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Taxation and Reporting of Settlements In Light Of Section 6045(f), |
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By Stephanie A. Spanhel
I. Introduction Internal Revenue
Code reporting requirements for payments arising from litigation are implicated every time such a payment changes hands. With the enactment of Internal Revenue Code section 6045(f) in 1997 and subsequent release
of its proposed regulations, parties making payments to both litigants and their attorneys are within the scope of new reporting requirements. Many payments, which previously were not required to be
reported, now are, or now are reportable with regard to different parties. The taxability of settlements is discussed in This article discusses reporting requirements for payments made to
non-attorneys. Even though section 6045(f) imposes new requirements for payments to litigants and their attorneys, this section merely overlaps, and does not change, the old reporting requirements. Further,
in circumstances where section 6045(f) does not apply or can be avoided, the old reporting rules are very much in effect. This article then explains section 6045(f) and its proposed regulations.
Public comments have been overwhelmingly critical of the proposed regulations, and raise many valid concerns. This article suggests several potential ways to avoid the new reporting requirements. II. Reporting Requirements For Payors of Settlements Whether or not a
payor will have to file an information return with respect to a settlement payment depends on the identity and status of the payee and whether the payment is fixed or determinable. If the payee is not an attorney,
the payor must file an information return under section 6041(a) if the amount of the payment is fixed or determinable, or under section 6051(a) if the payment constitutes wages and the payor has paid the payee wages to
which section 6051(a) applies in the current year. If the payee is an attorney, the payment must be reported under section 6045(f) even if the payment is not fixed or determinable. If the payment to a payee
attorney is fixed or determinable, it must instead be reported under section 6041(a). Thus section 6045(f) overlaps reporting requirements applicable to non-attorney payees, requiring information return for
previously unreportable payments. A. Payments from Attorneys to Clients Attorneys generally do not have to file information returns for funds received on account of
settlements or judgments on behalf of their clients. This is because the payee-client's attorney is not considered the payor of the funds. For example, if a plaintiff's attorney negotiates a total settlement
of $100,000 for his client, and then remits $40,000 to the client representing the client's award less attorney's fees and costs, no information return must be filed for that $40,000 payment. Private Letter Ruling
86-07-086 states: |
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Although the Law Firm may forward all or a portion of the settlement proceeds to the client by use of a check drawn on the Law Firm's account, the actual payer is the party paying the claim or satisfying the judgment. . . . In connection with its negotiation of settlement checks and payment of funds to its clients in settlement of the clients' claims against adverse parties, the Law Firm is not making payment in the course of such trade or business to another person and has no reporting responsibilities under section 6041(a) or withholding responsibilities under section 3406 for such payments. |
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However, if an attorney makes payments from the settlement amount to third parties, the attorney may have to report those payments under section 6041(a). In these instances, the Service utilizes the "oversight" test of Revenue Ruling 93-70. The "middleman" attorney must file an information return if the attorney exercises significant oversight or management functions in connection with the funds. In Technical Advice Memorandum 97-44-002 the Service imposed reporting
requirements on a personal injury attorney working under a contingent fee agreement. The fee agreement specified that costs, including payments to private investigators and expert witnesses, would be deducted from the
client's gross recovery and paid to these third parties by the attorney. Reasoning that the attorney selected, hired, negotiated with, and oversaw the private investigators and expert witnesses, the Service
concluded that the attorney performed oversight and management functions sufficient to invoke a reporting requirement. In Chief Counsel Advisory 199-92-8029 the Service considered similar payments to
medical providers. The Service concluded that: |
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[A]n attorney is subject to the information reporting requirements of section 6041 if he or she exercises significant oversight and management functions over payments to cover a client's medical bills from a settlement award. However, if the attorney does not exercise significant management and control functions over the payment, then the attorney is not subject to the section 6041 requirements with respect to that payment. Whether an attorney exercises significant oversight and management functions with respect to such a payment is based on all the facts and circumstances (e.g., the amount of discretion the attorney has in determining whether a service provider's claim is just and bona fide and in determining whether to deny or pay that claim). |
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In summary, attorneys need not file information returns when they remit funds received on account of settlement or judgment on behalf of their clients. However, if they exercise significant oversight or management functions over third parties whose claims are paid by the attorney on behalf of the client, the attorney is considered a payor and must follow the rules of section 6041. B. Payments to Non-Attorneys
Section 6041(a) sets forth the general rule that a person who makes a payment or payments in the course of their trade of business to any person totaling $600
or more in any taxable year must file an informational return. In the settlement context, section 6041 only requires reporting when the payment is taxable to the recipient. Section 6041(a) applies to
payments of "fixed or determinable gains, profits, and income." Thus, when determining if section 6041 requires reporting of a settlement payment, relevant inquiries are (1) the nature of the claim(s)
being settled; and (2) whether an agency relationship exists. 1. Nature of the Claim Whether a payment must be reported under section 6041 depends
on whether the payment is fixed or determinable and whether or not the payor must include the payment in his gross income. To be subject to required reporting, a payment must be fixed or determinable.
