Avoiding substantial penalties by properly reporting damage awards and settlements.

• Author: Kaminski, Stan

Nowadays, every mid- to large-size business and government agency has encountered the problem of paying out damage awards or settlements to third parties as a result of claimed contract violations, torts and other actions, as well as amounts paid to employees for alleged labor law, civil rights and other violations. Such payments may take the form of court-ordered judgments, administrative agency orders or settlements between the parties. Damage payments may be made directly to the injured party or to his or her attorney. In addition, separate attorneys' fees may be awarded or agreed to be paid by the business or government agency. As a result, whenever an award or settlement amount must be paid, proper Federal tax reporting is required to avoid potentially substantial tax penalties. The proper Federal tax reporting of awards and settlements can be broken down into four steps.

Determine Taxability

The first step is to determine the part of the award or settlement that is taxable. Depending on the type, all or part of the amount paid may be taxable. In some cases, only part of the award may be reportable as taxable. Likewise, attorneys' fees paid to an injured party's attorney may also be reportable as taxable income to the injured party. In this regard, the Supreme Court, in Banks, II, 125 SCt 826 (2005), held that fees paid to an injured party's attorneys under a contingent-fee arrangement are taxable income to the injured party.

Which Form to Use?

The second step is to determine the proper form to use 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 would need to be filed and given to the employee for the taxable amount of such compensation. On the other hand, nonemployees would receive Form 1099-MISC, Miscellaneous Income, for such amounts. 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 would 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. Note: After the...