy one or more contested or uncontested claims that have
resulted or may result from an event (or related series of events) that has occurred and
that has given rise to at least one claim asserting liability (i) under the Comprehensive
Environmental Response, Compensation and Liability Act of 1980; (ii) arising out of a
tort, breach of contract, or violation of law; or (iii) designated by the Commissioner in a
revenue ruling or revenue procedure. Third, § 1.468B-1(c)(3) provides that the fund,
account, or trust must be a trust under applicable state law, or its assets must be
otherwise segregated from other assets of the transferor (and related persons).

Section 1.468B-1(j)(1) provides that if a fund, account, or trust is established to resolve
or satisfy claims described in § 1.468B-1(c)(2), the assets of the fund, account, or trust
are treated as owned by the transferor of those assets until the fund, account, or trust
also meets the requirements of § 1.468B-1(c)(1) and (c)(3). On the date the fund,
account, or trust satisfies all the requirements of § 1.468B-1(c), the transferor is treated
as transferring the assets to a qualified settlement fund.

Section 1.468B-2(k)(2) provides that a qualified settlement fund is in existence for the
period that (i) begins on the first date on which the fund is treated as a qualified
settlement fund under § 1.468B-1; and (ii) ends on the earlier of the date the fund (A) no
longer satisfies the requirements of § 1.468B-1; or (B) no longer has any assets and will
not receive any more transfers.
PLR-104391-10 5

Based on the facts represented, in Year 1, the escrow accounts established by
Predecessor satisfied all three requirements of § 1.468B-1(c), and therefore are treated
as qualified settlement funds as of the date established.

First, with respect to § 1.468B-1(c)(1), the escrow accounts are established pursuant to
an order of a C, and are subject to the continuing jurisdiction of such C. The Cs, which
are governmental authorities under § 1.468B-1(c)(1), enacted E requiring Taxpayer
(and Predecessor) to make contributions into escrow accounts. Pursuant to this
legislation, Taxpayer must annually certify to the Cs that Taxpayer is in compliance.
The appropriate official of each C has the authority to monitor Taxpayer to enforce
annual compliance with the state’s legislation by pursuing civil litigation, imposing
penalties, or restricting Taxpayer’s ability to sell b in the settling jurisdiction.

Second, with respect to § 1.468B-1(c)(2), we are persuaded that the escrow accounts
were established to resolve or satisfy contested or uncontested claims that have
resulted or may result from a related series of events that have occurred and that have
given rise to at least one claim asserting liability arising out of a violation of law.

The event (or related series of events) that has already occurred is the manufacturing
and distribution of a products, including b, by Taxpayer. The claim that has already
arisen is that pursuant to the E, a manufacturer of a products is financially liable to
reimburse the Cs for the costs associated with the harms allegedly related to the sale of
b. This liability arises from alleged violations of various state laws by the
nonparticipating manufacturers. Although no C has filed a formal complaint against
Taxpayer, the regulation requires only that at least one “claim” asserting liability has
resulted or may result.

It is clear that the escrow accounts were established to resolve or satisfy the claims
made by the Cs. The E forces nonparticipating manufacturers to assume a share of the
financial burdens created by the harms allegedly caused by the use of b. The
legislation requires any nonparticipating manufacturer selling b within the C to make
annual deposits into escrow accounts, for the benefit of the C. The amounts of a
nonparticipating manufacturer’s deposits are based on the manufacturer’s sales of b
during the year in question. Taxpayer is a nonparticipating manufacturer, and the
amounts of Taxpayer’s deposits are calculated on this basis in order to compensate the
Cs.

Third, with respect to § 1.468B-1(c)(3), the contributed funds are physically segregated
from other assets of Taxpayer (and related persons). The contributed funds are held in
accounts separate from other assets. Under the regulations, a separate bank account
is sufficient to satisfy this requirement. See § 1.468B-1(h)(1).
PLR-104391-10 6

                   Deduction for Payments to Escrow Accounts

The second requested ruling is that the payments made by Taxpayer to the escrow
accounts in Year 3 are deductible in Year 3, and payments made by Taxpayer to the
escrow accounts after Year 3 are deductible in the year deposited into the accounts.
Section 162(a) of the Code provides the general rule that there shall be allowed as a
deduction all the ordinary and necessary expenses paid or incurred during the taxable
year in carrying on any trade or business. See also § 1.162-1(a).

Section 461(a) provides, in part, that a deduction shall be taken for the taxable year
which is the proper taxable year under the method of accounting used in computing
taxable income.

Section 1.461-1(a)(2) provides, in part, that under an accrual method of accounting, a
liability is incurred, and generally taken into account for federal income tax purposes, in
the taxable year in which all the events have occurred that establish the fact of the
liability, the amount of the liability can be determined with reasonable accuracy, and
economic performance has occurred with respect to the liability.

