James R. Hastings and Eric L. Toscano
With tax season nearly upon us, many lawyers are now asking themselves (and their CPAs) whether they have accurately reported funds received on a client’s behalf. This issue is particularly relevant to attorneys who earn their fees on a contingency basis and who withdraw fees and costs from a check made payable to the law firm in trust for the client. In this article, we hope to provide some answers.
The IRS requires taxpayers to file an information return in connection with certain transactions and may assess penalties for failure to comply with the rules. Generally speaking, information returns like Form 1099-MISC (“1099”) are necessary for payments of $600.00 or more distributed in the course of business. Internal Revenue Code (“IRC”) § 6041. The form is prepared in duplicate. One copy is filed with the IRS and the other issued to the recipient. The IRS then “matches” the payments and/or expenses from one taxpayer with receipts and/or income to another.
In addition to the $600.00 rule, anyone making a payment to an attorney in “connection with legal services,” or in the course of business must issue a 1099, regardless of whether the legal services were performed for the payor. IRC § 6045. This includes, for example, payments by attorneys to other attorneys for co-counsel, fee splitting, or referral fees. This rule also applies to client settlements paid by the defendant or the defendant’s insurer to an attorney and plaintiff jointly.
Whether the payor (here, the defendant or the defendant’s insurer) is required to issue a 1099 under these circumstances depends partly on whether the settlement proceeds are taxable or nontaxable to the claimant (here, the plaintiff).
Taxable v. Nontaxable
So what settlement proceeds are taxable? All amounts from any source are included in gross income unless a specific exception exists. For damages, the two most common exceptions are amounts paid for certain discrimination claims and amounts paid “on account of” physical injury. This covers observable bodily harm and may include emotional distress if there is a causal link to the physical injury.
Consequently, defendants issuing a settlement payment, or insurance companies issuing a settlement payment on behalf of the defendant, are required to issue a 1099 to the plaintiff unless the settlement qualifies for one of the tax exceptions. See IRC § 6041. In some cases, a tax provision in the settlement agreement characterizing the payments can result in their exclusion from income. Although tax provisions are not controlling, the IRS is generally reluctant to override the intent of the parties. Accordingly, any settlement payments made expressly for nontaxable damages are excluded from the 1099 reporting requirements.
On the other hand, if the settlement agreement is silent as to whether the damages are taxable, the IRS will look to the “intent of the payor” to characterize the payments and determine the 1099 reporting requirements.
Attorney or Client?
For taxable settlements, the defendant is required to issue a 1099 to the plaintiff under § 6041. In addition, if the proceeds are jointly payable to attorney and plaintiff, the defendant is required to issue a 1099 to attorney under § 6045 as amounts paid “in connection with legal services.” As a result, both attorney and plaintiff receive 1099s for the entire settlement amount. For nontaxable settlements jointly payable to attorney and plaintiff, the defendant is excused from issuing a 1099 to the plaintiff but will still need to issue a 1099 to the attorney for the entire amount. To avoid a situation whereby the IRS interprets the entire settlement as income to the attorney, the attorney can simply request a separate check payable to plaintiff for damages and one payable to attorney for attorney’s fees and reimbursable costs: only the amounts paid to attorney are reportable under § 6045.
All taxpayers need to issue 1099s for payments to attorneys, including payments from attorneys to other attorneys, as well as for payments under the $600.00 rule. In litigation, this is the responsibility of the defendant or the defendant’s insurance company. One way to avoid the necessity of requesting separate checks from the defendant or the defendant’s insurance company is to request a single check in the entire amount to “Attorney in trust for Client.” The attorney deposits this check into the attorney’s client trust account. Net settlement proceeds paid from the client trust account to the client are neither payments in the course of business nor payments to an attorney “in connection with legal services.” Consequently, the attorney does not need to issue a 1099 to the client when distributing these amounts.
About the authors:
James Hastings is a San Francisco tax lawyer and CPA specializing in tax planning, tax compliance, and tax controversy. His practice includes advising high net worth families; complex tax preparation services; and tax consulting with respect to business and estate transactions.
Eric L. Toscano is a San Francisco-based trial lawyer passionate about representing tenants in disputes with landlords and individuals who have been injured. He is the Managing Attorney at Toscano Law Group, where he represents tenants in disputes arising out of wrongful evictions, harassment by landlords, and substandard living conditions; individuals who have suffered personal injuries; and businesses involved in commercial disputes.