In The News

IRS Guidance on Attorney’s Fees Reporting Requirements

The IRS Office of Chief Counsel has released a memorandum on reporting requirements for attorney fees paid pursuant to settlement agreements, and the potential penalties that apply for failure to properly report [OCC Memo. 20133501F, 8-30-13; www.irs.gov/pub/irs-lafa/20133501f.pdf]

The Scenario

The employer entered into settlement agreements with former employees, which provided that the employees would waive any claims under a variety of statutes in return for specified sums. The settlement agreements resolved a variety of claims brought by employees, including claims for violations of the Age Discrimination in Employment Act, the Americans with Disabilities Act, and Title VII of the Civil Rights Act. The employer paid out a variety of payments in settling claims, including wages, tort damages, reimbursements of medical costs, and attorney’s fees. The attorney’s fees were paid directly to the employee, the employee’s attorney, or both.

During an IRS examination, it was discovered that certain settlement payments were mistakenly reported to the employees on Form 1099-MISC rather than Form W-2. Consequently, employment taxes were underwithheld.

Questions Answered

When are attorney’s fees that are paid by an employer as part of a settlement agreement with a former employee subject to employment taxes? In the absence of a specific allocation, attorneys’ fees in these settlement agreements are includable in income, and subject to employment taxes to the extent they are wages attributable to an employment-related claim. The IRS’s position is that payments constituting severance pay, back pay, and front pay are wages for employment tax purposes.

What are the information reporting requirements for attorney’s fees paid by an employer pursuant to a settlement agreement with a former employee? Information reporting requirements depend on the facts and circumstances of each case. Unless the attorney’s fees are specifically allocated in a settlement agreement, the payments made in settlement of wage-based claims are generally considered wages to be filed and furnished to the employee on Form W-2, Wage and Tax Statement. If the attorney’s fees are specifically allocated, they are generally filed and furnished to the employee on Form 1099-MISC, Miscellaneous Income. The reportable amounts always are required to be filed and furnished to the attorney on Form 1099-MISC.

What penalties can be assessed if an employer fails to comply with reporting requirements for attorney’s fees paid as part of a settlement agreement with a former employee?The employer may be subject to penalties under IRC §6721(a) and IRC §6722(a). If the employer intentionally disregarded the reporting requirements, the penalties increase under §6721(e) and §6722(e).

Example One:

  • Separate Checks to Claimant and Attorney
  • Clear Allocation

Facts: Claimant and the employer entered into a settlement agreement concerning claims against the employer under the Age Discrimination in Employment Act and similar state statutes. Claimant agreed to waive all claims in return for $500,000, payable in two lump sums of $250,000-each. The agreement also provided for $300,000-in attorney’s fees payable to Attorney 1 in two lump sums of $150,000, and $250,000-in attorney’s fees payable to Attorney 2 in two lump sums of $125,000-each. The first of each of the payments to Claimant and Attorneys 1 and 2 were paid in 2010, and the second were paid in 2011. For each tax year, the employer filed and furnished Forms 1099-MISC that reported the $250,000-payment to Claimant, the $150,000-payment to Attorney 1, and the $125,000-payments to Attorney 2. For 2010 and 2011, the employer did not include the $550,000-in attorney’s fees it paid on behalf of Claimant on the Forms 1099-MISC filed and furnished to Claimant, nor did the employer file and furnish any Forms W-2.

IRS Comment: To the extent the recovery is taxable to the claimant, the attorney’s fees totaling $275,000 for each year are includible in income and must be reported to the claimant by filing and furnishing an information return. Form 1099-MISC is the appropriate form to use when there is a clear allocation of an amount as attorney’s fees; because such a clearly allocated amount is not wages, it is not subject to employment tax. The employer must also report the portion of the settlement that was paid directly to Claimant by filing and furnishing a Form W-2 reporting $250,000-with the claimant as payee for each year. Finally, the employer must report the payments to the attorneys by filing and furnishing two Forms 1099-MISC with the two attorneys as payees for each year in the amounts of $150,000-and $125,000, respectively.

The impact of the failure to correctly report attorney’s fees paid in this situation could be significant and penalties may be applicable. Because the claim was made under the ADEA, the claimant can deduct attorney’s fees up to the amount includible in gross income as a result of the settlement. The claimant could deduct the amount of attorney’s fees, $275,000-for each year, as an above-the-line deduction pursuant to IRC §62(a)(20). If the attorney’s fees are not properly reported to the claimant, it is possible that the claimant would include only $250,000-in income each year, yet deduct some amount, potentially even the full $275,000, as attorney’s fees pursuant to §62(a)(20), effectively removing an amount exceeding the settlement recovery, and then some from his adjusted gross income.

