Tax reporting requirement causes confusion.

A recent change in federal tax law that imposes new reporting requirements on payments to attorneys is being widely misinterpreted by those required to issue the reports. These are generally business defendants and insurance companies.

ATLA opposed this new requirement, and ATLA's Public Affairs Department is working to get Treasury and IRS action to clarify it. Clarification is expected to be forthcoming shortly.

The Budget Reconciliation Bill, H.R. 2014, which Congress passed in August 1997, includes a provision ([sections] 1021) that requires greater disclosure by business defendants of fees paid to contingent-fee attorneys. The provision amends [sections] 6045 of the Income Tax Code concerning tax returns for brokers.

Previously, businesses had to report attorney fees only if they knew their exact amount. In most instances, that meant payments to their own attorneys or payments to opponents' lawyers by agreement or court order.

However, under the new law, business defendants must also disclose payments to attorneys for the grass amount of a recovery. Thus, when a business defendant writes a check to the plaintiffs attorney or to the attorney as co-payee in settlement of a claim, the defendant must issue an IRS form 1099 to the IRS listing the attorney's taxpayer identification number (TIN) and the total amount paid to the plaintiff.

Gross settlements

The 1099 form used for gross settlements is like the 1099 return made by a broker when a client sells a block of stock. The gross proceeds from the sale are reflected, even though there may be little or no net proceeds when the stock's cost basis is taken into account. The taxpayer must document the actual amount of gain or loss on his or her tax return. The IRS treats the amount on the 1099 as gross income to the taxpayer, not net income.

Similarly, under the new requirement, IRS coding of the 1099 return for attorney fees will not treat the total amount as net income received, but rather will take into account that most of the payment may be passed on to the client or paid out as expenses.

Unfortunately, several insurance companies have misinterpreted this new requirement. Farmers Insurance, for example, was reported to be demanding to know the amount of the attorney fees, and some insurers even requested a copy of the contract between the attorney and client. Attorneys are concerned that the new law might require them to turn over private fee information to an opposing party.

Unwarranted demands

These demands for information are unwarranted. Sources from Capitol Hill, the Treasury Department and the IRS are mystified at any interpretation of the new law suggesting that attorney fees have to be disclosed to the opposing party. The law is clear that the 1099 return only requires the defendant to report the gross amount of a settlement.

However, attorneys are required to submit their TIN to the insurance company or other business defendant to allow the IRS to properly record the 1099. A lawyer's failure to submit the TIN triggers a penalty of $50 per incident and, more important, triggers backup with-holding of some 31 percent of the gross amount.

The law also clearly states that the reporting requirement only applies to a settlement "payment to an attorney," either directly or as a co-recipient. A check made out only to the client would not be subject to disclosure under this provision.

Of course, many attorneys want the security of being a co-payee, rather than having the settlement drawn to the client alone.

While the new provision does not impose any additional accounting or reporting duties on plaintiff attorneys, their tax advisers may suggest new accounting procedures. ATLA suggests that attorneys check with their advisers.

Reporting client income

Unlike [sections] 1021 of last year's budget bill, a law enacted in 1996 does add reporting requirements for attorneys.

The Small Business Job Protection Act requires taxing as income compensation for claims originating in nonphysical injuries, such as damages in employment discrimination or sexual harassment cases. The act also requires taxing all punitive damages, regardless of the origin of the claim.

Attorneys are covered by the same reporting requirements as other businesses, so they must complete a return on amounts their clients receive in settlement of claims when they are subject to these taxes.

Attorneys should check with their tax advisers regarding compliance with this requirement. Legislation that would significantly roll back the impact of this tax on plaintiffs, and thus the reporting requirement, is pending in Congress. (New hope on nonphysical injury taxes, TRIAL, Jan. 1998, at 11.)

The reporting issue is likely to continue to cause headaches for lawyers until the IRS issues guidelines, and ATLA is working to ensure that guidelines are issued quickly.

Further information on both these issues is available through ATLA's fax-on-demand service. Call [phone] or [phone] and request document No. 2017.

Philip Buchan is an associated director of ATLA Public Affairs.