Another Court Case Confirms: Attorney Fees are Included in Taxable Settlement

When you pay a settlement to another party, it is common for the settlement to include a portion that you must send to the other party’s attorney, as the attorney’s fee.

When (if) you issue a 1099-MISC (box 3) to the other party, do you include the portion paid to the attorney, as well? The short answer is, yes. 

There is, of course, a long answer. Read on.

Reporting of Settlements in General

When you pay a settlement to another party — whether by court order or an out-of-court settlement — you issue a 1099-MISC (box 3) to the other party if the settlement is taxable to them. 

While this sounds complicated, the general rule is that most settlements are taxable, unless the law specifically says it’s not. And the law only gives us a few exceptions to the general rule of taxability. The exceptions are:

• Damages because of personal injuries or sickness (that is, “medical damages.”)
• Some emotional distress payments.
• Replacement of capital — such as, you pay a contractor to finish a building. They fail to complete construction, and the settlement calls for an amount of damages that represents a return of capital. 

If it’s on this list, it’s not taxable. Not taxable means not reportable. 

If it’s not on this list, it’s taxable, and thus potentially reportable on 1099-MISC (box 3). (Also, it’s “potentially” here because the dollar threshold and corporate exception to reporting would apply.)

Amount to Report

The amount to report in box 3 is simply the taxable amount to the recipient. Your author uses the word “simply,” and probably shouldn’t have. Shame on him.

The issue of “what” to report came up in a recent Tax Court case called Eiler v. Commissioner. In Eiler, the Eilers reached settlements with a number of agencies such as Equifax (among others) for violations of the Fair Credit Reporting Act (FCRA). The total settlement to the Eilers was $64,750. Of this, they received $4,700, and their attorneys got all the rest. 

Each of the places that were sued sent a 1099-MISC (box 3) to the Eilers, totaling $64,750 — the total amount of the settlements. 

Bizarrely, the law firm for the Eilers also sent a 1099-MISC (box 3) to them — showing $4,900 (unclear how it came to $4,900 instead of $4,700. In a footnote, the court also noted that it was confused here, too, but that it’s all a moot point because the whole settlement is taxable to the Eilers). 

Also not explained is why the law firm sent a 1099 in the first place — it usually would not be required to do so. See example 8 in regulation 1.6041-1(e)(5).

When the Eilers filed their tax return, they reported $4,900 — the amount shown on the 1099 from the law firm. The IRS said “wait a minute, it’s $64,750.” The case went to the Tax Court.

The court sided with the IRS.

Attorney Fees 

Tax law says attorney fees taken out of the settlement are still taxable income to the taxpayer. In this particular case, the Eilers received a settlement of $64,750. The fact that the attorneys walked away with 92.7% of the settlement is irrelevant. 

An older case — Sinyard v. Commissioner — confirmed this treatment, on the grounds that the attorneys fees represent a debt owed by the taxpayer. Under the constructive receipt of income (and another concept your author likes to talk about — beneficial ownership), the amounts paid to the attorneys out of the settlement are settling a debt between the taxpayer and the attorney. The taxpayer still owns the money, and they receive the economic benefit of having their debts to the attorney extinguished. This means, the full amount is taxable to the recipient of the settlement.

In the end, the court ruled that Mr. and Mrs. Eilers should be taxed on the full amount of the settlement. 

Odds and Ends

The Eilers tried to argue that their dispute with these credit agencies involved a violation of their civil rights. The court struck this down, too. 

This piece of the dispute involves a Plan B by the Eilers, to at least get a deduction for the attorney fees. Much of the time, under current law, attorney fees paid by individuals are not deductible at all. But if the settlement involves a violation of civil rights, the fees would be deductible in full.

Alas, the court said “no” to this dispute being a civil rights violation.

Bottom Line

The takeaway for us is, if a settlement is taxable to the recipient, you report it in full, even if the court or the settlement orders you to cut separate checks to pay the other party’s attorney fees.