Section 461(f) provides that if (1) the taxpayer contests an asserted liability, (2) the
taxpayer transfers money or other property to provide for the satisfaction of the asserted
liability, (3) the contest with respect to the asserted liability exists after the time of the
transfer, and (4) but for the fact that the asserted liability is contested, a deduction
would be allowed for the taxable year of the transfer (or for an earlier taxable year)
determined after application of § 461(h), then the deduction shall be allowed for the
taxable year of the transfer.

Section 461(h)(1) provides, in part, that in determining whether an amount has been
incurred with respect to any item during a taxable year, the all events test shall not be
treated as met any earlier than when economic performance with respect to such item
occurs.

Section 461(h)(4) provides that the all events test is met with respect to any item if all
events have occurred which determine the fact of the liability and the amount of such
liability can be determined with reasonable accuracy.

Section 1.468B-3(c)(1) provides that for purposes of § 461(h), economic performance
occurs with respect to a liability described in § 1.468B-1(c)(2) to the extent the
transferor makes a transfer to a qualified settlement fund to resolve or satisfy the
liability.

Section 1.468B-3(c)(2) provides that economic performance does not occur to the
extent (A) the transferor (or a related person) has a right to a refund or reversion of a
transfer if that right is exercisable currently and without the agreement of an unrelated
PLR-104391-10 7

person that is independent or has an adverse interest (e.g., the court or agency that
approved the fund, or the fund claimants), or (B) money or property is transferred under
conditions that allow its refund or reversion by reason of the occurrence of an event that
is certain to occur, such as the passage of time, or if restrictions on its refund or
reversion are illusory.

Section 1.468B-3(f)(1) provides that a transferor must include in gross income any
distribution it receives from a qualified settlement fund.

Section 1.468B-3(f)(3) provides that a distribution described in § 1.468B-3(f)(1) or (f)(2)
is excluded from the gross income of a transferor to the extent provided by § 111(a)
(regarding the recovery of tax benefit items).

Based on the facts represented, the amounts transferred into escrow accounts will be
used to pay money damages to the Cs for liabilities that arose as a result of Taxpayer’s
principal business activity, that is, the manufacture and sale of b and other a products.
Thus, such amounts are deductible under § 162(a) as ordinary and necessary business
expenses. To the extent that the all events tests under § 1.461-1(a)(2), including
economic performance, are met, the amounts transferred into the escrow accounts
would be deductible in the taxable year transferred. In this case, the first prong of the
all events test, i.e., all the events have occurred that establish the fact of the liability, is
met because this is a contested liability within the meaning of § 461(f). Likewise, the
second prong, i.e., the amount of the liability can be determined with reasonable
accuracy, is met because the amount of the liability can be readily ascertained based on
the formula prescribed by the D and the E. Finally, under § 1.468B-3(c), transfers to a
qualified settlement fund to resolve or satisfy claims for which it is established constitute
economic performance.

In addition, under the facts presented and representations made, the fact that the D and
the E provide for a reversion of monies if any remain after Time Period from the date of
the transfers does not prevent economic performance from occurring. The D provides
that the monies transferred into the escrow accounts revert to Taxpayer after Time
Period from the date of the transfers if the Cs have not filed and prevailed on claims
either by obtaining a judgment against, or a settlement with, Taxpayer. The funds exist
to satisfy the Cs’ claims brought against Taxpayer within Time Period after the date
monies are transferred into the funds. Thus, Taxpayer may not access the funds for
any purpose other than satisfying the Cs’ claims during the Time Period. Taxpayer
expects that claims will be made against all the assets of the funds and, if successful,
the funds will be used to satisfy the Cs’ claims and that nothing will remain to revert to
Taxpayer. There is no guarantee that any amounts will revert to Taxpayer after Time
Period. The reversion in this case requires not only the passage of time, but also the
successful defense against claims brought by the Cs before anything reverts to
Taxpayer. Although the passage of time (i.e., Time Period ) is certain to occur, it is
PLR-104391-10 8

clearly uncertain whether the Cs will neither file nor prevail on claims against Taxpayer.
Thus, the payments are not transferred under conditions that allow their refund or
reversion by reason of the occurrence of an event that is certain to occur. Finally,
Taxpayer does not have a currently exercisable right to a refund or reversion.

Therefore, we conclude that the payments made by Taxpayer to the escrow accounts in
escrow accounts in Year 3 are deductible in Year 3, and payments made by Taxpayer
to the escrow accounts after Year 3 are deductible in the year deposited into the
accounts. However, to the extent Taxpayer receives any distributions from the escrow
accounts, e.g., overpayments, refunds, interest, or other appreciation on the funds,
Taxpayer must include such amounts in its gross income.

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) provides
that it may not be used or cited as precedent.

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to Taxpayer’s authorized representatives.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalty of perjury statement executed
by an appropriate party. While this office has not verified any of the material submitted
in support of the request for rulings, it is subject to verification on examination.

                                   Sincerely,

                                   MARTIN SCULLY, JR.

                                   Martin Scully, Jr.
                                   Senior Counsel, Branch 6
                                   (Income Tax & Accounting)