Payments must be reported when they constitute income to the recipient (i.e. wages must always be reported). When the payor does not know whether the payment is taxable to the recipient, reporting is usually not
required. When payments are made to corporations, they generally need not be reported under section 6041.
a. Fixed or Determinable Payments that are not wages but are "fixed or determinable gains, profits, and income" must be reported under section 6041(a) when they are taxable income to the recipient. Regulation 1.6041-1 provides that: |
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Income is fixed when it is to be paid in amounts definitely predetermined. Income is determinable whenever there is a basis of calculation by which the amount to be paid may be ascertained. The income need not be paid annually or at regular intervals. The fact that payments may be increased or decreased in accordance with the happening of an event does not for the purposes of this section make the payments any the less determinable. |
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Thus, a payment to a client who clearly owns all of the payment will be both fixed and determinable. When a payment belongs to both attorney and client, the payment is not fixed or determinable. For example, if an attorney makes a $100,000 payment knowing all of the payment belongs to a client, that amount is fixed because it is known, and determinable because it all belongs to the client. If an attorney makes a $100,000 payment knowing 40% of the payment belongs to an attorney and 60% of the payment belongs to a client, the amount is fixed because it is known, and determinable because the payor can calculate what portion belongs to which underlying owner. Section 6041(a) specifically includes
"wages" in its illustrative list of fixed or determinable gains within its ambit. The Service has interpreted "wages" broadly, reading the term to mean all payments (whether or not in cash) for
services performed by an employee for an employer. Unless a specific exception applies, even payments to former employees may constitute wages. If a settlement payment constitutes wages to a payee-employee, and
that employee has received wages in the current year to which section 6051(a) applies, reporting of the settlement is required. In this case, the payor-employer may elect to lump all payments together in one
informational return, or issue separate information returns for ordinary wages and the settlement payment. While the fact that a settlement payment flows from an employer to a current or former employee may
be a helpful indicator that the payment should be taxed to the employee as wages, the relationship of the parties alone is not dispositive. For example, payments for mental suffering, personal injuries, and
various contract claims do not constitute wages when they do not include payment for lost wages. Even where a payment is founded in whole or in part on lost wages, the payment may not necessarily constitute
wages. When the settlement payment aggregates multiple claims, the payment may be allocated into wage and non-wage parts. b. Taxability Unknown When the payor does not know if the settlement
payment will be income to the recipient, whether or not the payor must file an information return depends upon whether the type of payment at issue is normally taxable, what the payment is for, and to whom the
settlement funds are made payable. Revenue Ruling 80-22 sets out the general rule that reporting requirements depend on the payor's knowledge. Even if the recipient knows the payment will be fully taxable, if
the payor does not also have this knowledge, the payor does not have to report. In cases where the payor knows the payment is of a type ordinarily taxable to this type of payee, however, the payor should report
unless the payor has actual knowledge that this particular payment is not taxable to this particular payee. The payor has no affirmative duty to ascertain whether or not the payment is taxable. When payments are
for services, however, section 6041A requires reporting. Echoing the rule of section 6041(a), section 6041A(a) applies to payments made in the course of a trade or business that total $600 or more in the current
year. Section 6041A does not differentiate between fixed or determinable payments and other payments, and therefore requires reporting of payments for services regardless of other factors.
2. Agency Issues Payments to or from agents raise issues of ownership. Logically, ownership of the payment rests with the
principal, regardless of whether the agent is making or receiving the payment on his behalf. The Service delves further into the agency relationship, however, and the scope of the agency will control the payment's
reportability. a. Payments From Agents To determine whether a payment that is made by an agent on behalf of his principal must be reported, the scope of the agent's duties is the critical
factor. The Service has taken an inconsistent approach regarding the reporting of payments from agents. Under traditional agency law, when an agent makes a payment to a third party, the payment is treated as if
it were made by the principal to the third party. The Service generally adheres to this approach for agents who act simply as paying agents. Thus, if a paying agent makes a payment to a third party on behalf
of his principal, the agent may not be required to report the payment. If the agent's duties extend beyond mere payment, however, the agent may have to report. For example, in Revenue Ruling 93-70, the
Service required a bank that acted as an escrow agent for a real estate project to report payments made on behalf of the project. The payments consisted of owner-provided funds, and were payable to contractors and
subcontractors on the project. Reasoning that the bank's duties included an "oversight function," the Service ruled that the bank was required to report under section 6041 as if the bank itself were the
payor. At times, the Service has rejected the paying agent's limited role as grounds for relief from reporting. For example, when an insurance company made payments to doctors on behalf of its insured in Revenue
Ruling 70-608, the Service required the insurance company to report the payments. Ruling that it will "look to the person identified on the check or draft as the payer . . . as the one responsible for filing
information returns," the Service ignored the fact that the payments would not have been reportable if the insured had made them.
