New reporting requirements on payments made to attorneys leave practitioners wondering why.
Pre-[sections] 6045(f) Reporting Requirements for Payments to Attorneys
The reporting of payments made in the ordinary course of business has historically been controlled by [sections] 6041. Reporting is required in situations in which a person makes a payment in the course of his or her trade or business to another person, of rent, salaries, compensations, remunerations, attorneys' fees, etc., or other forms of income in excess of $600.(3) There were only three instances in which payments to attorneys could be excepted from reporting. The first exception was where the payor could not determine how much of a payment was for the plaintiff and how much was for attorneys' fees. In such instances, the common trend was, "when in doubt, don't report." The second exception was for payments that were made to attorneys who were part of a professional corporation. The third exception was for nonbusiness payments made by an individual for personal matters such as divorce or a nonbusiness lawsuit settlement paid by an individual on his own behalf. Currently, this third category of payments is still exempt from reporting.
There has never been any formal reporting, requirements for disbursements to the client of funds from the attorney-maintained trust account. Typically, the right to recover a judgment or settlement lies within the party to a suit, rather than an attorney. Thus, where a party receives a judgment which includes attorneys' fees, the fees are treated as if paid directly to the prevailing party and then followed by payment by that party to his or her attorney. Even though an attorney is not required to report disbursements made to a client, the rules of professional conduct require that an attorney should be able to provide an accurate accounting for any client-held funds.(4)
Current Law [sections] 6045(f) -- Return Requirement for Payments to Attorneys
Section 1021 of the Taxpayer Relief Act of 1997 enacted the new IRC provision [sections] 6045(f).(5) Section 6045(f) became effective for payments made after December 31, 1997. The first information reports were required to be filed with the IRS by February 28, 1999, for payments made in 1998. The provision requires reporting of payments made to attorneys within the course of a taxpayer's trade or business. The statute requires that the payment be made for legal services. However, the statute is silent as to what legal services encompass. If a taxpayer has to report under IRC [sections] 6041 or [sections] 6051, no additional reporting is required under [sections] 6045(f). This new requirement imposed by Congress was met with apprehension as to whether this measure was actually needed and exactly what this statute requires.(6)
The Proposed Regulations
In May of 1999, the IRS issued proposed regulations in an effort to provide more guidance for taxpayers, tax practitioners, and IRS employees. Katherine Jacob Kiss, who is a senior attorney advisor in the IRS income tax and accounting branch within the Office of Assistant Chief Counsel at the IRS and also the author of the proposed regulations, explains:
For a proposed regulation, it is enacted in proposed format. So, it is our public announcement of what we think a reasonable interpretation of the statute is. In the absence of final regulations, it is incumbent on all taxpayers to comply with the statute in a reasonable fashion. So, if I was a taxpayer who had a recording obligation, I would look to the proposed regulations as a safe harbor.
The proposed regulations require:
* Any payments made to an attorney within the course of one's trade or business must be reported on a Form 1099-MISC, box 13, with an "A" next to the amount.
* The attorney must provide his or her Taxpayer Identification Number, which does not have to be certified, to avoid backup withholding by the payor of 31 percent.
* If a check is delivered to an attorney who is not a payee, that payment must be reported if it is reasonable to believe the attorney is receiving it in connection with legal services.
* If an attorney is listed on a check for a judgment or settlement, that payment to the attorney must be reported regardless of whether the check is delivered to the attorney or nonattorney. If there is more than one attorney listed, the information must be reported for the first attorney listed. The first attorney must in turn file information returns for payments the attorney makes to any other attorney listed.
* Payments to a professional corporation engaged in providing legal services are no longer excepted from reporting.
Attorney--"person engaged in the practice of law, whether as a sole proprietor, partnership, corporation, or joint venture."
Legal services--"all services performed by, or under the supervision of, an attorney."
* The Regulations impose penalties from as little as $50 per violation to criminal sanctions.
Reaction to [sections] 6045(f) and the Proposed Regulations
[sections] 6045(f). A main concern that commentators have about [sections] 6045(f) is that it will almost assuredly trigger IRS audits of the attorneys receiving payments. The concern is that attorneys are going to be receiving Forms 1099 for very large amounts, of which only a portion is actually attorneys' fees. Because there is no derivative requirement for the attorney upon disbursement of the funds to the client, these amounts on these Forms 1099 will inevitably be different from the amount reported as income by the attorney. The attorneys will be saddled with the requirement of explaining in all federal and state income tax returns the reasons for these differences. The plaintiff also could run into this problem when the payor of a damage award sends an information return to the plaintiff and attorney, each reporting the total gross amount of the damage award.(7) Commentators believed both parties would have to report the income to avoid the "matching process" by IRS computers where filed tax returns are compared against reported Forms 1099. Any discrepancies would send up red flags which likely would result in IRS audits.
