Tricks and Traps for Lawyers With Irs Form 1099

• Jurisdiction: United States,Federal
• Author: Robert W. Wood
• Citation: Vol. 2021 No. 1
• Publication year: 2021

Tricks and Traps For Lawyers With IRS Form 1099

Robert W. Wood¹

Robert W. Wood practices law with Wood LLP (www. WoodLLP.com) and is the author of Taxation of Damage Awards and Settlement Payments and other books available at www.TaxInstitute.com. This discussion is not intended as legal advice.

Lawyers and clients should care about IRS Forms 1099. They are used by payers and payees to report payments outside the employment relationship,² and allow computer matching of Social Security numbers and dollar amounts paid and received, so that IRS collection efforts can be streamlined and automated. In most cases, Forms 1099 report payments that qualify as income of one type or another and affect the amount (and, in some cases, the type) of taxes you pay. There is an exception to that general rule, however, that is important to both lawyers and their clients: a Form 1099 can report gross proceeds to lawyers, which may reflect payments that do not constitute income to either the attorney or their client³—but it is a category that a surprising number of lawyers may not understand.

If you receive a Form 1099 in the mail, open it and check the numbers. Errors in reporting do occur, of course, so if you believe a Form 1099 is wrong, you may be able to get the issuer to correct or undo it. But that is usually tough unless it is demonstrably an error. If you cannot get it corrected, you will likely be required to report the entire amount on your tax return, and will have to explain the error there.

For example, suppose you receive a Form 1099 on which a company reports that it made a payment to you of $100,000, but you can prove that the company actually paid you only $10,000. You hope the company would correct that kind of error. If you cannot get the company to correct it, however, you have no option other than to report the $100,000 on your tax return for the year and explain that you actually received only $10,000.

Unfortunately, in the author's experience, most "please fix my Form 1099" requests fall on deaf ears. That may be because the issuer of the form believes it issued the form correctly. And, it must be admitted, many Form 1099 reporting issues that seem like errors really are not. Suppose you are a plaintiff who receives a $100,000 legal settlement, from which your lawyer collects a 40% contingent fee of $40,000, leaving you with a net amount of $60,000. Even if the defendant paid your lawyer their $40,000 directly and you never received more than your $60,000 share, you—the client—will usually receive a Form 1099 for the full $100,000.

This result is the consequence of the Supreme Court's decision in the 2005 case Commissioner v. Banks.⁴Under Banks, plaintiffs are treated for tax purposes as receiving the entire gross legal recovery, including the portion paid to or retained by their attorneys for their contingent fees. Thus, under Banks, the hypothetical plaintiff in the preceding paragraph is treated as receiving the entire $100,000 gross recovery for tax purposes, and then as paying their attorneys the $40,000 contingent fee. Defendants' Form 1099 reporting obligations follow the Banks decision, and generally require the defendant to report the entire gross recovery, including the portion retained by their attorneys as contingent fees, as paid to the plaintiff.⁵

Failing to report a Form 1099 on your tax return (or at least explain it) is not an option: The payment will have been reported to the IRS by the payor, and the IRS, when it fails to see the form reported on your tax return, may send you a notice inquiring about the discrepancy. Thus, if you receive a Form 1099, report it, even if you claim that the money should be tax-free; report it even if some of it really went to your lawyer and you are entitled to a tax deduction for legal fees.

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Ideally, both a plaintiff and their lawyer should think about how any payments will be reported concurrently with the negotiation of any settlement. Arguing after the fact that the defendant should have issued two Forms 1099—one to plaintiff and one to lawyer—is nearly always a waste of time: the only time you have any bargaining power to control how Forms 1099 will be issued in respect of a settlement is before the settlement agreement is signed. In some cases, a defendant might be persuaded to completely avoid a Form 1099, as would be appropriate with respect to that portion of a settlement fairly attributable to physical injuries, physical sickness, and related emotional distress.⁶

Forms and Boxes on Forms

Generalized knowledge of, and worry about, Forms 1099 may cause some clients, as well as some lawyers, to prefer separate checks: one for the funds paid to the client and one for funds paid to the attorney directly. That way the attorney receives a Form 1099 for only the attorney fees (and not also for the client's money). And the client may think they can sidestep tax on the legal fees that way. But things are not that simple. Attorneys and their clients should consider the realities, and the different boxes on a Form 1099, before deciding how they would like settlement payments to be recorded.

There are different Forms 1099—and different boxes on a Form 1099—that signal different things to the IRS, and it is not the case that one Form 1099, or one box on a Form 1099, is as good as another. You should understand what the different form and boxes mean, and may want to make it...