Government mitigation trust qualified for settlement-fund tax treatment

Plain-English summary

A court-approved trust received part of a settlement paid by defendants accused of violating federal and state law in connection with a product. The trust would fund projects mitigating the resulting harm for states and governments of U.S. possessions, with unused amounts ultimately distributed only among those governmental beneficiaries. The IRS ruled that the trust was a qualified settlement fund because it was court approved and supervised, resolved legal claims, and was organized as a state-law trust. Settlement installments transferred to the trust could be excluded from its modified gross income because they satisfied the liabilities for which it was established. The trust's investment income was also excluded under section 115 because the trust performed an essential governmental function and all income accrued to governmental beneficiaries rather than private parties.

Ruling snapshot

• Question: Did the mitigation trust qualify as a settlement fund, exclude settlement transfers, and exclude investment income under section 115?
• Outcome: approved on all three issues
• Key authorities: IRC §§ 61, 115, 468B(g), 7701; Treas. Reg. §§ 1.468B-1, 1.468B-2; Rev. Rul. 77-261; Rev. Rul. 90-74

Full text (IRS public release)

Internal Revenue Service                                       Department of the Treasury
                                                               Washington, DC 20224

Number: 201930004                                              Third Party Communication: None
Release Date: 7/26/2019                                        Date of Communication: Not Applicable
Index Number: 115.06-00, 468B.02-00
                                                               Person To Contact:
----------------------------                                   ----------------------------, ID No. --------------
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--------------------------                                     Telephone Number:
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---------------------------                                    Refer Reply To:
-----------------------------------                            CC:EEE:EOET:EO3
-------------------------------------                          PLR-121082-18
                                                               Date:
                                                               April 15, 2019




Legend

Act                            =
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Agency                         =
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Court                          = --------------------------------------------------------------------------------
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Consent Decrees                =
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Court Order                    = --------------------------------------------------------------------------------
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Harm                           =
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Date 1                         =
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Date 2                         =
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Date 3                         =
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Date 4                         =
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Date 5                         =
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Date 6                         =
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Date 7                       =
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Date 8                       =
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Date 9                       =
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Defendants                   =
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Product Z                    =
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Allocable Percentage         =
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Trust                        =
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Beneficiary(ies)             = --------------------------------------------------------------------------------
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Trustee                      =
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Rates
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State X                      =
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State Y                      =
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Dollar Amount A              =
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Dollar Amount B              =
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Dollar Amount C              =
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Dollar Amount D              =
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Dollar Amount E              =
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Dear --------------------:

This letter responds to your letter dated June 21, 2018, and subsequent amendments
and correspondence submitted on behalf of the Trust, requesting certain rulings
concerning the application of various sections of the Internal Revenue Code and the
Income Tax Regulations to the Trust. In particular, you requested the following rulings:


    1. The Trust is a qualified settlement fund under Treas. Reg. section 1.468B-1(c).

    2. The Trust may exclude from its modified gross income, under Treas. Reg.
      section 1.468B-2(b)(1), the amount of certain funds transferred to the Trust after
      its establishment as a qualified settlement fund.

    3. Investment income earned by the Trust is excluded from its gross income under
      I.R.C. section 115.


FACTS

The Agency filed a complaint in the Court alleging that the Defendants violated certain
provisions of the Act with regard to the manufacture and design of Product Z. State X
filed a separate complaint alleging that the Defendants had also violated State X laws
with regard to the manufacture and design of Product Z.

The Court entered Consent Decrees on Date 1 and Date 2, pursuant to which the
Defendants agreed to pay a total of Dollar Amount A, in partial settlement of the claims
asserted by both Agency and State X.

