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Tax Reporting After Settlement

By Usman Baporia | Dec. 2, 2008

Expert Advice

Dec. 2, 2008

Tax Reporting After Settlement

The case is over. As in 95 percent of all litigation, this dispute settled. But your job as defendant's counsel isn't over. After you deliver the check to the plaintiff (or plaintiff's counsel), there's more to do. Parties who pay settlements also must comply with tax-reporting obligations at the beginning of the following calendar year. Failure to do so may expose the payor to unexpected penalties.

To avoid surprises, the parties should address tax-reporting requirements in the settlement documents. For their part, defendants seldom consider allocation issues beyond whether the settlement itself is deductible. Yet an allocation might be required in order for the defendant to comply with tax-reporting obligations. You should closely examine the applicable tax-reporting requirements before finalizing the settlement agreement and, in appropriate cases, consult a tax advisor.

The following examples illustrate the defendant's tax-reporting obligations in some common settlement scenarios.

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, ne 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.

As you can see, tax-reporting obligations will vary from case to case. The key is to be aware of them from the outset. A settlement agreement should clearly state any allocation between wages, contract damages, tort damages, and attorneys fees--as well as to whom those amounts will be paid and how they will be reported for tax purposes.

And if you are a general practitioner drafting a settlement document, think about consulting a tax professional before you click on the Print icon.

Ruth N. Holzman and Terry B. Bates are partners with Reed Smith, in Century City and Los Angeles, respectively. Holzman specializes in tax matters, and Bates in commercial litigation.


Usman Baporia

Daily Journal Staff Writer

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