WHY TAX TREATMENT OF ATTORNEYS' FEES SHOULD BE ADDRESSED IN SETTLEMENT
AGREEMENTS
by Robert W. Wood
Virtually every litigation settlement document should include discussion
of the tax consequences the parties intend for the settlement. It helps
avoid disputes between the parties, and disputes with the Internal Revenue
Service and state taxing authorities. There have been too many cases in
which one party anticipates there will be no withholding or no IRS Form
1099, and the other party assumes to the contrary. This is only one example
of the many disputes that can arise. These disputes are painful in time,
expense and even potential and malpractice exposure.
Another reason for addressing the anticipated tax consequences of
a settlement is that it can definitely influence the Internal Revenue Service's
willingness to agree with the parties that the treatment you specified
is appropriate. Neither the IRS nor the courts are bound by tax language
in the settlement agreement, but it certainly has an effect. Indeed, the
settlement may actually disintegrate if a disagreement about tax matters
is big enough. A few cases have explicitly considered what happens when
a settlement agreement is breached purely by reason of a tax dispute.
A Breach is a Breach
In Bowden v. U.S., the Court of Appeals for the D.C. Circuit faced
just such an issue. This case involved a former immigration and naturalization
service employee who had charged the Immigration and Naturalization Service
by which he was employed with race discrimination in 1978. He settled his
claim in 1990 in exchange for a lump-sum backpay award.
Under the settlement agreement, the INS paid Mr. Bowden $190,000,
which represented $242,000 (the agreed amount of the settlement) minus
payroll tax deductions. The IRS and the Maryland Tax Department then notified
Bowden in April of 1991 that he owed additional taxes on this settlement.
He wrote to the INS several times beginning in December of 1991, asserting
that the INS had agreed to pay all taxes on the settlement. The INS, predictably,
responded that it had already paid appropriate payroll taxes and that any
further tax problems were Bowden's alone.
Bowden then filed suit in the Federal District Court in the District
of Columbia arguing that his settlement agreement with the INS had been
breached. The District Court dismissed this suit without prejudice, finding
that the suit would have to be brought within the Federal Court of Claims.
The Court also found that he had failed to exhaust administrative remedies
regarding negligence under the Federal Tort Claims Act. Then Mr. Bowden
went to Claims Court. There, the INS argued that the first two counts Bowden
asserted were outside the jurisdiction of the Claims Court. (It surely
did not endear the INS to the Claims Court that this was contradictory
to the position the INS had taken in the Federal District Court!)
The Claims Court sent the case back to Federal District Court. Once
again, the Federal District Court dismissed Bowden's suit, this time with
prejudice. The District Court found that Bowden failed to make a timely
claim of breach of the settlement agreement, that he was not entitled to
interest under the Back Pay Act, and that he failed to exhaust administrative
remedies on his tort claim.
Then the matter went to the D.C. Circuit. There, the Court found
that Bowden failed to file an administrative complaint within thirty days
of receiving the tax bills, as is required by 29 C.F.R. 1613.217(b). The
Court further found that the INS had no responsibility to notify him of
this time limit. However, the Court found that the INS did waive a defense
by responding to the merits of Bowden's complaint without requesting his
timeliness. The INS also failed to raise the defense in the first suit
before the District Court, or before the Claims Court in its contradictory
jurisdictional arguments.
According to the Court, the crux of Bowden's position was that he
and an INS official had reached an oral agreement that the INS would pay
all taxes, and this oral agreement was inadvertently omitted from the written
settlement document. The government argued that evidence of prior oral
agreements is barred by the Parol Evidence Rule, and that the written agreement
included an integration clause that voided all prior agreements.
Despite what might seem the appeal of that legal argument, the D.C.
Circuit remanded the case to the District Court for a determination of
whether the agreement was partially or fully integrated. According to the
appellate court decision, if the lower court finds that the agreement is
fully integrated, it may not consider extrinsic evidence about an alleged
oral agreement to pay taxes.
Eighth Circuit, Too
Bowden was not the only case to present such a mess. In 1995, the
Eighth Circuit decided in Sheng v. Starkey Laboratories, Inc. There, the
failure of the parties to agree on the tax treatment of a settlement in
a sex discrimination case was considered a material issue that prevented
the finding of an enforceable contract between the parties. The federal
District Court ordered enforcement of a settlement between the parties
after one of the parties balked at the deal. The Eighth Circuit reversed.
