Avoiding Penalties When Reporting Damage Awards and Settlements

Four steps CPAs can take.

any businesses and government agencies have paid out damage awards or settlements to third parties for various violations. Whenever an award or settlement must be paid, proper federal tax reporting is required to avoid potentially substantial tax penalties. CPAs should be familiar with the four steps of such reporting, to properly advise clients.

Depending on the type of award, all or part of the amount paid may be taxable. So the first step is to determine the part of the award or settlement that is taxable. Likewise, attorneys’ fees paid to an injured party’s attorney also may be reportable as taxable income to the injured party. That was the case in Banks, II, 125 SCt 826 (2005), when the Supreme Court held that the contingent attorneys’ fees were taxable to the injured party.

Next, the proper form must be used to report the taxable amount paid. Generally, if the person receiving the funds is a past or present employee, and the payment is for past, present or future wages or other employment compensation, form W-2 must be filed and given to the employee for the taxable amount of such compensation. On the other hand, nonemployees receive form 1099-MISC (miscellaneous income). Payments for nonwage or noncompensation amounts would always be reported on form 1099-MISC, even for employees. If interest is paid on an award, it should be reported on a separate form 1099-MISC. Similarly, the payment of attorneys’ fees related to taxable awards or settlements must be reported on form 1099-MISC to the injured party. Certain includible attorneys’ fees and costs may be deductible; see IRC section 62(a)(20).

The third step is to determine whether the attorney or law firm receiving part of the award or settlement should be issued form 1099-MISC. Under proposed regulations section 1.6045-5(a), an attorney or law firm that receives any part of a settlement or award must receive form 1099-MISC from the payer. The amount reported on that form is the gross amount paid to the attorney or law firm. If the attorney’s or law firm’s name is on the settlement check as well as on a separate fee check, both amounts should be reported on form 1099-MISC to the attorney or law firm. If the attorney’s or law firm’s name appears only on a separate check for its fee, that amount alone would appear on form 1099-MISC.

The last step is to determine whether it’s necessary to withhold taxes. Withholding for wage compensation is generally required, while backup withholding for other amounts paid may or may not be required, depending on the circumstances. The failure to properly determine and report the taxable amounts of awards or settlements can result in severe penalties to the payer and liability for taxes not withheld.

For more information, see Tax Clinic, “Avoiding Substantial Penalties by Properly Reporting Damage Awards and Settlements,” by Stan Kaminski, JD, in the August 2006 issue of The Tax Adviser.

—Lesli S. Laffie, editor
The Tax Adviser

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