Which income of a qualified settlement fund established under a California court's continuing jurisdiction was taxable by California, and could the fund deduct a prior net operating loss?

Plain-English summary

California Legal Ruling 1993-4 held that a qualified settlement fund (QSF) established by a California court was taxable under Revenue and Taxation Code section 24693 on its California-source income, with two important qualifications.

First, interest on obligations of the United States was exempt from this California tax. Second, the fund could deduct a net operating loss under the QSF regulation, but only within the California loss limitations in effect for the relevant year.

For intangible-property income, the ruling presumed a California source because the California court that established the fund also exercised continuing jurisdiction over it. The presumption could be overcome if the fund established a commercial domicile elsewhere or the intangible property acquired a business situs elsewhere.

Facts addressed by the ruling

A California court established FUND to resolve claims against several defendants for a class containing California residents and nonresidents. The defendants transferred money and intangible property to the fund.

FUND qualified under Treasury Regulation section 1.468B. Its income included returns from intangible property and interest on United States obligations. In a prior year, its administrative costs, incidental expenses, and asset losses exceeded its income, creating a net operating loss.

California-source income

Section 23040 treated income from property located or having a situs in California, and income from activities conducted in California, as California-source income.

Accordingly, income from real or tangible property located in California was taxable to the QSF. For intangible property, the usual tax situs was the owner's commercial domicile unless the property had developed a business situs elsewhere.

The ruling said a QSF's commercial domicile generally would be presumed to be the court or governmental authority that established or approved the fund and maintained continuing jurisdiction. Because FUND was under a California court's continuing jurisdiction, its intangible income was presumed attributable to California unless it proved a commercial domicile or business situs elsewhere.

Interest on United States obligations

Section 24693 imposed an income tax on the fund in lieu of the other California personal-income or bank-and-corporation taxes measured by that income.

Under 31 U.S.C. section 3124, states could not tax interest on United States obligations except through the type of nondiscriminatory corporate franchise tax described in that federal provision. The FTB characterized section 24693 as an income tax, so FUND's interest on United States obligations was exempt.

Net operating loss deduction

Treasury Regulation section 1.468B-2 taxed a QSF on modified gross income and allowed a net operating loss deduction to the extent a corporation could deduct the loss under I.R.C. section 172(a).

The FTB treated California's different NOL rules as an "obvious difference" from federal law. It therefore allowed a QSF's NOL only under the California limits applicable to the year.

The ruling described the historical section 24416 rules as allowing losses from years beginning on or after January 1, 1987, permitting only 50% of a year's loss to be carried forward, and allowing no carryback. Those limits are historical and should not be assumed to govern a current fund.

What this means for you

Settlement fund administrators and trustees

Identify each income stream and its source. Court supervision in California created a presumption that intangible income was California-source, but the ruling recognized contrary proof of another commercial domicile or business situs.

Litigation attorneys

The holding is limited to FUND's income, its California source, the federal-obligation-interest exemption, and its NOL deduction. Analyze any other settlement tax issues separately under the law governing them.

Accountants and tax professionals

Separate ordinary California-source income, federally protected interest, and loss deductions. Then apply the QSF rules together with the California NOL limitations for the actual tax year rather than using the ruling's 1993 percentages automatically.

Common questions

Q: Was every dollar received by FUND taxable?

A: No. The holding taxed California-source income other than interest on United States obligations.

Q: Why was intangible income treated as California-source?

A: The California court established the QSF and retained continuing jurisdiction, creating the ruling's commercial-domicile presumption.

Q: Could the fund rebut that presumption?

A: Yes. The holding recognized proof that the QSF had a commercial domicile elsewhere or that the intangible property had acquired a business situs elsewhere.

Q: Could FUND deduct its prior net operating loss?

A: Yes, but only as determined under Treasury Regulation section 1.468B-2 and subject to California's NOL limitations for the applicable year.

Q: Was interest on federal obligations taxable?

A: No. The FTB held it exempt from the section 24693 income tax under 31 U.S.C. section 3124.