b. Payments To Agents When a payor makes a payment to an agent, both section 6041 and its regulations provide that the payor may demand to know the name and address of the actual owner of the payment. The plain language of section 6041(c) evidences Congress' intent that, when known, the payor may issue an informational return for the principal. The Service disagrees, finding the recipient's status irrelevant and section 6041(c) "rather ambiguous." Whether a payor should issue a Form 1099 for a payment made to an agent remains unclear.
c. Joint Payees
If the payor knows that one of the recipients is the actual owner of the payment, then the payor logically should treat the payment as if it were made only to that actual owner. Though the authority is sparse,
this seems to not be the case when the payment would be reportable to the agent had the payment been made only to the agent but not reportable to the principal had the payment been made directly to the principal.
For example, in Revenue Ruling 70-608, the Service ruled that joint payments made to a doctor and an insured by an insurance company should be treated as if made only to the doctor. The Service ignored the fact
that the payment belonged to the insured-principal. In dubious harmony with itself, Revenue Ruling 70-608's teaching seems to be that, so long as the payment is made in the course of the payor's business and
likely to be taxable to any payee or potential owner, then an information return must be filed by the agent regardless of the underlying ownership of the payment. C. Payments to Attorneys
Payments to attorneys and law firms have historically been a troubling area for the Service. Prior to the enactment of section 6045(f), the Service treated these payments inconsistently. Section 6045(f) clarifies reporting of some previously questionable payments, particularly with respect to payments to and from agents. However, both section 6045(f) and its proposed regulations paint with a broad brush, subjecting many payments to attorneys to reporting requirements for the first time. 1. Other Law Prior to the
enactment of section 6045(f), the service had no real test as to when a payment to an attorney had to be reported. Though no specific authority separated attorneys from other types of payees, the Service's
writings evidence discomfort at treating attorneys the same as other payees. For example, in Private Letter Ruling 88-33-029, when a check was payable to both attorney and client, the Service ruled the payor
should report the payment as made wholly to the attorney, even though the amount paid to the attorney was neither fixed nor determinable. In Private Letter Ruling 96-01-035, however, the Service found under
similar facts that the payor was not required to report the payment, reasoning that the amount of the payment which would ultimately belong to the client was not taxable, and that the amount of the payment which would
ultimately belong to the attorney was not fixed or determinable. 2. Section 6045(f) Section 6045(f) provides: |
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Return required in the case of payments to attorneys.— (1) In
general.—Any person engaged in a trade or business and making a payment (in the course of such trade or business) to which this subsection applies shall file a return under subsection (a) and a statement under
subsection (b) with respect to such payment. (2) Application of subsection.— (A) In general.—This subsection shall apply to any payment to an attorney in connection with legal
services (whether or not such services are performed for the payor). (B) Exception.—This subsection shall not apply to the portion of any payment which is required to be
reported under section 6041(a) (or would be so required but for the dollar limitation contained therein) or section 6051. |
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Thus, this section applies to all payments made to attorneys in the course of the payor's trade or business, regardless of whether the attorney is the exclusive payee, whether the amount is fixed or determinable, hether the payment to the attorney constitutes payment to a corporation, or whether the payment is $600 or more. Today, the payment found not subject to section 6041(a) in Private Letter Ruling 96-01-035 would be reportable under section 6045(f). As noted above, the Service's approach to
payments made jointly to an attorney and his client before the enactment of section 6045(f) was inconsistent. Reversing the presumption in the Service's payor-knowledge test under Revenue Ruling 80-22,
congressional history reveals that, absent the payor's actual knowledge of the amount which belongs to the attorney and the amount which belongs to the client, a joint payment to an attorney and his client should be
fully reported with respect to the attorney. Thus the new default rule is to report all payments to and received by attorneys; reporting of reduced amounts are only allowed when the payor is certain the amount
could not possibly be income to the attorney. 3. Proposed Regulations Under Section 6045(f) The Service has issued proposed regulations for section 6045(f), which
will go into effect for payments made after December 31, 2000. The proposed regulations also clarify that reporting is required for payments made to attorneys who practice in the corporate form. They also
provide that payments made in the course of the payor's trade or business to an attorney "in connection with legal services" must be reported regardless of whether or not: |
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(i) Payments to the attorney aggregate less than $600 for the calendar year; (ii) A portion of a payment is kept