Kiss believes this concern by commentators is unfounded, and said, "I am 100 percent confident that my colleagues at the IRS are very well aware of the difference between gross proceeds and income." She points out that there is no corresponding line on a Form 1040 to match with amounts reported in box 13 of a Form 1099-MISC. Neither Form 1040 nor any other of the myriad tax reporting forms have been amended to require the reporting of gross proceeds that have been reported to a taxpayer. Although there is no matching process which could trigger an audit, Kiss noted that an attorney who reports an unusually small amount as income from a gross proceeds payment, i.e., 10 percent, may alert an auditor as to possible underreporting and the attorney should be ready to substantiate that claim. This possibility emphasizes an attorney's ethical duty to maintain a complete and accurate accounting of client-held funds.
Commentators also feel that [sections] 6045(f) would work to inundate businesses that pay and receive attorneys' fees in the course of their trade or business with paperwork for a minimal benefit.(8) The IRS is very aware of the burdens that the new regulations will impose on taxpayers. "Without rebuttal, every systems person that came and testified alerted us to the fact that all of their resources were dedicated to preparing their systems to face the Y2K hurdle," stated Kiss. In response to these concerns, the Service delayed the effective date of the Regulations for one year, until December 31, 2000. While this concession does not address the ultimate burden of complying with these regulations, Kiss pointed out that [sections] 6045(f) was not legislation sponsored by the IRS, and whatever cost/ benefit analysis that took place occurred on the Congressional level.
Proposed Regulations. The Regulations still have left many questions unanswered for the taxpayer trying to be compliant. The phrase legal services is very broadly defined as any service performed under the supervision of an attorney. The IRS and Treasury admit that the definition is broad, but do not give any guidance on the issue.(9) Kiss stated that the IRS has received many comments on how to narrow the definition of legal services, but the possibility of it being changed is remote. The vagueness behind this definition is a huge problem of the Regulations.
As illustrated in the Regulations, the definition seems to require that the attorney be engaged in the practice of law. "If you are engaged in the practice of law, and the services are performed by or under your supervision, then you fall within the statute," believes Kiss. Also, every example in the Regulations revolves around payments concerning a lawsuit. If practicing law is a requirement for [sections] 6045(f) to apply, then perhaps a large and growing area of services being provided by attorneys will be excepted from reporting, i.e., attorneys working in accounting firms. Without a more exacting and less vague definition of legal services, a taxpayer is not left with any guidelines on what type of activities Congress intended to be covered by [sections] 6045(f) and require reporting.
The Regulations also provide that a payor who reports under [sections] 6045(f) is not relieved of any other reporting requirements for that payment. This is illustrated in the proposed regulations examples: When a payment would represent wages to the client, the payor must issue a Form W-2 for the client along with a Form 1099-MISC for the attorney.(10) There is no such clear example for payments that are taxable damages, but not wages, where historically the payor did not report these payments, because it was not known how much of the payment the client would receive after attorneys' fees were deducted. It seems under the Regulations that duplicate reporting would be required in such a situation, with each party making its own adjustments on the tax returns to get to taxable income.
Another problem with the Regulations is that they do not address who the payor is for [sections] 6045(f) purposes. It has been proposed that this definition should be consistent with [sections] 6041(a) which describes the payor as the person who makes a payment in the course of its trade or business to another person of fixed or determinable income.(11) Thus, it is unclear whether a third party who makes a payment to an attorney at the direction of a principal would require this third party to file an information return. An example of such a situation is a "settlement agent" in a real estate sale who pays the fees of the buyer's and seller's attorneys. Under the old law the agent did not have to file a Form 1099 for these payments, because they were done only upon the direction of the client. The agent who is in the trade or business of making such payments would be required to report these payments to the attorneys, which would lead to a monsoon of Forms 1099 in real estate transactions. Professionals in this area disagree as to whether these "settlement agents" should report these payments.(12)
There is also a lot of confusion by the companies issuing these Forms 1099 on where to report these payments. The Regulation requires the reporting to be made on a Form 1099-MISC. Form 1099-MISC requires nonemployee compensation to be reported on line 7. If the payment is of gross proceeds in which the amount for attorneys' fees is not known, the amount goes on line 13 with an "A." The American Trial Lawyers Association has been notified by its members that many insurance companies are misreporting or reporting in the wrong box payments made to attorneys for 1998. Kiss has seen this problem also: "In the last filing season we did receive a fair amount of anecdotal evidence that some payors were taking gross proceeds and recording them in box 7 as opposed to box 13. Box 7 is matchable." Kiss suggests that attorneys receiving Forms 1099 check to make sure the amount has been recorded in the proper box.