Citations and references

• Cal. Rev. & Tax. Code §§ 23040, 23051.5(f), 23501, 24416, 24693, and 25120-25139
• I.R.C. §§ 61, 172(a), and 468B
• 31 U.S.C. § 3124
• Treas. Reg. §§ 1.468B-1, 1.468B-2, 1.461-2(c)(1), and 301.7701-2 through 301.7701-4

Source

• Landing page: California FTB Legal Rulings
• Official HTML: Legal Ruling 1993-4

Original ruling text

Home

Legal Ruling 1993-4

STATE OF CALIFORNIA
Franchise Tax Board - Legal Division

November 15, 1993

Taxation of a Qualified Settlement Fund

Issue

To what extent is a qualified settlement fund (including a designated settlement fund), as defined in Treas. Reg. § 1.468B, subject to tax under Revenue and Taxation Code (RTC) § 24693?

Facts

Pursuant to the order of a California court, FUND is established to resolve or satisfy one or more claims asserting liability of one or more defendants to a class of plaintiffs who are residents and nonresidents of California. Defendants X, Y, and Z transfer funds and intangible property to FUND.

FUND is a qualified settlement fund (QSF) under Treas. Reg. § 1.468B. Modified gross income of the FUND consists of income from intangible property, including obligations of the United States exempted from state tax by section 3124, Title 31, United States Code. During a prior year, FUND had a net operating loss, i.e., the costs of administration, incidental expenses, and losses related to the sale, exchange, or worthlessness of assets exceeded income received by FUND.

Law and Analysis

In General

Internal Revenue Code (IRC) § 468B provides for the taxation of designated settlement funds and directs the Department of the Treasury to prescribe regulations providing for the taxation of an escrow account, settlement fund, or similar fund, whether as a grantor trust or otherwise.

§ RTC § 24693 n1 incorporates IRC § 468B by reference, with modifications to provide that a tax shall be imposed upon the gross income of the fund at a rate equal to the rate in effect under RTC § 23501. This tax is in lieu of any other tax imposed by part 10 (Personal Income Tax) or part 11 (Bank and Corporation Tax) of the RTC upon or measured by that income.

n1 Section 468B of the IRC was originally incorporated in California law by AB 53 (Stats. 1987, Ch. 1138), which added section 17515 to the RTC. Section 17515 was repealed by AB 802 (Stats. 1989, Ch. 1352), which added section 17570 to the RTC. SB 2252 (Stats. 1990, Ch. 1348) repealed section 17570 of the RTC and added section 24693.)

In accordance with IRC § 468B(g), the Treasury promulgated rules for the taxation of qualified settlement funds, including designated settlement funds as defined in IRC § 468B. (See Treas. Reg. §§ 1.468B-O to 1.468B-5, T.D. 8459, 57 Fed. Reg. 60983, December 23, 1992.) Pursuant to RTC § 23051.5(f), these regulations govern the interpretation of comparable provisions in the RTC.

Taxation of Interest on Obligations of the United States

RTC § 24693 imposes tax on "the gross income" of the fund. This tax is in lieu of any other tax imposed by part 10 or part 11 (which includes the corporate franchise tax) upon or measured by that income.

Section 3124, Title 31, United States Code, exempts interest on obligations of the United States from state taxation, other than a nondiscriminatory franchise tax imposed on a corporation.

Since the tax imposed by RTC § 24693 is an income tax, interest on obligations of the United States Government received by FUND is exempt from the tax imposed by RTC § 24693.

Taxation of Qualified Settlement Fund (QSF) Income

Pursuant to Treas. Reg. § 1.468B-1(c)(1), a qualified settlement fund (QSF) is a fund, account, or trust that is established pursuant to an order of, or is approved by, the United States, any state, 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.

