Episode 39: Settlement Payments, Attorney Fees and 1099 Reporting

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Welcome to another episode of Information Return Intelligence, the fast moving weekly podcast where we talk about all things related to Form 1099 and the W9 and other things like that in the information reporting world of US taxes. My name is Jason Dinison. I've been teaching on this subject since 2012. Information Return Intelligence is sponsored every week by IOFM, the Institute of Finance and Management. This week we're going to talk about another court case that confirms how settlements are treated when you have to issue a ten ninety nine to someone in a legal settlement. Do you include attorney fees? The answer is yes, and that's the subject of today's episode. Remember not to make any final decisions based on anything you hear in this podcast or if you're watching the video version anything you see in it, always consult with paid counsel before you make final decisions. So one of the things your organization may encounter is legal settlements where you have either a court order or an out of court settlement where you're told to pay a certain amount to someone else. And sometimes those settlements will tell you to cut a check to the other party's attorney. When you issue a ten ninety nine miscellaneous box three to the party that sued you, do you include the portion paid to their attorney? Yes. That's the short answer. Now we can't stop the episode here after just like ninety seconds or two minutes. So let's break this down because there is as always a long answer. Let's start by talking about reporting of settlements in general. When you pay a settlement to another party, whether it's by court order or an out of court settlement, you'll need to issue a ten ninety nine miscellaneous box three to them, the party that's suing you, if the settlement is taxable to them. Now that sounds complicated because how on earth are you going to know whether the settlement is taxable to them? Well it's actually not that difficult, which I know is easy for me to say, but I really don't think it is, because the general rule is that settlements are taxable to the recipient unless the law specifically says the settlement isn't taxable, and the law only gives us a few exceptions to the general rule that settlements are taxable. Those exceptions are medical damages, some but not all emotional distress payments, and replacement of capital. Think of replacement of capital as someone has paid something and they're getting their money back. That's a replacement of capital. If it's not one of those things, then the settlement is taxable, and if it's taxable, it's reportable. And when we say it's reportable, it's box three of ten ninety-nine miscellaneous. And the amount to show in box three is whatever the taxable amount is to the recipient. And this came up in a July court case called Eiler vs. Commissioner. And in this case, there was this couple with the last name of Eiler that had reached a settlement with a number of agencies such as Equifax and others. It wasn't just Equifax, but it was allegations of violations of the Fair Credit Reporting Act. And in the end, places such as Equifax and several others paid a settlement to the Islers, and the total dollar amount of the settlement from all of these different agencies was sixty four thousand seven hundred and fifty dollars. Of that amount, the Islers only actually walked away with four thousand seven hundred dollars. Their attorneys got all the rest. Before we go further, let's hear a word from our sponsor, IOFM. The Institute of Finance and Management is the leading organization providing training, education, and certification programs specifically for professionals and accounts payable, procure to pay, accounts receivable, and order to cash, as well as key tax and compliance resources for global and shared services professionals, controllers, and their finance and accounting teams. IOFM is the trusted source of information in the rapidly evolving field of financial operations. Check them out at IOFM.com. And now back to the show. What happened in this case is that each of the places that were sued sent a ten ninety nine miscellaneous Box three to the ILES, totaling sixty four thousand seven hundred and fifty dollars. But when the ILers filed their tax return, they only reported the amount that they actually walked away with. They didn't report the full sixty four thousand seven hundred fifty. The IRS, of course, had a problem with that. So the IRS came calling and said hello, hello, can you hear us? We think that the four thousand and something of income that you reported is wrong because you got these ten ninety nines totaling over sixty four thousand. So we're assessing tax against you on sixty four thousand seven hundred and fifty dollars. And the case went to tax court, and the court sided with the IRS. And this may not be a very fair outcome if you're following along and thinking through this. The attorneys here walked away with ninety-two point seven percent of the settlement. Yet the Islers have to claim and pay tax on all of the settlement themselves, and as we'll talk about in just a bit, they get no deduction even for their attorney's fees. They're just hit with sixty-four thousand seven hundred and fifty dollars of income that they have to pay taxes on. And one of the citations that the court gave in this Eiler's case is to an older case called Sineard vs. Commissioner, where in that case the court ruled something similar, saying that attorney's fees represent a debt owed by the taxpayer, and under what's called constructive receipt of income, the amounts paid to the attorneys out of the settlement were settling a debt the sineard case used the term extinguishment. It was an extinguishment of debt between the taxpayer and their attorney. The taxpayer still owns the money and they receive the economic benefit of having their debts to the attorney extinguished, therefore the full amount of the settlement is taxable to the recipient. Now this gets into things here that are not exactly 1099 related, but I wanted to mention this for the sake of completeness, but also because it's interesting. The Islers also tried to argue that their dispute with these credit agencies involved a violation of their civil rights. And the reason they did that is because they were trying a plan B to at least get a deduction for their attorney's fees. Under current law, most of the time, attorney fees paid by individuals are not deductible at all. Unless it's a civil rights case. If it's a case involving a violation of civil rights, you can deduct your attorney's fees. Now, if you're listening and you're like, oh my business deducts attorney's fees, yes, businesses still can, but individuals cannot deduct attorney fees anymore. They used to, but the law changed in the Tax Cuts and Jobs Act back in 2018. And so no deduction is allowed anymore for attorney's fees unless it's a violation of civil rights. Those types of cases, attorney fees are deductible. While the court said that this dispute was not a violation of civil rights. So in the end, the Islers had to pay tax on a lot of basically phantom income. This case doesn't break any new ground on anything, but it's timely and relevant, and it gives us a good reminder if you're ever involved in legal disputes with your organization having to pay a settlement to someone else. You've got to figure out is the settlement taxable to the recipient? And if the answer is yes, then the full amount is taxable to them and reportable by you on your ten ninety-nine to them. Even if the settlement agreement directs you to send money to their attorney, it still belongs to the individual who sued you. That's a wrap on another episode of Information Return Intelligence powered by IOFM and produced by Dynason Media Ventures. You can find all of our podcasts at podcasts.