QSF Tax: Form 1120-SF, Claimant 1099s, and Attorney Fees

A qualified settlement fund is taxed twice over, but not in the way people usually assume. The fund itself pays a flat 37% federal rate on the investment income it earns while holding settlement money, with no deduction for what it pays out to claimants. Claimants are then taxed separately on their distributions, and how much of that distribution is taxable depends entirely on what the underlying claim was for. Understanding both layers, and how they interact, is the whole game.

How the Fund Itself Is Taxed

A QSF is treated as a separate U.S. person for federal tax purposes. It pays tax on what the regulations call “modified gross income” at a flat rate equal to the maximum rate for estates and trusts under Section 1(e), which for 2026 is 37%.¹ There are no graduated brackets. Unlike a trust, which only reaches the top rate above roughly $16,000 in income, a QSF pays 37% on its first dollar of taxable investment income.

What Is and Isn’t Taxable to the Fund

The settlement money that a defendant transfers into the fund is not taxable income to the QSF. The regulations exclude those transfers from the fund’s gross income. What the fund does owe tax on is the return it earns while holding the money: interest, dividends, and capital gains from selling fund assets.

There is a narrow exception to the exclusion for transfers in. Dividends the fund receives on the transferor’s own stock, interest on the transferor’s debt, and any payments compensating the fund for late transfers are all taxable to the fund.¹

What the Fund Can Deduct

Three categories of deductions can reduce the fund’s taxable income:

Administrative expenses of running the fund, including legal and accounting fees, actuarial costs, state and local taxes, and claim-processing expenses. These are deductible to the extent a corporation could deduct them. Legal fees incurred by or on behalf of individual claimants do not count.¹
Investment losses from selling or exchanging fund assets, or from assets becoming worthless, under the same rules that apply to corporations.
Net operating losses, when administrative costs and investment losses exceed income in a given year. The excess carries forward.

Distributions Are Not Deductible

This is the point that catches most people off guard. Distributions the QSF makes to claimants, or back to the defendant, are not deductible by the fund.¹ The fund cannot offset its investment income by pointing to money it paid out. Every dollar of interest or gain the fund earns while holding settlement money is taxed at 37%, and paying claimants does not soften that.

Investment strategy matters because of this rule. Parking large sums in high-yield instruments while the allocation process drags on generates income that gets taxed at the top rate with no relief. Administrators who plan for a short holding period, or who invest conservatively while distributions are pending, keep the fund’s tax bill down.

State Tax

Most states with an income tax also tax QSFs at the entity level, but state treatment does not automatically follow federal treatment. Some states may not tax QSFs at all. The administrator should evaluate obligations in every state where the fund operates or holds assets. QSFs are creatures of federal tax law, and states are not required to mirror the federal framework.

When the Defendant Gets Its Deduction

The main tax benefit a QSF offers the defendant is timing. An accrual-basis taxpayer can normally deduct a liability only when “economic performance” occurs, which for settlement payments generally means the claimant is actually paid. The QSF regulations change that. Economic performance happens when the defendant transfers money or property to the QSF itself, even though no claimant has received anything yet.²

So the defendant can take the deduction in the year of transfer, sometimes years before the individual claimants see any money. In a mass tort case where allocation among hundreds of claimants takes a year or more, that timing shift is the whole reason to use a QSF.

The regulations impose limits. Economic performance does not occur if the defendant keeps a right to get the money back that it can exercise on its own, without approval from the court or the claimants. Transfers made with conditions that guarantee a reversion, like the simple passage of time, also fail. The transfer must be genuinely irrevocable. And if the defendant transfers property instead of cash, the transfer is treated as a sale at fair market value, which can trigger gain or loss.²

How Claimants Are Taxed on Their Distributions

For a person receiving money from a QSF, the tax result depends on why they were owed the money in the first place. Tax law looks to the origin of the claim. The settlement agreement is the single most important document in this analysis, and vague or silent allocations invite the IRS to treat the entire payment as taxable.