If a fund, account, or trust that is a qualified settlement fund could be classified as a trust (within the meaning of Treas. Reg. § 301.7701-4), it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. If a fund, account, or trust, organized as a trust under applicable state law, is a qualified settlement fund, and could be classified as either an association (within the meaning of Treas. Reg. § 301.7701-2) or a partnership (within the meaning of Treas. Reg. § 301.7701-3), it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. If a fund, account, or trust established for contested liabilities pursuant to Treas. Reg. § 1.461-2(c)(1) is a qualified settlement fund, it is classified as a qualified settlement fund for all purposes of the IRC and the RTC. See Treas. Reg. § 1.468B-1(b).

RTC § 23040 provides that "income derived from or attributable to sources within this State includes income from tangible or intangible property located or having a situs in this State and income from any activities carried on in this State, regardless of whether carried on in intrastate, interstate, or foreign commerce."

Under RTC § 23040, income received by such a QSF from real or tangible property located in California is derived from sources within California and taxable under RTC § 24693. The situs of intangible property for tax purposes is the commercial domicile of the owner unless the intangible property has acquired a business situs elsewhere. See Southern pacific v. McColgan (1945) 68 Cal.App.2d 48 [156 P.2d 81 and 18 Cal. Code Reg. § 23040].

Generally, the commercial domicile of a corporate taxpayer is the corporation’s principal office or place of business or from where the corporation’s business is managed or controlled. In the absence of evidence of a commercial domicile elsewhere, the commercial domicile of a QSF (including a designated settlement fund) will be presumed to be at the court or the governmental authority which ordered or approved the establishment of the QSF and which exercises continuing jurisdiction over the QSF.

In general, intangible property has a business situs where it is employed as capital or where it is possessed in connection with a business so that it attaches to and becomes an asset of the business. With regard to intangibles used in a unitary business conducted within and without California, see the Uniform Division of Income for Tax Purposes Act (UDITPA), RTC §§ 25120-25139.

Net Operating Loss Deductions

Pursuant to Treas. Reg. § 1.468B-2, a qualified settlement fund is subject to tax on its modified gross income. Modified gross income is its gross income, as defined in IRC § 61, reduced by several deductions including a deduction for the amount of a net operating loss of the fund to the extent the loss would be deductible in determining the taxable income of a corporation under IRC § 172(a).

The amount and operation of a deduction for a net operating loss under the RTC is substantially different than federal law. This difference is an "obvious difference" for purposes of RTC § 23051.5(f). As a result, a qualified settlement fund is permitted a deduction for the amount of a net operating loss, as determined under Treas. Reg. § 1.468B-2, subject to the limitations for such deductions under the RTC.

Since a net operating loss is deductible to the extent the loss would be deductible in determining the taxable income of a corporation, the deductibility of a net operating loss by a qualified settlement fund is governed by RTC § 24416, as in effect for the year in question, without regard to whether the provision of the RTC imposing tax on a qualified settlement fund was codified in the Personal Income Tax Law or the Bank and Corporation Tax Law.

In general, RTC § 24416 permits the deduction of a net operating loss attributable to years beginning on or after January 1, 1987. Only 50 percent of the entire amount of the net operating loss for any year is eligible for carryover. Net operating loss carrybacks are not allowed.

Holding

FUND income (other than interest on obligations of the United States) from California sources is taxable under RTC § 24693. Income from intangible property (other than interest on obligations of the United States) received by a QSF which was established or approved by, and subject to the continuing jurisdiction of, a court or government agency located in California is attributable to California sources and taxable under RTC § 24693, unless the QSF has established a commercial domicile elsewhere or the intangible property has acquired a business situs elsewhere.

A qualified settlement fund is permitted a deduction for the amount of a net operating loss, as determined under Treas. Reg. § 1.468B-2, subject to the limitations for such deductions under the RTC.

Drafting Information

The principal author of this ruling is Patrick J. Kusiak of the Franchise Tax Board Legal Division. For further information regarding this notice, contact Mr. Kusiak at the Franchise Tax Board Legal Division, P.O. Box 1468, Sacramento, CA 95812-1468.

Last updated: 09/24/2025