This story has its beginning in a simple employment dispute. The
underlying claim was made by Beihua Sheng, a former employee of Starkey
Laboratories who sued for sexual harassment and retaliation. Although a
settlement was reached at the $73,500 figure, there was confusion about
just what happened in the settlement conference. The respective parties
met for a settlement conference in front of a Magistrate in the U.S. District
Court for the District of Minnesota. The parties were referred to the settlement
conference by a judge who had presided over the litigation of Sheng's discrimination
claims.
After some discussion, the attorneys for Sheng and Starkey Laboratories
shook hands on the $73,500 figure. Unfortunately, the attorneys could not
agree on the tax treatment of the settlement. Not surprisingly, Sheng's
attorney asked for an assurance that Starkey Laboratories would not withhold
taxes from the proceeds. Starkey Laboratories, on the other hand, asked
for an indemnification clause that would protect the company in the event
the Internal Revenue Service thought that withholding was required. According
to Sheng's lawyer, the parties had agreed to meet again to iron out this
nettlesome tax question.
When is a Settlement a Settlement?
Later that day, the parties learned that the judge presiding over
the substantive discrimination suit had granted summary judgment to Starkey
Laboratories on December 17, 1993 (three days before the settlement conference
before the magistrate had even begun!). When this judge became aware of
the settlement on December 20, he withdrew his December 17 order which
had granted summary judgment. On December 21, he issued a new order endorsing
the settlement and dismissing the plaintiff's case without prejudice.
The plaintiff tried to enforce the alleged settlement for $73,500.
Starkey Laboratories, on the other hand, sought to reinstate the December
17 summary judgment ruling so that it could escape payment altogether.
Starkey Laboratories argued that there could not have been an enforceable
settlement either because: (1) the parties were negotiating without the
knowledge that summary judgment had already been granted; or (2) they had
failed to reach a complete agreement on material terms—because the tax
treatment of the settlement proceeds had not been addressed.
The District Court determined that the summary judgment ruling had
not "matured" into a court order before the settlement was reached. The
court also determined that the failure to agree on tax consequences did
not preclude a finding that the settlement had been reached. Indeed, the
court noted that on December 20, 1993, the IRS had issued a Revenue Ruling
(No. 93-88) ostensibly settling the question that settlement proceeds in
a post-1991 Title VII claim are not taxable. Regardless of what the parties
thought, then, the court acknowledged that the IRS would not attempt to
tax the proceeds.
Taxes Are Material
Starkey Laboratories did not give up here. On appeal to the Eighth
Circuit Court of Appeals, the defendant argued that no settlement was ever
reached because they had not agreed on the tax consequences of the settlement
payment when they became aware of the summary judgment ruling. A "mutual
mistake of fact" on the part of the parties existed, argued Starkey. The
Eighth Circuit Court of Appeals listened intently to these arguments, and
reversed the district court because the settlement was inchoate.
Applying basic contract law, the Eighth Circuit Court of Appeals
concluded that no contract exists unless the parties agree to all material
terms. What is a "material" term has to be evaluated when the contract
is being formed. Events occurring subsequent to the settlement agreement
(here, the later IRS Revenue Ruling about Title VII recoveries) could not
make terms that were material at the time a deal was being considered into
nonmaterial terms. The tax and indemnity issues, reasoned the court, were
material terms on which no agreement had been reached between the parties.
That vitiated the settlement.
The final chapter in Sheng v. Starkey Laboratories, though, came
on remand of the case to District Court. There, the District Court found
the parties had reached agreement on all essential terms of settlement.
Consequently, the court rescinded the dismissal order and reinstated the
summary judgment order in Starkey's favor. Sheng appealed!
In the Circuit Court for the second time, the Eighth Circuit agreed
with the District Court (on remand) that the settlement did not hinge on
the tax issues. Plus, the Eighth Circuit found that summary judgment motion
and the judge acting on it did not give rise to a mistake of fact that
vitiated the settlement.