Physical Injury Recoveries Are Tax-Free

Section 104(a)(2) excludes from gross income any damages received on account of personal physical injuries or physical sickness, other than punitive damages.³ The exclusion covers the full amount allocated to the physical injury, including pain and suffering, emotional distress flowing from the injury, and medical expenses (unless those expenses were previously deducted).

The word “physical” does the work. Emotional distress on its own does not qualify. A wrongful termination claim that causes severe anxiety is not a physical injury claim, even if the stress eventually produces physical symptoms. The injury must be physical at its origin, and the claimant bears the burden of showing that the settlement amount is directly tied to a physical injury or sickness.

What Is Taxable

Anything that doesn’t fit within the physical injury exclusion is generally taxable as ordinary income:

Economic losses. Lost wages, lost business profits, and breach of contract damages are ordinary income to the recipient.
Emotional distress without physical injury. Settlements for defamation, discrimination, or standalone emotional harm are fully taxable. You can exclude amounts up to your actual out-of-pocket medical expenses for treating the emotional distress, if those expenses were not previously deducted.
Punitive damages. Always taxable. Section 104 explicitly carves punitive damages out of the physical injury exclusion. If the agreement allocates $100,000 to punitive damages, that full amount goes on your tax return, regardless of whether the underlying claim involved a physical injury.³

The settlement agreement should explicitly break down how the total is allocated among physical injury, economic loss, emotional distress, and punitive damages. When it lumps everything together, the IRS tends to treat the entire payment as taxable. Fixing the allocation at drafting is far easier than arguing about it later in an audit.

The Attorney Fee Problem

Claimants who receive taxable distributions face a harsh math problem. A contingency-fee lawyer might take 33% to 40% of the recovery, but for most taxable settlements the claimant owes federal income tax on the full gross amount before the attorney’s cut. You pay tax on money you never actually receive.

The itemized deduction for legal expenses in investment or tax-related matters was suspended by the Tax Cuts and Jobs Act through 2025, and at the time of writing its status for 2026 and beyond depends on whether Congress extends the suspension. For many claimants, there is simply no way to deduct the attorney’s fee from taxable income.

An important exception exists. Section 62(a)(20) allows an above-the-line deduction for attorney fees and court costs paid in connection with claims of unlawful discrimination or whistleblower violations. “Unlawful discrimination” is defined broadly and covers claims under Title VII of the Civil Rights Act, the Americans with Disabilities Act, the Age Discrimination in Employment Act, the Fair Labor Standards Act, the Family and Medical Leave Act, the National Labor Relations Act, federal whistleblower protection provisions, and even state or local employment and civil rights laws.⁴ The deduction is capped at the amount of income you include from the judgment or settlement in the same year, so it cannot create a loss.

If your claim falls outside these categories, the tax-on-the-gross problem is real and should be priced into any settlement number.

Timing and Structured Settlement Options for Claimants

One of the more useful features of a QSF is what it does to income timing. When the defendant transfers money into the QSF, that transfer does not trigger constructive receipt by the claimants. They do not owe tax on settlement proceeds until they actually receive distributions from the fund. That gap can last months or years, and during it the claimant has no tax liability on money that has already left the defendant.

The delay isn’t just a technicality. It lets the defendant deduct immediately while giving the claimant room to control the tax year in which income is recognized. Splitting a large distribution across two calendar years can keep the claimant in a lower bracket for each one.

Structured Settlements Through the QSF

A QSF can also be the starting point for a structured settlement, where the claimant receives periodic payments instead of a lump sum. Under Section 130, a “qualified assignment” lets the QSF (or the defendant) transfer the payment obligation to a qualified assignment company, which then funds the periodic payments through an annuity. If the payments are for physical injury or sickness and meet the requirements of Section 104(a)(2), the periodic payments stay tax-free to the claimant, including the investment growth built into the annuity.

The requirements are specific. The periodic payments must be fixed in amount and timing, the claimant cannot accelerate, defer, or change them, and the payments must be excludable under Section 104(a). If the QSF loses its qualified status or the court’s continuing jurisdiction ends, any structured arrangements tied to it can be jeopardized.