Another problem with the Regulations is there is no threshold amount below which reporting is not required; the $600 limitation in [sections] 6041 does not apply here. However, Kiss points out that if a payor knows that an attorney's portion of a payment does not exceed $600, this could excuse the payor from the reporting requirement. If a payor knows how much of a payment is for the attorney, it is required to be put in box 7 on the Form 1099-MISC. Thus, if the payor knows the amount is less than $600, it falls within the de minimis exception of [sections] 6041, and the payor is relieved of his or her reporting requirement under [sections] 6045(f). "To my way of thinking, that is a logical interpretation of the communication between the two statutes."
Compliance with [sections] 6045(f)
A common recommendation to comply with the new law is to structure future settlements so that two separate checks, one for legal fees and costs and the other for net damages, are issued.(13) The result would be that the payor would report one check as nonemployee compensation to the attorney and the payment of damages would not be included in the payment to the attorneys. A problem with this practice is if an attorney requests opposing counsel to issue separate checks, this could affect the finalization of a settlement. A payor may be less willing to settle a case if an attorneys' fee seems disproportionate for the situation and may use this information to effect further negotiations.
Kiss points out that attorneys should not allow this new law to change their method of practicing law. An attorney should not focus on trying to avoid the receipt of these Forms 1099. She points out that this is the reason for the delivery rule which elevates the substance of a payment over its form. Attorneys who might ask a payor to not list his or her name on a check to avoid this reporting, but receive the check anyway, would still fall under this statute. Kiss pointed out, "Since this is a federal information reporting statute, we would like to have all of the attorneys in the nation receiving consistent information returns." As mentioned above, the issuance of these Forms 1099 will not cause an increase in IRS audits, so an attorney would be well advised not to concern himself with not falling under the specter of [sections] 6045(f).
Suggestions by Commentators
Commentators have come up with suggestions as alternatives to [sections] 6045 and the Regulations. One approach is to require that the gross proceeds damage award be reported only to the attorney who in turn sends an information return
to the client for the amount disbursed.(14) Filing this Form 1099 would help a lawyer to show what amount of the proceeds went to the client. A problem with this approach is that the attorneys are only the receiving agents for their clients and the responsibility to report is with the payor. This approach could raise conflict of interest problems, because the attorneys are retained exclusively for their client. When an award is arguably nontaxable, the filing of a Form 1099 could cause problems with the client.
Another recommendation is to have all judgment and settlement gross proceeds reported only to the plaintiffs. This would remedy a concern that certain taxable damages are not being reported by plaintiffs. This recommendation follows the notion that the responsibility of reporting the payment is the defendant payor's and not the attorney's. This practice would lead to a more accurate reporting of taxable damages to plaintiffs, which commentators feel is a bigger problem than the nonreporting of attorneys' fees. The problem with this approach is that the plaintiffs will not want the burden of explaining the differences of Form 1099 income from their taxable income. Plaintiffs would argue that this provision would only serve to create more professional service (i.e., accounting) fees which would serve to negate the benefit attained by the judgment or settlement.
The reporting requirements of [sections] 6045(f) are sure to create a significant amount of paperwork for companies which routinely make payments to attorneys in the normal course of business. Due to the vague wording of [sections] 6045(f) and the accompanying proposed regulations, almost every type of payment made to an attorney within the course of business will now be reportable. Under previous law, most payments made to attorneys were reportable with three exceptions. The two exceptions relating to payments of which the amount of attorneys' fees was unknown and payments made to attorneys in professional corporations have been eliminated. Attorneys who receive judgments or settlements and hold funds in escrow for their clients will now be attributed proceeds which are the property of their clients.
The practicing attorney should strive to report payments made to clients from settlements and judgments held in escrow. The attorney could structure the fees and expenses for an engagement to take into account the expenses associated with making such a reporting. The attorney might want to consult a CPA or practitioner in the field of tax law at the outset to figure out the taxability of the damages or compensation sought. However, an attorney should never volunteer to be responsible for reporting such payments, which may cause a payor to be in violation of this new law. This reporting of disbursements is solely to protect an attorney in a future audit and should not be taken to relieve the attorney or any other parties from their duties to report.
Once a judgment or settlement has been reached, the attorney should notify the client of his decision to report the disbursement made to the client, and explain to the client that the possible receipt of multiple Forms 1099 for the one payment will not affect the client's tax liability. If a lawyer files a Form 1099 for the client, the amount should be entered in box 3 of the Form 1099-MISC which is categorized as "other income" on Form 1040. Reporting the disbursements made out of client-maintained escrow accounts probably would not present much of an additional expense to attorneys since they are already ethically required to account for client-held funds.
