What does Virginia Ruling of the Tax Commissioner P.D. 09-12 conclude about Qualified Settlement Funds?

Subject

Cash qualified settlement funds had to file Virginia corporate returns

Plain-English summary

Virginia required the cash disputed-claims reserves to file corporate income-tax returns as qualified settlement funds. The bankruptcy trustee elected to treat each reserve as a disputed ownership fund, and because each held only cash, federal rules taxed it as a QSF.

Virginia followed the federal classification. Although a QSF calculates tax on modified gross income using estate-and-trust rates, federal regulations treat it as a corporation and its tax as corporate income tax. Virginia therefore classified it as a corporation for state purposes.

To the extent a QSF had modified gross income subject to federal tax, it had to file a Virginia corporate income-tax return and pay tax at Virginia's corporate rate.

What this means for you

• A fund's federal election and asset composition can determine Virginia entity classification.
• QSF treatment can create a separate Virginia corporate filing even when the parent trust files Form 1041.
• Track modified gross income separately for each reserve or fund.
• Confirm current Virginia filing, nexus, apportionment, and rate rules for settlement funds.

Common questions

Did the reserves remain mere bank accounts for Virginia tax?

No. The federal DOF and QSF elections created the tax classification Virginia followed.

Why were trust tax rates mentioned?

Federal QSF tax used those rates, but the fund was still treated as a corporation.

What income triggered the Virginia return?

Modified gross income subject to federal QSF tax.

Citations and references

• Va. Code § 58.1-301.
• 23 VAC 10-120-20.
• IRC § 468; Treas. Reg. §§ 1.468B-2 and 1.468B-9.
• P.D. 99-260, 95-13, and 92-224.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 09-12

Original ruling text

February 4, 2009

Re: Request for Ruling: Qualified Settlement Funds

Dear *:

This will reply to your letter in which you request a ruling as to whether the income generated from a Qualified Settlement Fund (QSF) is subject to tax.

FACTS

Corporation A and its subsidiaries (collectively, the "Group") filed for bankruptcy and ultimately ceased operations. Pursuant to a plan of liquidation, the Group was placed into a distribution trust (the "Trust"). For federal income tax purposes, the Trust will be considered a grantor trust and each creditor will be treated as the owner of its pro-rata share.

Pursuant to the liquidation plan, the bankruptcy trustee set up priority claims trust accounts and unsecured claims trust accounts and funded them with cash transferred from the Trust. The priority claims trust accounts and unsecured claims trust accounts were designated as disputed claims reserves (DCR). For federal income tax purposes, the Trustee will treat each DCR as a disputed ownership fund (DOF). Because the DOFs were funded with cash, each will be taxed as a QSF for federal income tax purposes.

The Trust will file an income tax return for estates and trusts (Form 1041). Each DCR will file a separate corporate income tax return for settlement funds (Form 1120-SF), on which its modified gross income will be subject to federal income tax at the rates applicable to estates and trusts.

You request a ruling concerning whether the portion of the income of a liquidating/grantor trust that qualifies as a DOF and taxable as a QSF not included in federal taxable income (FTI) or distributable net income of the trust is subject to Virginia income tax.

RULING

Virginia's conformity to federal law is set forth in Va. Code § 58.1-301. This section states that, except as otherwise provided, the terms used in the Virginia income tax statutes will have the same meanings as used in the Internal Revenue Code (IRC). Therefore, FTI for corporations is identical to that as defined by the IRC.

Title 23 of the Virginia Administrative Code (VAC) 10-120-20 defines a corporation to be any entity created as a corporation under the laws of a state or the United States, District of Colombia, or foreign country, or any association, joint stock corporation, partnership, or other entity subject to corporation income tax under the IRC. You contend that a QSF would not be subject to tax as a corporation because a DCR is merely a bank account holding cash and does not qualify as a corporation, association, joint stock corporation, partnership or other entity subject to tax under the IRC.

While DCRs are not "corporations" as defined in the Virginia regulation, the Trust has elected to treat the DCR as a DOF, which in turn is treated as a QSF. Pursuant to Public Document (P.D.) 99-260 (9/27/1999), QSFs are classified as corporations for Virginia tax purposes because they are treated as such under IRC § 468.

The Taxpayer argues that DCRs are subject to the unique taxing regime applicable only to QSFs and are not considered to be subject to United States corporation income tax. This argument is based on Treas. Reg. § 1.468B-2(k), which provides that the federal income tax of DCRs is treated as corporation income tax for purposes of the application of Subtitle F of the IRC. Subtitle F includes only the procedural, administrative and certain definitional provisions of the IRC.

Treas. Reg. § 1.468B-2(k) provides in pertinent part that ". . . a qualified settlement fund is treated as a corporation and any tax imposed [on the modified gross income] is treated as a tax imposed by section 11." Section 11 of the IRC is the corporation income tax section. While QSFs may be unique in that tax is imposed on their modified gross income at the rates applicable for trusts and estates, QSFs are subject to federal corporation income tax. See also P.D. 95-13 (1/24/1995) and P.D. 92-224 (11 /5/1992).

Pursuant to Treas. Reg. § 1.468B-9(c)(2)(ii), a Trustee may elect to have DCRs treated as DOFs for federal income tax purposes. Under Treas. Reg. § 1.468B-9(a), a DOF is defined as an escrow account, trust , or fund established to hold money or property subject to conflicting claims of ownership. If the assets transferred to a DOF are solely passive, the DOF is taxable as a QSF. See Treas. Reg. § 1.468B-9(c)(1)(ii). In the instant case, the Trustee elected to have the DCRs treated as DOFS. Because the DOFs consisted solely of cash, the DOFs were treated as QSFs for federal income tax purposes.

A QSF is subject to tax based on its "modified gross income". See Treas. Reg. § 1.468B-2(a). Once computed, the QSF is taxed using the rates applicable to estates and trusts." See Treas. Reg. § 1.468B-2(a). For purposes of Subtitle F of the IRC ( i.e. , procedure and administration), a QSF is treated as a corporation and the tax treated as an income tax. See Treas. Reg. § 1.468B-2(k). Thus, to the extent a QSF has modified gross income subject to federal income tax, it will be required to file a Virginia corporate income tax return and remit tax based on Virginia's rate for corporate income tax.

This ruling is based on the facts presented as summarized above. Any change in facts or the introduction of new facts may lead to a different result.

The Code of Virginia and regulation sections cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-2409312471.B