Imagine all the legal fees generated by these two District Court
decisions and two appeals? All of this was after the execution of a settlement
agreement, making a rather dramatic case for considering these issues before
a settlement agreement is finally negotiated.
Address Taxes to Save Taxes
The very recent case of Wallace R. Noel, et ux. v. Commissioner,
demonstrates that even if one does not address tax consequences, and even
if one executes a general release, all is not lost. In that case, the Tax
Court held that the proceeds a businessman received from settling a dispute
with Pizza Hut, Inc. were partially excludable under Section 104. Admittedly,
this case involved the pre-August 20, 1996 version of Section 104. Plus,
the Court did hold that most of the proceeds were taxable as received in
exchange for stock. Still, on the basis of a general release, the Tax Court
did find Section 104 to apply to part of the recovery. That by itself,
in the current strict climate, seems pretty remarkable.
Wallace Noel owned several Pizza Hut restaurants as a franchisee.
In 1975, he transferred them to Pizza Management, Inc. in exchange for
11% of its stock. By the 1980s, Pizza Management had 200 franchised Pizza
Hut restaurants, and was developing plans for a public offering of stock.
Pizza Hut prevented the Pizza Management public offering, asserting that
the public offering violated the franchise agreement.
As a consequence, Pizza Management's value was adversely affected.
In addition, Mr. Noel personally suffered emotional distress, damages to
his business reputation, and setbacks in other financial ventures. In 1988,
he sued both Pizza Management and Pizza Hut, alleging that Pizza Management
breached its obligations to him, and that Pizza Hut tortiously interfered
with his contractual rights and prospective business ventures. The suit
was settled in 1990, with Noel transferring all his Pizza Management stock
to Pizza Hut in exchange for $3.2 million.
On his 1990 return, Mr. Noel treated $2 million of the proceeds as
the amount he received for his Pizza Management shares (which had a $5
per share book value). He treated the remaining $1.2 million as an amount
received in exchange for a release of claims excludable under Section 104.
Predictably, the IRS determined that no part of the $1.2 million was excludable
from income. The Service also concluded that Noel's basis in his Pizza
Management stock was $200,000 rather than the $1.5 million that he claimed.
Court Unravels It
The Tax Court noted that the settlement agreement and release did
not specify what portion of the $3.2 million in proceeds were paid to Noel
for the release of claims as opposed to the sale of the stock. As such,
the Tax Court felt that its obligation was to determine the intent of the
payor in making the payment. Despite the testimony of Pizza Hut through
its representatives that all of the proceeds represented a payment for
Mr. Noel's stock, Judge Fay found that Pizza Hut paid Noel to purchase
his stock and to settle his claims. The court emphasized that the release
was not merely a general release, and that Pizza Hut would not have purchased
Noel's stock without also getting a release. This kind of "but for" analysis
enabled the court to come the conclusion that at least some portion of
the recovery ought to relate to personal injury damages.
But what portion, that was the question. The court allocated $2.4
million of the settlement proceeds to the stock purchase, concluding that
Noel sold 400,000 shares at $6 per share. Of the remaining $880,000 in
proceeds, the court concluded that one- third (or $295,000) was paid to
Noel to settle tort claims and was therefore excludable under Section 104.
However, the remaining two-thirds of the proceeds represented nonexcludable
proceeds to settle Noel's contract claims.
Faced with a general release, the Tax Court went into a kind of nitty-gritty
analysis about just how many claims Mr. Noel had and what they were. The
court had no trouble (despite an appallingly general document) in segregating
the stock sales proceeds from the release payments. The court then further
bifurcated the release payments between the torts and excludable release
payments and the ones that were for contract claims and therefore constituted
taxable income.
Turning to Mr. Noel's basis in his Pizza Management stock, Judge
Fay agreed with the IRS that most of the adjustments to stock basis Noel
claimed were not allowable. However, the court held that Mr. Noel properly
included in basis $219,000 of the $300,000 in attorneys' fees he paid in
the Pizza Management/Pizza Hut dispute. According to the court, because
73% of the proceeds were allocated to the Pizza Management stock purchase,
that proportion of the attorneys' fees was allocable to the stock's basis.
On the remaining attorneys' fees, the portion attributable to the tort
claim was not deductible under Section 265, and could not be allocated
as basis. The remaining $54,000 that represented the settlement of the
contract claim was deductible as a miscellaneous itemized deduction.