Dollar Amount A would be used to fund projects designed to mitigate the Harm caused
by the Defendants from the manufacture and design of Product Z (Mitigation Projects).
The Allocable Percentage of Dollar Amount A would be required to be held in trust to
fund Mitigation Projects for the benefit of Beneficiaries. The remaining percentage of
Dollar Amount A would be required to be held in trust to fund Mitigation Projects for the
benefit of a different group of beneficiaries that are not part of this ruling. Pursuant to
the Consent Decrees, as later modified by the Court Order, once the court approved the
trust agreement (Trust Agreement), a trust (the Trust) was to be established for the
Beneficiaries and a separate trust was to be established for the beneficiaries that are
not a part of this ruling.

The Defendants were to pay Dollar Amount A in four installments with respect to the
Mitigation Projects. The first two installments were to be paid by the Defendants into
the Court’s registry (Court Registry), and after the two trusts were established, the final
two installments were to be paid by the Defendants to the Court appointed Trustee who
serves as the two trusts’ trustee. Trustee would allocate the funds to the respective
trusts in the prescribed percentages.

On Date 3 and Date 4, the Defendants deposited the first two installments (Dollar
Amount B) into the Court Registry. The funds were held in the Court Registry under the
Court’s sole dominion and control in an interest-bearing account. Interest earned on

Dollar Amount B while held in the Court Registry did not reduce the Defendants’
obligations to pay the entire Dollar Amount A as established in the Consent Decrees.

On Date 5, the Court Order approved and ordered the establishment of the two trusts.
On Date 6, pursuant to the Court Order, the Trust was formed as a State Y statutory
trust. At the same time, a separate trust was also formed for the benefit of the other
group of beneficiaries that are not part of this ruling.

On Date 7, the Court transferred Dollar Amount B and Dollar Amount C from the Court
Registry to the Trustee. Dollar Amount C represented the interest earned on Dollar
Amount B while held in the Court Registry from Date 3 to Date 7. Trustee then
allocated those funds to each of the two trusts in the prescribed percentages such that
the Trust received the Allocable Percentage of Dollar Amount B, along with the
Allocable Percentage of Dollar Amount C.

On Date 8, the Defendants transferred the third installment (Dollar Amount D) to the
Trustee. Trustee then allocated the Allocable Percentage of Dollar Amount D to the
Trust.

On Date 9, the Defendants transferred the fourth and final installment (Dollar Amount E)
to the Trustee, and Trustee allocated the Allocable Percentage of Dollar Amount E to
the Trust. The fund installments transferred to the Trust on Date 7, Date 8 and Date 9
are collectively referred to as the Transfers of Funds.

Trustee is required to establish a subaccount for each Beneficiary and fund those
accounts in accordance with the Court-approved allocation percentages amongst the
Beneficiaries. Trustee is also required to establish and fund subaccounts from which to
pay expenses and taxes. These subaccounts are only for accounting purposes and for
the allocation of funds amongst the Beneficiaries.

Trustee is to invest and reinvest the principal and the income of the Trust. Trust’s
assets and investment income thereof must be used to fund Mitigation Projects. Each
Beneficiary must submit a Mitigation Project plan before Trust disburses funds, and
every Beneficiary must use the portion of Trusts’ assets allocated to it solely for
Mitigation Project. Beneficiaries consist only of states and governments of possessions
of the United States.

In addition to Trustee’s disbursement of funds for Mitigation Projects, Trustee may
disburse funds for administrative expenditures associated with implementing the
Mitigation Project. Such administrative expenditures include expenditures by
Beneficiaries and any third-party contractor(s). However, such administrative
expenditures are not to exceed 15 percent of the total cost of the Mitigation Project.

Beneficiaries must return any unused funds to the Trust no later than the Trust’s
fifteenth anniversary. At such time, the Trustee shall distribute any funds not needed for
the expenses incurred with winding up and dissolving the Trust solely among the
Beneficiaries pursuant to the Rates described in the Trust Agreement. After this
distribution, the Trustee shall distribute any remaining assets entirely among the
Beneficiaries.

