MORE CONFUSION OVER 1099s

Tax professionals (and an increasing number of litigators) are understandably concerned about IRS Form 1099 obligations. When a case settles or goes to judgment, who should get Forms 1099 and in what amounts? Once the lawyer has the money (if the money comes via a joint check payable to the plaintiff’s lawyer and client), how should the plaintiff’s lawyer deal with it? Should the plaintiff’s lawyer issue a Form 1099 to the client?

There are many more questions that can be asked about this subject, but at least a few answers can be given in this brief article. I will raise some of the current issues surrounding these not-so-new (but now terribly important) questions.

1997 Law Change
In 1997, Congress enacted Section 6045(f) of the Internal Revenue Code. Much to the bane of most lawyers, Section 6045(f) requires that most payments to attorneys now must be subject of a Form 1099. In the old days, sole proprietor attorneys had to receive 1099s, but partnerships and corporations did not. Now, regardless of the form in which the law firm (or lawyer) does business (yes, even professional corporations, partnerships and LLPs), a Form 1099 generally must be sent by the client to the lawyer. This law took effect on January 1, 1998, so most of these Forms 1099 did not start showing up in the lawyers’ mail until January of 1999. The general requirement for 1099s of course (and W-2’s as well) is that they must be sent to the taxpayer no later than January 31 of the year following the year in which the payment is made. Then, they must be sent with a Form 1096 transmittal form to the IRS no later then the end of February (so there is a one month lag). Presumably, one reason for the one-month delay is so taxpayers can try to have any mistakes quickly corrected.

The most controversial aspect of Section 6045(f) turns out not to be the requirement that lawyers should receive a Form 1099. After all, lawyers should pay their taxes just like everyone else. And, the IRS long ago made clear that it had special concerns with lawyers. Many lawyers have been viewed as likely to underreport income. For many years there was a special IRS investigation dubbed “Project Esquire” to seek out lawyers to make sure that correct taxes were paid. In some cases, criminal prosecutions were even pursued.

Client Payments
The  most controversial aspect of Section 6045(f) concerns payments to or for clients. Since 1998, the IRS has proposed two sets of regulations to try to deal with this question, covering a variety of subjects. Neither set of proposed regulations has been finalized. The IRS finally relented in January 2001 and said the regulations would not be effective until they were finalized. Yet, many companies seem to be treating these proposed regulations as gospel already:

Question:  What happens when a check is cut to a lawyer and client jointly (as often happens in contingent fee litigation); who should get the 1099?

Answer:  The general IRS answer to this question in both sets of proposed regulations (and it remains the IRS view to this day) is that the client and the lawyer should each receive a Form 1099 for the entire amount of the payment!  Clients and lawyers are understandably concerned about “double counting” of income. There are ways that the proposed regulations (both sets) had tried to deal with this concern.

One of the ways to diffuse this bomb was if the lawyer disclosed to the defendant exactly who was getting what (for example, lawyer will get $40,000 in fees and client will get $60,000 as a settlement out of a total payment by the defendant of $100,000). Here, the lawyer only wants to receive a Form 1099 for $40,000, and the client wants to receive one for $60,000. The proposed regulations make clear that the lawyer would still get a 1099 for $40,000, plus the client should receive a 1099 for the entire $100,000.

If your blood does not start to boil yet, then consider some of the lesser known provisions in the proposed regulations. One provision would require a defendant to issue a Form 1099 to both the lawyer and the client (each for the full amount) if a check made payable solely to the client was merely delivered to lawyer’s office. For example, if the case settles for $100,000, the check is made payable solely to the plaintiff (let’s say the lawyer was doing this case pro bono or on an hourly basis), the IRS view was that the defendant should issue a Form 1099 for $100,000 to the lawyer and $100,000 to the plaintiff!

Regulations Delayed
The proposed regulations (in both sets) were sufficiently controversial, that even though the IRS had announced in 2000 that these new rules would take effect for payments on or after January 1, 2001, the IRS reneged under a great deal of pressure. The IRS announced just after New Year’s Day 2001 that the new rules would not take effect until final regulations were published in the Federal Register. A good part of 2001 has already passed, and no final regulations have been released. It is not clear when that will happen, nor even whether it will happen in tax year 2001.

Until then, many companies are using the second set of proposed regulations as the litmus test for what the IRS will probably expect. Many are therefore issuing 1099s like mad. Yet, the final regulations have simply not been published and many of these companies are, I feel, being overly cautious.

