BEWARE OF THE 1099!
A few weeks ago, I wrote a blog on whether settlement monies constitute taxable income under the Internal Revenue Code. By happenstance, this month’s edition of the California Lawyer, (Vol. 28, No. 12, December 2008) contains an article written by Ruth N. Holzman and Terry B. Bates entitled “Tax Reporting After Settlement.”
They start with the premise that just because a dispute has settled, this does not mean everything is concluded: there are still tax reporting obligations that must be met at the beginning of the new calendar year. That is, the party who is paying out settlement funds must issue 1099 – misc. forms to plaintiff and/or counsel or suffer unexpected penalties. In filling out these forms, the paying party must allocate the monies between plaintiff and counsel. This allocation should be addressed as part of the settlement negotiations and set out in the settlement agreement, and not be raised for the first time as an after-thought and long after the settlement agreement has been signed. In certain cases, parties may want to consult a tax advisor.
To highlight the consequences of not thinking ahead, the authors provide four different examples of settlements and how they affect the paying party’s settlement obligation:
“EXAMPLE 1: Single check, joint payees. Assume the plaintiff has sued for breach of contract. The parties settle for $100,000, of which $35,000 is designated as attorneys fees. The defendant delivers a single check for the entire $100,000 sum, payable jointly to the plaintiff and plaintiff’s counsel. In such a case, the defendant must issue two 1099-MISC forms for $100,000–one for the plaintiff and one for the plaintiff’s attorney. The payor is required to issue a 1099 to each payee (Treas. Reg. §§1.6041-1(a) and (f) and §§1.6045-5(a)(1) and 1.6045-5(f), Example 1).”
“If the check is delivered to the plaintiff’s attorney but payable to the plaintiff only, no separate 1099 is required for the plaintiff’s attorney (Treas. Reg. §§1.6045-5(a)(1) and 1.6045-5(f), Example 3).”
“The penalty for failure to file a 1099 is $50 per return. Although a small amount, it can add up with multiple plaintiffs.”
“EXAMPLE 2: Separate checks. Assume the same case as in Example 1, but with a twist: The settlement is paid with two checks, one for $65,000 to the plaintiff and one for $35,000 to the plaintiff’s attorney. In this scenario, two 1099s are required, but the one issued to the plaintiff must report the entire $100,000 settlement, whereas the one issued to counsel reports only the $35,000 fee (Treas. Reg. §§1.6041-1(a) and (f)(2), Example 2; and
§§1.6045-5(a)(1) and (f), Example 3).”
“EXAMPLE 3: Single check, joint payees; damages not taxable to plaintiff. Assume the case involves $100,000 in non-taxable damages for personal physical injuries to the plaintiff, and that the settlement is paid via one check made payable jointly to the plaintiff and plaintiff’s counsel. The defendant must issue a 1099 for the entire $100,000 to plaintiff’s counsel, but does not issue a 1099 to the plaintiff (Treas. Reg. §1.6041-1(f) and
§1.6045-5(f), Example 2).”
“EXAMPLE 4: Mixed contract and tort settlement. Assume the plaintiff has filed suit for breach of an employment contract, seeking back pay and damages for emotional distress. The parties settle for $75,000 and make the following allocation: $15,000 for back pay; $30,000 for emotional distress; and $30,000 for attorneys fees. The defendant (who is the plaintiff’s former employer) issues two separate checks, one to the plaintiff for back pay and damages combined, and one to the plaintiff’s counsel for fees. Though the defendant must issue a 1099 to the plaintiff’s lawyer for the $30,000 fee payment, the defendant’s tax obligations with respect to the plaintiff are more complicated. In this example, the defendant-employer must withhold and pay federal and state income taxes and other payroll taxes on the $15,000 wages allocation. Only the balance of the wages settlement, net of all withholding, should be paid to the plaintiff, together with the $30,000 allocated for emotional distress. (The defendant-employer must also issue the plaintiff a Form W-2 for the $15,000 in wages, as well as a 1099 for the balance of the settlement amount, $60,000.) Had an uninformed defendant-employer issued the plaintiff a check for $45,000 and provided the plaintiff with a 1099 for the entire $75,000 settlement, the defendant would risk exposure to stiff penalties for failure to withhold taxes from wages paid.”
These examples poignantly demonstrate that not thinking ahead can have unintended tax consequences. That settlement that you just obtained can suddenly vanish into the coffers of the U.S. Treasury.
So, while everyone is always happy about settling, don’t let the happiness turn into anger at the IRS. . . .
. . . Just something to think about.