Example Two:

  • Check to Claimant for Wage Income
  • Joint Check to Claimant and Attorney for Other Income
  • No Specific Allocation for Attorney’s Fees

Facts: Claimant and the employer entered into a settlement agreement concerning claims against the employer under Title VII. Claimant agreed to waive all claims in return for the total sum of $1,000,000. The settlement was to be paid in two checks: a check payable to Claimant for $600,000, less statutory deductions and withholdings, and a check payable jointly to Claimant and the claimant’s attorney for $400,000. The agreement provided that the employer would report the payment of $600,000-to Claimant on Form W-2 and the employer would issue Forms 1099-MISC to the claimant and the attorney with respect to the payment of $400,000. The employer filed and furnished a Form 1099-MISC that reported the $400,000-payment to Attorney but did not file or furnish an information return that reported the attorney’s fee payment to Claimant.

IRS Comment: Since there is no clear allocation for attorney’s fees, the fees are wages subject to employment tax. The employer should file and furnish a Form W-2 reporting $1,000,000-with the claimant as payee, and a Form 1099-MISC reporting the $400,000-payment with the attorney as payee. The attorney is subject to information reporting because the attorney was named as a joint payee on the check for $400,000-(see §6045(f)).
The settlement agreement itself correctly instructed the employer to report to both the claimant and attorney the amount on the check issued jointly to them, but incorrectly states that Form 1099-MISC was the appropriate form. Even so, the employer failed entirely to report the payment to the claimant. There may be an especially good argument here for the increased penalty due to intentional disregard, since the employer signed an agreement stating that it would report the joint payment to both parties.

Example Three:

  • One Check to Attorney
  • No Specific Allocation

Facts: Claimant and the employer entered into a settlement agreement concerning claims against the employer under the ADA. Claimant agreed to waive all claims in return for a lump sum of $300,000 in a check made payable to his attorney’s office. The employer issued a check for $300,000-to the order of Attorney “for [Claimant].” The employer filed and furnished a Form 1099-MISC that reported the $300,000-payment to Attorney. The employer did not file or furnish an information return that reported a payment to Claimant with respect to the settlement.

IRS Comment: Pursuant to regulation §6045-5(f), the attorney is not the payee and therefore the information reporting requirements do not apply if the attorney’s name is included on the payee line of a check as “in care of” the attorney. However, IRC §6041 and the regulations under it provide that the employer should have filed and furnished an information return that reported the full amount of the settlement as payment to the claimant. Since there was no specific allocation for attorney’s fees, the amount paid constitutes wages subject to employment tax. Thus, the employer must file and furnish Form W-2 reporting $300,000-to the claimant.

Penalties/Adjustments

When an employer fails to file and furnish a required Form 1099-MISC or files and furnishes a Form 1099-MISC reporting incorrect amounts, the only penalties or adjustments that can be asserted against the employer in these situations are the penalties under §6721 and §6722. In each of the examples here, the employer either failed to file and furnish a required information return, or filed and furnished an information return reporting incorrect amounts. Note that in some cases, the potential impact on the individual income tax reporting of the claimants is quite significant.

It may be appropriate to assert the increased penalty for intentional disregard under §6721(e) and §6722(e) in some situations. If an employer has a pattern of failing to file information returns required under §6041 that properly report attorney’s fees to claimants paid pursuant to settlement agreements, or makes no attempts to correct its failures, the increased penalties may be asserted. If it can be established that an employer failed to file correct information returns because the cost of doing so was more than the penalty under §6721(a), there may be a good case for asserting the increased penalty for intentional disregard of the reporting requirements.

If the employer continues to fail to file and furnish correct information returns for settlement payments after a penalty has been asserted under §6721(a) or §6722(a) or §6721(e) and §6722(e), the increased penalty under §6721(e) and §6722(e) for an intentional failure should definitely apply. In addition, the failure to file correct information returns likely caused some of the claimants to underreport their income for the years in which they received settlement payments.




IN THE NEWS

IRS Guidance on Attorney’s Fees Reporting Requirements

The IRS Office of Chief Counsel has released a memorandum on reporting requirements for attorney fees paid pursuant to settlement agreements, and the potential penalties that apply for failure to properly report. More››

Federal Per Diem Rates for Fiscal Year 2014

Rates remain at 2013 levels for most locations. More››

IRS Offers Penalty Relief to Form 1099-K Filers Reporting Incorrect TINs

The IRS has announced transitional penalty relief for filers reporting incorrect taxpayer identification number d information on Form 1099-K, Payment Card and Third Party Network Payments, and payee statements filed pursuant to IRC §6050W [Notice 2013-56, 9-4-13].    More››

AP Answers Is the Perfect Resource

Available both online and by telephone, AP Answers helps members get answers to their accounts payable questions by connecting them with AAPA member volunteers specializing in a wide range of accounts payable topics. More››

AP Book Guides You to a Successful AP Department

Published in conjunction with the American Accounts Payable Association (AAPA), Aspen Publishers’ AAPA Guide to Accounts Payable is your one-stop shop for everything you need to know about how to run a successful AP department. More››

Free Job Board Newsletter

In job search mode or just want to keep up to date on the latest opportunities? Sign up for the free Job Board News* brought to you in partnership with jobing.com. Visit AAPA’s Job Board page for more information.

* Please note that this is a separate opt-in email list from the American Accounts Payable Association.

Congress 2014 Education AP Guide