by the attorney as compensation for legal services rendered; or (iii) Other information returns are required with respect to some or all of a payment under other applicable provisions of the Internal
Revenue Code and the regulations thereunder. |
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These payments must be reported on a Form 1099-Misc. The proposed
regulations continue, imposing special rules for payments made to non-payee attorneys, joint payees, and non-attorneys. Payments delivered to non-payee attorneys must be reported "if, under the circumstances,
it is reasonable for the payor to believe that the attorney is receiving the check in connection with legal services." If an attorney and a non-attorney are both listed as payees, the payor must file a report
"with respect to the first listed attorney." If two or more attorneys are listed as payees, the payor must file a report "with respect to the attorney who received the check." In this
case, the attorney who received the check must then file information returns for the other attorneys. The proposed regulations provide exceptions to section 6045(f) reporting for several types of payments
to attorneys, such as wages or compensation to the attorney from the attorney's employer, compensation or profits paid to a partner by a partnership, and dividends paid to an attorney-shareholder of a corporation that
provides legal services. These types of payments are generally subject to other reporting requirements. When a payment is reportable under section 6041(a), the proposed regulations provide that the payment
is exempted from reporting under section 6045(f). Additionally, "[p]ayments of the balance of the gross proceeds made to an attorney," if a filing is required with respect to the attorney under
section 6041(a), need not be reported under section 6045(f). Notably, the exception for section 6041(a) payments applies only to "income to an attorney of a fixed or determinable amount." Recall
that if the payment if fixed or determinable income to the attorney, section 6041 requires reporting. Thus, in the context of a settlement, the proposed regulations except from section 6045(f) reporting only that
part of a payment which is known by the payor to not belong to the attorney. This part of the payment must be reported, as required by section 6041(a) rather than section 6045(f). If the payment is not
fixed or determinable, or is not income to the attorney, the payment must be reported under section 6045(f). The theme of the proposed regulations is that any payment received by an attorney must be reported. For example, if a defendant delivers to an attorney a settlement check payable either only to the plaintiff to only to the plaintiff's attorney, the payment must be reported with respect to plaintiff's attorney. If a check is payable to both plaintiff and plaintiff's attorney, then the payment must be reported with respect to plaintiff's attorney. While section 6041(a) requires reporting of many of these types of payments, section 6045(f) overlaps section 6041(a) by requiring reporting for every previously excepted payment payable to or delivered to an attorney. Only amounts which are fixed or determinable by the payor as amounts which do not belong to the attorney are excluded from 6045(f) reporting, because these amounts are reportable under section 6041(a). An attorney's reporting burden may rise due to the tiered reporting required in section (b)(3) of the proposed regulation. Tiered reporting applies
both to checks made payable to multiple attorneys and checks delivered to one attorney where multiple attorneys are owners of the check. For example, when an attorney is the first payee on a check made payable to
multiple attorneys, the payor must report the entire payment with respect to the first payee attorney. Upon distribution of the funds to the other attorneys entitled to payment, the first payee attorney must file
information returns with respect to those other attorneys. The regulations include six simple examples. They illustrate that when a payor does not know what parts of a settlement check belong to the
attorney and client, the payment must be reported under section 6045(f) as fully made to the attorney if the attorney is a payee or the check is delivered to the non-payee attorney's office. This is so even if the
payor knows that the payment is excludable from the client's income. When the attorney's fee is a fixed or determinable amount know to the payor, the payor must report only that amount with respect to the
attorney. 4. Public Comments on the Proposed Regulations Public comments on the proposed regulations under section 6045(f) have been largely critical. Commentators have identified several deficiencies in the regulations,
focusing principally on its broad scope and lack of clarity. For example, Charles Shewbridge took issue with the regulations' tiered reporting requirement, arguing that tiered reporting would be both burdensome and
confusing. Mr. Shewbridge was also concerned that reporting based on recipient rather than payee would make automated record keeping virtually impossible. He further noted that removal of the $600 bottom
threshold may require payors with automated record keeping systems in place to perform substantial modifications to their systems. Attorney Joel Friedman, who practices in a small firm in Arizona and exclusively
represents Social Security and workers' compensation claimants, argued that the proposed regulation would have substantial adverse impact on his workers' compensation practice. Due to the large volume of clients,
the attendant large volume of settlements, and the 60-plus sources from which workers' compensation payments delivered to attorneys flow, he commented that the reporting burden on both payors and attorneys would be high.