Filing and Reporting the Administrator Handles

Running a QSF is a real administrative job. The fund administrator handles tax filings, information reporting, and recordkeeping for the fund’s entire life.

EIN and Election

The fund needs its own Employer Identification Number, obtained on Form SS-4.⁵ That EIN separates the fund’s tax identity from the defendant, the claimants, and the administrator personally. All later filings and bank accounts use this number.

The QSF election itself is made by attaching a statement to the fund’s first Form 1120-SF. That statement identifies the court order establishing the fund, the defined class of claimants, and the other structural details required by the regulations. The election must be filed by the due date of the first return, including extensions. Missing this deadline can jeopardize QSF status entirely and cost the defendant its immediate deduction.

Form 1120-SF

Every QSF files an annual income tax return on Form 1120-SF, reporting transfers received, income earned, deductions claimed, and distributions made. The deadline is the 15th day of the fourth month after the end of the fund’s tax year. For a calendar-year QSF, that’s April 15.⁶ A fund with a fiscal year ending June 30 files by the 15th day of the third month after year-end instead.

The QSF also makes quarterly estimated tax payments on its investment income. Underpayment triggers the usual penalties.

1099s to Claimants and Attorneys

The administrator issues Form 1099 to report taxable distributions. Form 1099-MISC covers most settlement payments, while Form 1099-NEC applies to payments classified as nonemployee compensation. The $600 reporting threshold applies. Distributions that qualify for the physical injury exclusion under Section 104 are not reported on a 1099, because they are not taxable income to the claimant.

Payments to attorneys carry a separate reporting obligation. Any payor who makes payments of $600 or more to an attorney in connection with legal services must report those payments on an information return, even when the attorney is receiving the claimant’s share.⁷ In practice, the QSF often issues one 1099 to the claimant for the full taxable distribution and a separate 1099 to the attorney for the same payment. The claimant then deducts the attorney’s fee only if a provision like Section 62(a)(20) applies.

1099 forms generally must reach recipients by January 31 of the year after the distribution, with IRS copies filed by the applicable deadline. Getting the tax character wrong on these forms causes problems for everyone. Reporting a physical injury payment as taxable will generate IRS notices to the claimant, who then has to prove the error.

Closing the Fund

Once distributions are complete and administrative obligations are wrapped up, the QSF has to be formally closed. The administrator files a final Form 1120-SF marked as the final return, pays any remaining tax, and confirms that all information returns have been issued. Skipping the final return leaves the entity open on IRS records and generates automated notices long after the fund’s real work is done.

Medicare’s Claim on Settlement Money

Settlement funds that resolve claims involving medical expenses run into the Medicare Secondary Payer Act. Medicare has a statutory right to recover payments it made for treatment that should have been covered by the settlement. When a QSF distributes proceeds that include compensation for future medical care, the administrator and the claimant both have to think about whether Medicare’s interests are protected.

In workers’ compensation cases, CMS has published specific review thresholds for Medicare Set-Aside arrangements. For liability settlements of the kind that typically flow through QSFs, CMS has not established formal review thresholds at the national level, but Medicare maintains that its secondary payer rights apply equally to liability claims. Don’t assume a liability-based settlement is exempt from Medicare scrutiny. If Medicare’s interests aren’t accounted for, Medicare can refuse to pay for future treatment related to the settled injury, and the claimant covers those costs out of pocket.

1
eCFR. 26 CFR 1.468B-2 – Taxation of Qualified Settlement Funds
2
eCFR. 26 CFR 1.468B-3 – Rules Applicable to the Transferor
3
Office of the Law Revision Counsel. 26 US Code 104 – Compensation for Injuries or Sickness
4
Office of the Law Revision Counsel. 26 US Code 62 – Adjusted Gross Income Defined
5
Internal Revenue Service. About Form SS-4, Application for Employer Identification Number
6
Internal Revenue Service. Instructions for Form 1120-SF
7
eCFR. 26 CFR 1.6045-5 – Information Reporting on Payments to Attorneys