Turning lastly to penalties, the court did not sustain the accuracy-related
penalty against Noel, finding that he reasonably relied on his accountant's
advise to exclude a portion of the settlement proceeds under Section 104.
Lessons Learned
Failing to explicitly address tax consequences can be a substantive
disaster, fomenting further litigation. Plus, it can even more readily
foul up intended tax treatment. It is perhaps a mistake to make too much
of the Wallace R. Noel case. At the same time, those of us who seem always
to be advocating using detailed settlement agreements cannot help but look
somewhat askance at the relative degree of success obtained in this case,
notwithstanding very generalized documents.
After all, although it is not necessarily a good idea to wait for
the IRS or Tax Court to try to determine the intent of the payor and just
what certain amounts ought to be allocated to, if one has a general release
or general sale agreement, perhaps there is little choice. It is still
true that the settlement document itself represents only a manifestation
of the intent of the payor and an agreement of the parties, one that is
not binding. Yet it is precisely in that document that such nitty-gritty
items as 1099s and such can be handled and specify clearly. Failing to
do so sometimes gives rise to nasty disputes (witness the "you breached
my settlement agreement" argument raised in the Bowden case above).
In any event, while Wallace R. Noel may not be a super victory for
taxpayers on the sheer numbers, in this increasingly hostile environment
to Section 104 exclusions, it is significant that despite what appears
to be any planning in the settlement agreement, Mr. Noel did achieve a
partial Section 104 exclusion in Tax Court. That leads one to question
how successful he might have been had he addressed the issue earlier on!
Attorneys' Fees
The tax treatment of attorneys' fees in contingent fee situations
is particularly onerous if the plaintiff can only deduct the attorneys'
fees as miscellaneous itemized deductions. That is the case in the overwhelming
majority of situations simply because the plaintiff's case normally does
not arise out of a trade or business. If it did, it could go on a Schedule
C and not be subject to the alternative minimum tax, nor the phase-out
of miscellaneous deductions, the 2% floor on miscellaneous itemized deductions,
etc.
Recently, the Sixth Circuit Court of Appeals reversed a district
court decision to find that an amount of attorneys' fees paid from a personal
injury judgment did not constitute taxable income to the plaintiff. As
with all cases in this area, the precise facts are truly important, something
that many commentators have (oddly) not noted about this entire area. And
that means there's still some room for planning, even if one is in one
of the "bad circuits" that has not been friendly to the taxpayer on these
issues.
The case is Estate of Arthur L. Clarks v. United States. The case
concerned Mr. Clarks who received a $5.6 million jury verdict for personal
injury damages against K-Mart way back in 1988. In 1991, K-Mart paid him
$11.3 million, which included $5.7 million in interest. Of the $11.3 million,
$3.7 million (including $1.9 million in interest) was paid directly to
Clarks' attorney under the terms of a contingent fee agreement.
Mr. Clarks died in 1992. His estate filed a 1991 income tax return,
but did not include as income any portion of the interest paid to the attorney.
The IRS determined a deficiency which the estate paid. The estate then
claimed a refund, arguing that the interest portion of the attorneys' fees
was not taxable to Clarks. After all, argued the estate, Clarks never received
that portion of the funds. The district court felt strongly about this
issue (in favor of the government) and granted the government's motion
for summary judgment.
Reasonableness on Appeal
The Sixth Circuit, however, took a longer look at the situation.
The Sixth Circuit held that the interest paid to Clarks' attorney was not
taxable income to Mr. Clarks because it was actually earned by Clarks'
attorney. Citing (you guessed it!) Cotnam v. Commissioner, the Sixth Circuit
explained that the contingent fee agreement constituted an assignment of
a portion of the judgment sought to be recovered. This transferred ownership
of a part of Clarks' claim to his attorney, said the court. Clarks released
his right to a portion of the claim, so the amount that Clarks' attorney
received with respect to that portion did not constitute income to Clarks.