Jude Damasco noted that the regulations are overly simplistic, focusing on single-plaintiff cases and altogether failing to contemplate payments made to multiple plaintiffs to qualified settlement funds.
Concerning the new requirements as they relate to attorneys outside of their role in litigation, Tanya Duncan, representing the Massachusetts Bankers Association, wrote that the unclear definition of "payor" in the proposed regulation would require reporting for all mortgage lending settlement transactions in which an attorney participates, regardless of whether or not the attorney has any ownership interest in the funds. Noting that in real estate transactions banks act as distributors, rather than payors, she argued that if banks were considered payors under the regulations, the practice of reporting payments to attorneys for these transactions would be "misleading and inaccurate," and additionally that the regulations could create "a tracking nightmare." Since banks are not generally equipped to issue information returns based on where a check is delivered, rather than based on the individuals named on the check, compliance with the regulations would require substantial modifications to banks' current systems. Ms. Duncan's second concern was also echoed by Jennifer Burns, a bank representative. 5. Avoiding § 6045(f)
Section 6045(f) can be avoided by making payment directly to the receiving party. For example, a payor can mail a settlement check directly to the payee, or the payee can pick up the check directly from a
defendant. If a payor knows what amount of the check belongs to the client, the payor may issuer separate checks for the client and attorney. However, direct communication with a represented party may
require the other attorney's consent. When negotiating settlement allocations, attorneys should address section 6045(f) where feasible in order to minimize reporting requirements on both sides of the "v"
in the suit. As to the tiered reporting requirements, attorneys who frequently work together can minimize their reporting burden by running balances with each other. Under the proposed regulations, an attorney must file a report with respect to another attorney "for payments the attorney makes to any other attorneys." Therefore, tiered reporting is only required when payments are actually made, rather than accrued. Attorneys who frequently work together could avoid cross payments by having certain payments made to one attorney and certain payments made to the other attorney. Though these friendly attorneys may have some reporting requirement when they square up with each other, their reporting burden will be minimized. Finally, an attorney may be able to avoid having information returns filed with respect to both himself and his client by having the payment made directly to the client and
failing to inform the payor who owns what part of the payment. So long as the payment is not "to an attorney" (meaning both attorney as payor and attorney as recipient of payment) the payor need not
issue an information return when the amount of the payment is not fixed or determinable with respect to the attorney. If the payor does not know who owns what part of the payment, then the payment should not be
determinable to either the attorney or the client. Then, the client might be able to avoid having an information return filed with respect to him for nontaxable claims. D. Procedural Requirements A payor must provide a payee with a Form 1099 by January 31 of the year following payment, and must file a Form 1099 with the Internal Revenue Service by February 28 of the year following payment. If
paper forms are filed they must be accompanied by Form 1096 (Annual Summary and Transmittal of U.S. Information Returns). If 250 or more returns are filed, the filer must use magnetic media. E. Penalties The general penalty for failure to file an informational return is $50 per
return, not to exceed $250,000 per filer per calendar year. "Failure to file" means both failures to file any report and failures to include all required information. If an information return omits
required information or contains incorrect information, the filer may reduce the penalty by remedying the failure within 30 days or prior to August 1 of the calendar year in which the failure occurred. There are
special rules for de minimis failures, small businesses, and intentional failures to file. Failing to provide a payee statement generally yields a penalty of $50 per failure, not to exceed $100,000 per person per
calendar year. If the filer can demonstrate reasonable cause of failing to file, then no penalty will be due. To escape a penalty, the filer must show that the failure to file was "due reasonable cause and
not to willful neglect." The regulations expand on this concept, requiring the filer to show reasonable cause by establishing "significant mitigating factors" or "events beyond the filer's
control." The thrust of the regulations is that the filer must have acted in a responsible manner. If a filer made reasonable attempts to comply with reporting requirements (such as consulting a
competent tax advisor), no penalty should be assessed. III. Conclusion Section 6045(f) affects every party making payment arising from litigation, and every attorney receiving payment
arising from litigation. This section and its proposed regulations shift the focus of information return requirements away from certainty as to amount and ownership of payment. Instead, section 6045(f)
requires an information return be filed with respect to every payment made to an attorney. When section 6045(f) does not require an information return with respect to a payment, section 6041(a) and other rules
still apply. |
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