Pursuant to the Trust Agreement, the Defendants retain no ownership or residual
interest with respect to the portion of Dollar Amount A and investment income thereof
that the Trust received. The Trust Agreement further provides that the Court will be the
sole and exclusive forum for enforcing the operation of the Trust and resolving disputes
related thereto.

The Trust represents that none of the Transfers of Funds represents dividends on stock
of a transferor (or a related person), interest on debt of a transferor (or a related
person), or payments in compensation for late or delayed transfers.


RULINGS REQUESTED

1.    The Trust is a qualified settlement fund under Treas. Reg. section 1.468B-1(c).

2.    The Trust may exclude the Transfers of Funds from its modified gross income
      under Treas. Reg. section 1.468B-2(b)(1).

3.    The investment income earned by the Trust is excluded from its gross income
      under I.R.C. section 115.


LAW AND ANALYSIS

1.    Trust’s Status as a Qualified Settlement Fund under Treas. Reg. section 1.468B-
      1(c)


Section 468B(g)(1) provides that “[n]othing 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.” Section 468B(g)(1) authorizes the issuance of regulations
providing for the taxation of any such account or fund whether as a grantor trust or
otherwise. Sections 1.468B-1 through 1.468B-5 regarding qualified settlement funds
were issued pursuant to section 468B(g).

Section 1.468B-1(a) provides that a qualified settlement fund is a fund, account, or trust
that satisfies the three requirements of section 1.468B-1(c). First, section 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 continuing
jurisdiction of that governmental authority. Second, section 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, section 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).

Based on the facts represented by the Trust, the three requirements of section 1.468B-
1(c) are satisfied, and as such, the Trust is a qualified settlement fund for Federal
income tax purposes. First, the Court entered an order approving the establishment of
the Trust and the Trust remains subject to the continuing jurisdiction of the Court. See
section 1.468B-1(c)(1). Second, the Trust was established to resolve or satisfy claims
of the United States and State X that arose from Defendants’ violations of the Act and
State X laws which have given rise to at least one claim asserting liability. See section
1.468B-1(c)(2). Third, the Trust was organized as a trust under applicable state law.
See section 1.468B-1(c)(3).


2.     Modified Gross Income/Transferred Funds Excluded under Treas. Reg. section
       1.468B-2(b)(1)


Section 61(a) provides that gross income means all income from whatever source
derived.

Section 1.468B-2(a) provides that a qualified settlement fund is a United States person
and is subject to tax on its modified gross income for any taxable year at a rate equal to
the maximum rate in effect for that taxable year under section 1(e).

Section 1.468B-2(b) provides that the term modified gross income means “gross
income”, as defined in section 61, computed with certain modifications.

Under section 1.468B-2(b)(1), amounts transferred to the qualified settlement fund by,
or on behalf of, a transferor to resolve or satisfy a liability for which the fund is
established are excluded from gross income. However, dividends on stock of a
transferor (or a related person), interest on debt of a transferor (or a related person),

and payments in compensation for late or delayed transfers, are not excluded from
gross income.

The Trust was established to resolve or satisfy claims of the United States and State X
that arose from the Defendants’ violations of the Act and State X laws. The Transfers of
Funds were and will be made to resolve or satisfy the related liabilities. Such transfers
were or will be made by the Defendants to the Trust via the Trustee, or from the Court
Registry to the Trust via the Trustee. Further, as represented by the Trust, none of the
Transfers of Funds falls within the three specific exceptions to the general provision in
section 1.468B-2(b)(1) that excludes transfers into the Trust from the Trust 's gross
income.

Accordingly, based on the information submitted and representations made, we
conclude that the Trust may exclude the Transfers of Funds from its modified gross
income because the Trust may exclude such transfers from its gross income under
section 1.468B-2(b)(1).


3.     I.R.C. section 115


Section 115(1) provides that gross income does not include income derived from any
public utility or the exercise of any essential governmental function and accruing to a
state or any political subdivision thereof.