(Obviously, it did constitute income to the attorney. )
Cotnam Analysis
There has been a great deal of talk in the recent case law (especially
in circuits dismissing the Cotnam authority out of hand), that this authority
is simply outdated, is peculiar to Alabama law, etc. But the Sixth Circuit
honestly attempts to take the Cotnam authority on, examining it against
other established case law. Judge Merrit of the Sixth Circuit distinguished
Cotnam from another even more famous tax case, Lucas v. Earl, and an equally
famous case, Helvering v. Horst.
In those now ancient cases, the taxpayers assigned their income to
family members. The taxpayers in Lucas and Horst were considered to have
taxable income even though they never actually received the income because
the income was already earned, vested and relatively certain to be paid
to the assignor before any assignment was made. Thus, these cases, thus,
invented the "assignment of income" doctrine.
In the Sixth Circuit in Estate of Arthur Clarks, however, the situation
was different. In Lucas v. Earl and in Helvering v. Horst, the income had
a tangible known value to the assignors, and the assignees (family members)
did not perform any services to receive the income. In contrast, Mr. Clarks
did not have a predetermined interest in any tangible funds before he entered
into the fee agreement with his attorney. Given the speculative nature
of the lawsuit, Judge Merrit reasoned, Mr. Clarks' claim simply constituted
an intangible, contingent expectancy. The only economic benefit Mr. Clarks
derived from his claim amounted to a portion of the total judgment he received
as a result of his attorney's efforts.
This discussion, of course, might be applied across the full range
of litigation. After all, is the Sixth Circuit saying that one must examine
the speculative nature of this particular lawsuit, or isn't any lawsuit
speculative in nature? That's a difficult question to judge. In virtually
any lawsuit, one can say that the only economic benefit the plaintiff expects
to receive will be derived from the efforts of his or her attorney.
Continuing to distinguish the assignment of income cases, Judge Merrit
of the Sixth Circuit also noted that, unlike the assignees in the Lucas
v. Earl and Helvering v. Horst cases, Mr. Clarks' attorney performed services
and the income was a result of the attorney's own skill and judgment. The
attorney earned the income, said the Sixth Circuit, not the plaintiff.
Conflict among Circuits
The presence of this sensible authority ought to cause naysayers
on the issue to it up and take notice. After all, recently, the authority
had not been too rosy. The Sixth Circuit in Estate of Arthur Clarks goes
through the authority, commencing with Cotnam v. Commissioner, and the
more recent cases thereafter. Cotnam, as most readers know, involved the
Fifth Circuit holding that the amount of a contingent fee paid out of the
judgment to the plaintiff's attorneys was not income to the plaintiff.
Under Alabama state law, which applied in the Cotnam case, a contingency
fee contract operates as a lien on the recovery. The Alabama Code provided
that attorneys at law will have the same right and power over suits, judgments
and decrees to enforce their liens as their clients had or may have for
the amount due. That gave the Cotnam court solid ground to say there had
been a transfer of part of the plaintiff's claim and that any recovery
on a portion of that claim (by the lawyers) was simply gross income to
the lawyer.
The Eleventh Circuit (which was made up of a portion of the Fifth
Circuit when the Fifth was split in two) followed the Cotnam result, but
without any analysis. Now, the Sixth Circuit has followed the Cotnam result,
too, but it did so by looking to the vicissitudes of state law.
In the case of Arthur Clarks, the relevant state law was Michigan
law, and the court said that the lien law there operated in more or less
the same way as the Alabama lien in Cotnam. Not surprisingly, most of the
law concerning personal property liens (and attorney liens in particular)
go back many years. Indeed, the Sixth Circuit had to cite a case dealing
with attorneys' liens going back to 1889! The court found that these hoary
cases generally supported treating the attorney as having an ownership
interest in that portion of the case.
Yet, the Sixth Circuit noted that a more recent decision by the court
of appeals for the Federal Circuit reached a contrary result. In Baylin
v. United States, the Federal Circuit did not follow Cotnam. The Baylin
court held that the contingent fee portion of the settlement from a condemnation
proceeding that was paid directly to the lawyer was still income to the
plaintiff taxpayer. The Baylin court mentioned the Supreme Court's liberal
interpretation of "gross income," and then went on to find that even though
the plaintiff never had actual possession of the funds that went to the
lawyer, the plaintiff received the benefit of those funds in that they
discharged an obligation the plaintiff owed to the lawyer. This is the
"discharge of indebtedness" theory under which some of these cases are
decided.
