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.
HOW MUCH IS TAXABLE?
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.
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