The linchpin of this reporting requirement is that the activity performed by the attorney must be for legal services. Without a refinement and narrowing of the definition of legal services, a taxpayer will not have any guidance as to whether the activity performed for them is a "legal service." The Regulations define an attorney as a person engaged in the practice of law and legal services as activities performed under the supervision of an attorney. Thus, it can be reasonably concluded that payments made to attorneys not engaged in the practice of law would not fall under this statute. As the ABA decides whether to allow attorneys to share fees in multidisciplinary practices and whether the accountants in the big five firms are engaged in the unauthorized practice of law, what is considered the "practice of law" is an ever-evolving concept. Thus, a taxpayer who wants to be compliant with [sections] 6045(f) might want to report any payments made to attorneys, regardless of whether the attorney holds himself or herself out to be engaged in the practice of law. As the concept of the "practice of law" evolves, the reporting requirements under [sections] 6045(f) probably will evolve concurrently.
It is unclear whether Congress will heed the concerns of the legal community and repeal this legislation which does not seem to have much practical use. The time and expense that will go into complying with this new law by taxpayers most likely will outweigh the benefit to the government. If the goal is to get attorneys to report their income more accurately, this legislation does not accomplish that goal. Since the Forms 1099 will not be matched to what an attorney reports as income, these Forms 1099 do not seem to serve any purpose. While the Forms 1099 could be used as a basis for determining an attorney's income when the IRS decides to audit that attorney, they do not seem to add anything to the attorney's already existing obligation to accurately account for client-held funds. This legislation does not seem to effectuate any legitimate governmental or societal interest and should be retroactively repealed as soon as possible.
(1) See Prop. Treas. Reg. (REG-105312-98)--Reporting of Gross Proceeds Payments to Attorneys.
(2) See Letter from the American Bar Association Tax Section to William V. Roth, Jr., chair of the Committee of Finance, and Bill Archer, chair of the Committee on Ways and Means (June 25, 1998) (hereinafter ABA Opinion).
(3) See I.R.C. [sections] 6041(a) (1986). See also Treas. Reg. [sections] 1.6041-1(d)(2) (1997).
(4) MODEL RULES OF PROFESSIONAL CONDUCT Rule 1.15(a) (1995). The rule states that an attorney must: "Maintain complete records of all funds, securities, and other properties of a client coming into the possession of the member or law firm and render appropriate accounts to the client regarding them; preserve such records for a period of no less than five years after final distribution of such funds or properties; and comply with any order for amount of such records issued pursuant to the Rules of Procedure of the State Bar."
(5) See H.R. CONF. REP. No. 105-220, at 1241 (1997).
(6) See Campion, Rodolff, Van Riper & Procopio, L.L.P., Legal Fees now a taxing problem; Lawyers, Insurers fret about broad new 1099 requirement, THE LAW IN REVIEW, Vol. 2, Issue 4, Apr. 1998. See also ABA Opinion.
(7) Such a situation may arise when the award settlement comprises back wages owing the attorney's client which would be included in the employee's Form W-2.
(8) See Kevin Hume, New tax provisions could blitz lawyers with paper, THE NATIONAL LAW JOURNAL, Mar. 23, 1998, at B07. See also ABA Opinion.
(9) See Prop. Treas. Reg. 81.6045-5, 64 Fed. Reg. 27730 (1999) (Preliminary notes).
(10) See Prop. Treas. Reg. [sections] 1.6045-5(f), 64 Fed. Reg. 27730 (1999) (example 1).
(11) See Treas. Reg. [sections] 1.6041-1(a)(1)(i) (1997).
(12) See James L. Dam, New Tax Law `Nightmare' For Lawyers, 98 LWUA 173 (1998).
(13) See H.R. CONF. REP. No. 105-220, at 1243 (1997).
(14) See ABA Opinion.
Peter Blatt is an associate with the private client service group of Jones, Foster, Johnston & Stubbs, P.A., West Palm Beach. He concentrates his practice primarily in estate and gift taxation, corporate taxation, and partnership taxation. He received his accounting degree from Boston University and his J.D. and LL.M. from the University of Miami School of Law.
Stephen Taylor is an associate with Deloitte and Touche tax practice in Miami. His areas of practice include international and financial institutions taxation. Mr. Taylor graduated from Oglethorpe University with a B.B.A. in accounting and received his J.D. from the University of Florida Levin College of Law.
This column is submitted on behalf of the Tax Section, David E. Bowers, chair, and Michael D. Miller and Lester B. Law, editors.
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|Author:||Blatt, Peter; Taylor, Stephen|
|Publication:||Florida Bar Journal|
|Date:||Mar 1, 2000|
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