The Sixth Circuit in Arthur Clarks went on to analyze the Baylin
court's rule. Baylin, interestingly, relied on the two early Supreme Court
cases noted above, Lucas v. Earl, and Helvering v. Horst. As noted above,
these cases involved assignments of income by persons who had earned the
income already (but not received it physically). To make matters worse,
they "assigned" the income to family members.
Hence the "assignment of income" doctrine. After going through some
pains to recite the individualized facts of both the Lucas and Horst cases,
the Sixth Circuit said that in both of those cases each taxpayer earned
and created the right to receive and enjoy the benefit of the income before
any assignment. The income assigned to the assignee was already earned,
vested and relatively certain to be paid to the assignor.
The court in Estate of Arthur Clarks does a good job of distinguishing
both the Lucas and Horst cases, and comes back to the notion that the Cotnam
court had it right all along. After all, said the court, the majority in
the Cotnam decision correctly distinguished Lucas v. Earl, and Helvering
v. Horst. In the case of Mr. Clarks, as in Cotnam, the value of the taxpayer's
lawsuit was entirely speculative and dependent on the services of his counsel.
The claims simply amounted to an intangible, contingent expectancy.
Indeed, the only economic benefit Mr. Clarks could derive from his
claim against the defendant in state court was to use the contingent part
of it to help him collect the remainder. Like an interest in a partnership
or a joint venture, said the court, Mr. Clarks contracted for services
and assigned his lawyer a one-third interest in the "venture" in order
that he might have a chance to recover the remaining two-thirds. Just as
in the Cotnam case, said the Sixth Circuit, the assignments that Clarks'
lawyer received operated as a lien on a portion of the judgment sought
to be recovered, thus transferring ownership of that portion of the judgment
(when it eventually became a judgment) to the attorney.
How Important Is This?
The Sixth Circuit has given an enormously strong endorsement of the
Cotnam theory, and an equally strong statement about the scope of the assignment
of income doctrine and the seminal cases (Lucas and Horst) from which all
of this assignment of income phobia sprang. The assignment of income doctrine,
certainly as pronounced in the Lucas and Horst cases, involved gratuitous
transfers, and involved timing (after the income was earned) that was radically
different from virtually all of these attorneys' fee cases.
Do you think that an attorney would work on a case based on the strength
of the notion that he would receive a right to payment only once the client
determined if payment was actually going to be made? The contract between
client and lawyer is entered into at the very inception of the relationship—typically
before the lawyer is willing to do any work to develop the case. Perhaps
that is why the Sixth Circuit even mentioned the partnership theory. After
firmly putting to rest (at least in my mind) the irrelevance of the Lucas
and Horst lines of authority, and after firmly asserting the relevance
of Cotnam, the Sixth Circuit went on to close its opinion by drawing yet
another analogy.
The present transaction (Mr. Clarks' agreement to the one-third contingency
fee and the events that transpired thereafter) is more like a division
of property, said the court, than an assignment of income:
"Here, the client as assignor has transferred some of the trees
in his orchard, not merely the fruit from the trees. The lawyer has become
a tenant-in-common of the orchard owner and must cultivate and care for
and harvest the fruit of the entire tract. Here the lawyer's income is
a result of his own personal skill and judgment, not the skill or largesse
of a family member who wants to split his income to avoid taxation. The
income should be charged to the one who earned it and received it not as
under the government's theory of the case, the one who neither received
it nor earned it. The situation is no different from the transfer of a
one-third interest in real estate that is thereafter leased to a tenant."
[Citations omitted.]
Supreme Court
The fact that the Fifth, Eleventh and now Sixth Circuits have held
that a plaintiff is not taxable on the contingent fee portion of attorneys'
fees, while other circuit courts have ruled to the contrary, heightens
the conflict that already exists in the circuits. If this mess is not resolved
by statute, then maybe the Supreme Court will have to rule on the question.
And if it does so, my vote is with the Fifth, Eleventh and now Sixth Circuits.
Admittedly, though, the facts in many of these attorneys' fee cases
varies dramatically. Advisors and taxpayers alike should be alert to some
of the traps. For example, it is vitally important (for an argument to
exist that the client doesn't have the income) that the fees be "direct
paid" from the defendant to the attorney.
