Numerous tax consequences may arise when a taxpayer receives or pays a lawsuit judgment, award, or settlement. Unfortunately, attorneys representing taxpayers are often not extensively knowledgeable in the tax consequences of their actions. Therefore, it is common for practitioners or taxpayers to support their tax positions after their pleadings and legal documents have already been executed. As soon as taxpayers and practitioners become familiar with the tax consequences of lawsuits such as income inclusion, treatment of attorney fees, and Form 1099-MISC reporting requirements then the taxpayer or practitioner would be capable of advising their legal counsel on how to structure their lawsuit and/or settlement agreements.
Gerstenbluth v. Credit Suisse Securities, 728 F.3d 139 (7th Cir. 2013)
Chester Gerstenbluth was a former employee of Credit Suisse whom was relieved of his duties as an employee as a result of his age. As a result Gerstenbluth contacted the Equal Employment Opportunity Commission and as a result of their investigation Gerstenbluth received $250,000 as a settlement from Credit Suisse. As a part of the settlement agreement Credit Suisse retained the rights to withhold applicable tax withholdings, however the settlement agreement failed to specify the recognition of the $250,000 payment in regards to federal income and employment taxes.
The following calendar year Credit Suisse issued a W-2 while including the settlement paid as a part of his wages, tips, and other compensation while withholding the Federal Insurance Contribution Act (FICA) taxes. As a part of the IRC §3101, FICA taxes are imposed on wages (all remuneration) received as a result of employment. Chester argued that the settlement should not get included as wages and thus FICA taxes should not have been withheld and defined his settlement as a payment to withdraw his complaint of age discrimination. IRS Publication 4345 also states that a settlement regarding unlawful discrimination shall get reported as Other Income on Form 1040. Even though Gerstenbluth had a great argument, the court decided that his arguments were not good enough to change how Credit Suisse reported the settlement. This leads to an important consideration for taxpayers; unless a recipient can specifically define the recognition of a settlement then the recipient is at the mercy of the payer.
Gerstenbluth continued to argue the recognition of the settlement he received and eventually ran out of arguments while the court continued to rule in favor of Credit Suisse. Gertenbluth’s scenario demonstrates the importance for taxpayers and practitioners of understanding the tax implications of settlements, judgments, and awards.
IRC §62 states that all income is taxed regardless of the source. There is one exception, income derived from personal injury has been considered as a non-income item dating back to when 1919 as a part of the 16th Amendment. IRC §104(a)(2) also explains that a legal settlement or court ruling as a result of personal injury in not taxed. Whereas punitive damages are included in gross income regardless of whether they were received as a result of physical or non-physical injury; although there are exclusions available in relation to wrongful death cases (IRC §104(c)).
Treatment of Attorney Fees
The amount of attorney fees awarded must also get included within gross income regardless of whether the attorney fees were paid directly to the lawyers (543 U.S. 426 (2005)). A deduction is allowed for legal fees and court costs associated with the taxable amount of the money received, however the deduction is as a part of Schedule A (Itemized Deductions) as a Miscellaneous Itemized Deduction subject to the 2% Gross Adjusted Income (AGI) limitation. In addition, the Miscellaneous Itemized Deductions are a tax preference item for Alternative Minimum Tax (AMT).
Form 1099-MISC Reporting Requirements
The IRC §6041(a) and IRS Letter Ruling 8841033 in conjunction with one another allows for the determination that if a payer pays out an award that is not taxable to the recipient then the payer is relieved of the responsibility of filing Form 1099-MISC. However, based on Treasury Regulation §1.6041-1(f) for those payments to another person that are taxable, the payer must include the amount that will appear in the recipient’s gross income not reduced by attorney fees on Form 1099-MISC in Box 3. Whereas payments paid to an attorney regardless of the taxability of the payment must get reported on Form 1099-MISC in Box 14 as gross proceeds.
Deduction of Legal Expenses
There are several IRC sections relative to the deductibility of attorney fees including the following:
Understanding the 1099 Series of Returns
Understanding the 1099 Series of Information Returns can present a challenging task for novice practioners due to the variety of 1099 returns; there are 17 different varieties of Form 1099. The 1099 series of returns provide an important aspect for practitioners to understand but also serves as integral resource for the IRS in collecting the necessary information to identify issues on Form 1040 and other tax returns. The accurate filing and use of information reporting via the 1099 series of returns is an important aspect for practitioners to understand. In order to better understand Form 1099, practitioners should become familiar with the importance of accuracy related to Form 1099, the general rules and due dates, penalties, and all seventeen varieties of Form 1099.
