Fall 2006 • Issue 23, page 1

IRS Says All Receivership Estates are Qualified Settlement Funds & Receivers Must File Form 120-SF Returns or Face Personal Tax Liability

By Rosen, Charles*

The IRS has begun appending a proviso to proofs of claim it has filed in receivership cases stating that all receiverships have an obligation to prepare and file a Form 1120-SF “U.S. Income Tax Return for Settlement Funds” the proviso adds that failure to do so will result in personal liability.¹

The proviso makes reference to United States v. Brown, a 2003 10th Circuit decision dealing with when a receivership estate is a “Qualified Settlement Fund” (“QSF”) as defined by Treasury Regulation 1.468B-1(c).

The Brown case concerned German citizens who thought they were investing in securities but were, in fact, defrauded. A receivership was created and some of the improperly obtained funds were recovered from the perpetrators. This fund in the receiver’s hands was at the center of the dispute.

The IRS maintained that this fund was a QSF that was liable for income taxes. Opponents stated that the funds should be treated as if owned by the claimants (the defrauded investors) and because the claimants were foreign citizens, the fund was not taxable under an international treaty designed to prevent double taxation. The trial court agreed with the opponents but the Tenth Circuit reversed.

Most of the court’s analysis is not germane to this discussion, and the characteristics of a QSF are not easily pried out of the arcane language of the statute. But a few key provisions are enlightening.

A “designated settlement fund” under Treasury Reg. 1.468-1(d) is (generally speaking) a fund established pursuant to a court order to resolve and satisfy present and future claims against an entity arising out of personal injury, death, or property damage and which extinguishes completely the taxpayer’s tort liability to such claimants. One thinks of class actions designed to win damages from major corporations, like tobacco companies, as an example.

Gross income to such a QSF is to be taxed at a rate equal to the “maximum rate in effect for such taxable year under section 1(e),” says Reg. 1.468B(b)(1).

Under ordinary circumstances the facts of the Brown case are sufficiently odd that its precedential value would be quite limited. The IRS has changed this with its new proviso. The government’s strained reading of the Brown case and Code Section 468B is apparently that all receivers are required to file a Form 1120-SF, U.S. Income Tax Return for Settlement Funds, because all receivers oversee settlement funds.

When pressed informally, a government attorney indicated this would include equity receiverships and other types of receiverships for which a receiver is merely taking control and management of property until such time as the appointing court has determined who is the true owner of the property.

How can this be challenged? As mentioned, this proviso has been attached to government proofs of claim filed in receivership cases. These allege claims for uncertain amounts, but do not set forth any particular tax period or estimated amount of tax, and are likely to be interpreted as a notice or warning. A receiver might object to such an uncertain claim, but this would not resolve the issue of whether the receiver is required to file such a special tax return.

Further, 28 U.S.C. Section 2201 prohibits any court from granting declaratory relief to parties if the matter relates to a federal tax. And IRS Code Section 7421 ( 26 U.S.C. section 7421) – the so-called Anti-Injunction Act – prohibits any party from enjoining the I.R.S. from collecting a tax.²

While courts do permit a party to challenge a proof of claim filed by the IRS in a receivership, probate or bankruptcy case (thus waiving sovereign immunity), this challenge would not go to the question of whether preparation and filing of a special 1120-SF return is required.

In a receivership with which I am currently associated, one of the I.R.S. area counsel attorneys assigned to the case has agreed to accept a series of questions of utmost importance to receivers concerning the government’s interpretation of Section 468B. These questions will be forwarded to Chief Counsel attorneys directly responsible for interpreting this Code section.

I hope we will receive a response that clarifies and corrects what can only be a misinterpretation of the indicated code section. A second attorney in my office has an analogous situation and will be requesting a private letter ruling from the I.R.S. on the issue.

I will keep readers of the Receivership News posted as matters progress.

*Charles F. Rosen is an attorney with the firm Law Offices of A. Lavar Taylor and is an expert in receivership and bankruptcy tax law. Mr. Rosen served as bankruptcy advisor for the Special Procedures Branch of the Internal Revenue Service for more than twenty years.

¹ The full text of the proviso is:
“In addition to the liquidated claim amount listed above [i.e. typically an amount related to pre-receivership conduct by the taxpayer], the Internal Revenue Service asserts that the receivership has an obligation to file Forms 1120-SF, U.S. Income Tax Return for Settlement Funds (Under Section 468B). See, I.R.C. Section 468B and the related Treasury Regulations and United States v. Brown, 348 F.3d 1200 (19th Cir. 2003) which treat a receivership as a settlement fund. The receiver has an obligation to report income from, among other things, the sale of receivership assets. Section 468B…imposes a tax on settlement fund taxable income at a rate equal to 35 per cent. Accordingly the Internal Revenue Service asserts a contingent and unliquidated claim for the income taxes of the receivership estate for all years in which the receivership was operated and for the years in which it continues in existence. After the receiver has filed returns for the receivership estate, the Internal Revenue Service will have those returns reviewed and/or audited and will amend this claim accordingly. The Internal Revenue Service notes that any failure by the receiver to fulfill his duties and provide for the appropriate Federal taxes can result in personal liability of the receiver for the tax obligations of the receivership pursuant to 31 U.S.C. 3713(b).”

² The rule is that the taxpayer must pay the tax in full, including penalties and interest, file a claim for a refund and have the claim denied, and only then may the taxpayer sue to recover the fund.