It is also vitally important that the contingent fee agreement specify
in strong terms when the interest in the case is assigned. And, the attorneys'
lien law in the state can be helpful. I'm not positive that the attorneys'
lien law ought to be the most relevant factor, and most attorneys are not
even familiar with how attorneys' liens are manifested (recorded, etc.).
This will continue to be a volatile area. Taxpayers and their advisors
(and certainly litigators, too) should be awfully careful. They should
obtain tax advice before the settlement is reached. They should be careful
how the payments are made. Of course, they should also be careful what
the settlement agreement specifies about who is going to get any 1099 or
W-2 forms. The forms issue (with its audit risk controls) can have an enormous
impact on the ultimate result of the case.
Reporting Attorneys' Fees
Finally, a few words about a very troubling subject, the reporting
of attorneys' fees. Both inside and outside of lawyer circles, there has
been a good deal of complaining about Internal Revenue Code Section 6045(f).
This provision was enacted as part of the inaptly named Taxpayer Relief
Act of 1997. It imposes a number of new burdens on reporting entities,
and ostensibly new burdens on recipients of attorneys' fees.
Strangely enough, Section 6045(f) was not widely noticed when it
was first enacted. Perhaps because it was enacted in 1997 but did not take
effect for payments commencing in 1998, it was not until the beginning
of 1999 — when Form 1099 reports were prepared for the 1998 tax year —
that people began to sit up and take notice about the new burdens and risks
this Code section proffered.
Proposed Regulations Issued, Then Delayed
The proposed Treasury Regulations under §6045(f) went a long
way toward making those who were not otherwise aware of the situation become
aware. Happily, they did not carry a retroactive effective date, so many
commentator groups, including the American Bar Association, the American
Institute of Certified Public Accountants, Tax Executives Institute, and
various other groups, attacked the provisions as being overbroad, under-explanatory,
and confusing in a number of respects.
Since the general reaction to a Form 1099 filing obligation on the
part of most taxpayers is to err on the side of caution (in other words,
to send a 1099 Form when in doubt), there has understandably been fear
that the complex web of this reporting obligation would be expanded even
further than these proposed regulations seek to do.
The IRS announced in Notice 99-53, that the effective date for the
proposed attorney reporting regs was delayed for one year. These regs (REG-105312-98)
are not scheduled to be effective until they are finalized, and then are
to apply to payments made after December 31, 2000. That means we all have
a bit of breathing room to attempt to convince the Service that it needs
to revise some of these rules.
Yet, the Notice 99-53 is quite clear that payments of gross proceeds
to attorneys made after December 31, 1997 are now (and continue to be)
reportable on Form 1099-MISC. This was accomplished merely by the enactment
of §6045(f), and needs no regulatory explanation. Of course, TEI does
point out (as have others), that some of the rules having nothing to do
with withholding are quite bazaar. For example, few commentators fail to
miss the fact that if separate checks are made out to attorney and plaintiff
for separate amounts, one would think separate Form 1099s could be called
for in the respective amounts paid to each. But surprise! The mere
fact that the client's check is delivered to the attorney's office will
require the payor to issue a Form 1099 to the attorney for the full amount
(both the amount paid to the attorney and the amount "separately paid"
to the client). These and other glitches deserve repeated comment by taxpayers
and their representatives.
Why Tax Treatment of Attorneys' Fees Should be Addressed in Settlement
Agreements, Vol. 14, No. 16, BNA's Employment Discrimination Report,
April 19, 2000, p. 546.
If the cases described above do not present sufficient reason for
virtually everyone to try to address anticipated tax consequences in the
settlement document purely because of the risk that the settlement may
fall apart entirely for failing to do so, then a more substantive tax consideration
may be the deciding factor. It is well established that most of the litigated
cases to consider what tax treatment ought to apply to a certain type of
payment involve general releases with no allocated settlement. In my experience,
the IRS (and state taxing authorities, too) are far less likely to inquire
into the background of a settlement if the settlement document is explicit
as to tax consequences. True, the IRS and other taxing authorities can
certainly do so, and they are not bound by mere recitations of tax treatment
in a settlement document. Still, one ought to take one's bite of the apple
if one can.