Importance of Accuracy
Information returns provide information pertaining to activities amongst the taxpayer and third parties, examples of information returns include:
The accurate filing of information returns allows for the Internal Revenue Service (IRS) to compare information received from the information returns with taxpayers’ tax returns using their document matching programs. Any mismatch of information amongst the information returns and the taxpayers’ tax returns will result in an automatic CP Notice. There are numerous CP Notices available, and the CP Notices are often misinterpreted by taxpayers as an assessment that has already been enforced by the IRS. A CP Notice in nothing more than a request to the taxpayer for additional information so that the IRS is capable of resolving the mismatch of recognized between the information return and tax return.
General Rules and Due Dates
While there are multiple variations for the type of information provided to the IRS with Form 1099, there is consistency with the general rules, due date, and potential penalties associated with Form 1099. For instance, all 1099s will contain sections that require both issuers’ and recipients’ identifying information as well as account numbers, if available.
All Form 1099s require accurate names and Taxpayer Identification Numbers (TIN) such as Social Security Numbers (SSN), Individual Taxpayer Identification Numbers (ITIN), or Employer Identification Number (EIN). If the recipient of Form 1099 is a U.S. Citizen or Resident the IRS also recommends that the issuer requests that the recipient completes Form W-9 (Request for Taxpayer Identification Number and Certification) or if the recipient is a foreign person to complete the appropriate variation of Form W-8. The issuer must incorporate significant effort in obtaining the recipients TIN for Form 1099, if the recipient fails to provide such information then the issuer must write, “Refused to Provide,” within the Recipient’s Identification Number section.
The IRS requires that all entities filing 250 or more Form 1099s to Electronic File those forms using the Filing Information Return Electronically (FIRE) system; while entities filing less than 250 are highly encouraged to also use the FIRE system. Form 4419 (Application for Filing Information Returns Electronically) must be completed at least 30 days prior to the due date of the Information Returns.
Issuers who submit their Form 1099s via paper filings must have the Form 1099s submitted prior to February 28th, while electronic filers have until March 31st of the year following the calendar or fiscal year for which the information returns are pertinent to. Issuers may receive up to a 30 day extension of time to file Form 1099s by complete Form 8809 (Application for Extension of time to File Information Returns) and no explanation or signature is required, although the form must get submitted prior to the original due day of the Form 1099.
Different due dates apply for furnishing copies of Form 1099 to the recipient depending on the type of payment being reported to the IRS. Generally Form 1099 must be provided to the recipient by January 31st of the year following the calendar or fiscal year for which the information returns are pertinent towards, however in certain instances Form 1099 is due to the recipient by February 15th. If an issuer needs an extension of time to provide Form 1099 to recipients, the issuer must send a letter to the IRS along with an explanation for the extension of time along with additional information. The letter for an extension of time must get postmarked before the due date and if approved, the extension of time is for a maximum of 30 days.
Penalties of Failing to Provide Form 1099
Internal Revenue Code §6721(a)(2) states that failure to file or provide all the required information within an information return may be subject to a penalty of $100 for each information return up to a maximum penalty of $1.5 million. These penalties may be reduced if corrective action is taken by the issuer; for instance, if the error is corrected within 30 days after the required filing date the penalty will get reduced to $30 per information return and a maximum of $250,000 (IRC §6721(b)(1)). Corrective action occurring beyond 30 days but before August 1st the penalty is reduced to $60 per return and a maximum penalty of $500,000 (IRC §6721(b)(2)). The penalties may be reduced even further if the average annual gross receipts of the most recent three years of the issuer do not exceed $5 million the maximum penalty amounts are reduced to $500,000, $75,000, and $200,000 accordingly.
These penalties are not applicable to an insignificant error or omission, specifically those errors not preventing the IRS from processing returns associated with the correlating information. However, Reg § 301.6721-1(c)(1) states that errors regarding monetary amounts, recipients’ TIN, and recipients’ names are never considered as insignificant error or omission. IRC §6724(a) does allow for any of the associated penalties to get waived by the IRS if it is proven that the error causing the penalty was a result of reasonable cause and not willful neglect.
The Types of Form 1099
Listed are the seventeen different variations of Form 1099:
Each of the listed Form 1099s has their specific purpose and filing requirements. Therefore it is important for taxpayers and practitioners to know what information returns are applicable to each unique scenario encountered. While the 1099 Series of Information Returns can present a challenging task to fully comprehend and understand, becoming familiar with the importance of accuracy related to Form 1099, the general rules and due dates, penalties, and all seventeen varieties of Form 1099 provides a great starting point to ensure that taxpayers and practitioners remain compliant with the IRS.
Adam Carr, MBA, EA