Section 115(2) provides that gross income does not include income accruing to the
government of any possession of the United States, or any political subdivision thereof.

Section 7701(a)(10) provides that the term "State" shall be construed to include the
District of Columbia, where such construction is necessary to carry out provisions of this
title.

Section 7701(b)(10)(d) provides that, with certain exceptions, references in the Code to
possessions of the United States shall be treated as also referring to Puerto Rico.

Rev. Rul. 77-261, 1977-2 C.B. 45, holds that income from an investment fund,
established under a written declaration of trust by a state, for the temporary investment
of cash balances of the state and its participating political subdivisions, is excludable
from gross income for federal income tax purposes under section 115(1). The ruling
reasons that the investment of cash balances by a state or political subdivision thereof
in order to receive some yield on the funds until needed to meet expenses is a
necessary incident of the power of the state or political subdivision to collect taxes and
other revenue to fund government expenses. The ruling points out that it may be
assumed that Congress did not desire in any way to restrict a state's participation in

enterprises that might be useful in carrying out projects that are desirable from the
standpoint of a state government and which are within the ambit of a sovereign to
properly conduct.

In Rev. Rul. 90-74, 1990-2 C.B. 34, the Service determined that the income of an
organization formed, funded, and operated by political subdivisions to pool various risks
(casualty, public liability, workers' compensation, and employees' health) is excludable
from gross income under section 115(1). In Rev. Rul. 90- 74, private interests neither
materially participate in the organization nor benefit more than incidentally from the
organization.
Trust will use its assets and income thereof to mitigate Harm suffered by Beneficiaries
and their citizens. All of the Beneficiaries are either a state, or a government of a
possession of the United States. By carrying on this activity, Trust is performing an
essential governmental function.

Trust will devote its entire operation to the purpose of funding Mitigation Projects that
benefit Beneficiaries. Other than payments for goods and services necessary for Trust
to perform the task of mitigating Harm and for administering Trust for this purpose, none
of Trust’s income will revert to a private party.

Upon dissolution, Trustee shall distribute any funds not needed for the expenses
incurred with winding up and dissolving the Trust solely among the Beneficiaries in
accordance with the Rates. After this distribution, the Trustee shall distribute any
remaining assets entirely among the Beneficiaries. All of the Beneficiaries are either a
state or a government of a possession of the United States. None of Trust’s assets will
be distributed or revert to any entity whose income is not excludible from gross income
under section 115.

Based solely on the facts and representations, we conclude that the Trust is exercising
an essential governmental function, with its income accruing to a state, a government of
any possession of the United States, or political subdivision thereof. Therefore, Trust's
income is excludable from gross income under section 115

The ruling contained in this letter is based upon information and representations
submitted by or on behalf of Trust and accompanied by a penalty of perjury statement
executed by an individual with authority to bind Trust and upon the understanding that
there will be no material changes in the facts. While this office has not verified any of
the material submitted in support of the request for this ruling, it is subject to verification
on examination. The Associate office will revoke or modify a letter ruling and apply the
revocation retroactively if there has been a misstatement or omission of controlling
facts; the facts at the time of the transaction are materially different from the controlling
facts on which the ruling was based; or, in the case of a transaction involving a
continuing action or series of actions, the controlling facts change during the course of
the transaction. See Rev. Proc. 2019-1, section 11.05.

No opinion is expressed concerning the federal tax consequences under any Code
provision other than the provisions specifically cited above. 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
concerns only the federal income tax treatment of Trust's income and may not be cited
or relied upon by any other taxpayer, including Trust's beneficiaries.

This ruling is directed only to Trust. Code 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 Trust's authorized representative.


                                       Sincerely,



                                       Andrew F. Megosh, Jr.
                                       Senior Tax Law Specialist
                                       Exempt Organizations Branch 2
                                       Associate Chief Counsel (EEE)