Avoiding substantial penalties by properly reporting damage awards and settlements.

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 American Jobs Creation Act of 2004, a taxpayer receiving reportable income in the form of attorneys' fees and costs can now deduct (in computing adjusted gross income) such fees and costs when paid in connection with an action involving a claim of unlawful discrimination brought under various Federal and state statutes; see Sec. 62(a)(20).

Who Gets a Form?

The third step is to determine whether the attorney or law firm receiving part of the award or settlement should be issued Form 1099-MISC. Under Prop. Regs. Sec. 1.6045-5(a), the attorney or law firm who receives any part of the settlement or award must receive Form 1099-MISC from the payer. The amount reported on that form is the gross amount paid to the attorney or law firm. If the attorney's or law firm's name is on the settlement check as well as on a separate attorneys' fees check, both amounts should be reported on Form 1099-MISC to the attorney or law firm. If the attorney's or law firm's name is only on a separate check for its fees, only that amount would appear on Form 1099-MISC.

Withholding

The last step is to determine whether and how much tax withholding is required. Withholding for wage compensation is generally required, while backup withholding for other amounts paid may be required, depending on the circumstances.

The failure to properly determine and report the taxable amounts of awards or settlements can result in severe penalties to the payer. While the mere failure to file a Form W-2 or Form 1099-MISC triggers a mere $50 penalty per form under Sec. 6721, if the failure to file is due to intentional disregard, the penalty could be up to 10% of the amount that should have been reported. Moreover, a business or government body that fails to withhold taxes on such taxable amounts paid could be liable for the taxes not withheld.

FROM STAN KAMINSKI, J.D., DUANE MORRIS LLP, CHICAGO, IL (NOT AFFILIATED WITH BAKER TILLY INTERNATIONAL)