Alternative Minimum Tax Problem
Many (if not most) readers are aware that one of the main reasons all of this matters a great deal is that increasingly, with smaller and smaller IRS audit staffs, one of the principal ways audits are generated is by a mismatching of 1099s and reported income. Forms 1099 have become very, very important.

Particularly in the litigation context, where large attorneys’ fees are often paid to reach a particular result, there can be a dramatic difference between the tax result to the plaintiff if he or she receives and reports only the net amount recovered (after attorneys’ fees and costs) or reports the entire gross amount of the recovery, and then deducts the attorneys’ fees and costs. The reason for the difference in tax result relates to several items, the 2% miscellaneous itemized deduction rule, and the phase_out of exemptions and deductions for high income persons (a threshold which is not very high anymore). Most significantly, though, the alternative minimum tax can kick in to wallop attorneys’ fee deductions terribly.

“Netting”
Well, is the plaintiff taxable on the gross amount of a recovery (and must he or she run the gauntlet of these various limitations on the deductions for attorneys’ fees), or can the plaintiff merely report the net? That turns out to be a very sticky question. A bitter split in the circuits is being fought on that very question. One could easily consume 50 pages about all of the cases that have considered this issue, and how they come down, in some cases based primarily based on what state law says about attorneys’ fees and attorneys’ liens. With a bit of oversimplification, the case law right now breaks down as follows:

1.  Circuits permitting netting of attorneys’ fees, so that the plaintiff only would have to report (in a properly structured deal) the net amount he receives, include the Fifth Circuit, Eleventh Circuit and Sixth Circuit. See Cotnam v. Commissioner, 236 F.2nd 119 (5th Cir. 1959), Willie Mae Barlow Davis v. Commissioner, 210 F.3rd 1346 (11th Cir. 2000), Estate of Arthur L. Clarks v. United States, 202 F.3d 854 (6th Cir. 2000), and Srivistava v. Commissioner, 220 F.3d 353 (5th Cir 2000).

2.  Circuits in which the plaintiff must include the entire gross amount of the settlement (even if the plaintiff is never allowed to touch the amount the plaintiff’s attorney gets!) include the Ninth Circuit, First Circuit and Federal Circuit. See Alexander v. Commissioner, 72 F.3d 938 (1st Cir. 1995), Baylin v. United States, 43 F.3d 1451 (Fed. Cir. 1995), Benci-Woodward, et ux., et al. v. Commissioner, 219 F.3d 941 (9th Cir. 2000), and Coady v. Commissioner, 213. F.2d 1187 (9th Cir. 2000).

3.  Circuits not yet having ruled on the issue include the Seventh Circuit (although a case is now pending on this topic in the Seventh Circuit), the D.C. Circuit of Appeals, the Second Circuit, the Third Circuit, the Fourth Circuit and the Tenth Circuit.
Supreme Court or Congress?

I am not sure who will be the “fixer” of this problem. The Supreme Court ought to resolve this violent split in the circuits. Strangely, though, the Supreme Court recently turned down a request for Certiorari in one of the Ninth Circuit cases (Coady v. Commissioner). Hopefully, the Supreme Court will take up this issue.

Otherwise (or also!), Congress should deal with the topic. There is great momentum to repeal the alternative minimum tax, which would alleviate most of this problem (although not quite all). Unfortunately, the massive tax bill signed by President Bush on June 7, 2001 with the unfortunate moniker the “Economic Growth and Tax Relief Reconciliation Act of 2001” took so much energy (and money, according to revenue estimators) that an outright repeal of the individual alternative minimum tax right now seems unlikely. Time will tell how this gets fixed.

Form 1099 Penalties
I haven’t addressed penalties for failure to file Form 1099, which is worth a brief mention. The basic penalty for failure to file a 1099 form is $50 per failure (and it doesn’t even reach the $50 level until the 1099 is a few months late). $50 per failure is a penalty designed to smart only with multiple or mass failures. For example, if you are dealing with a class action with 25,000 members that should have received Forms 1099, the $50 per failure penalty adds up.

Moreover, in the case of wilful failures to file Form 1099, the penalty is 10% of the amount involved. If a Form 1099 should have been sent out (even to one individual) for $10,000,000, that means the penalty could be $1,000,000. Although this is a frightening penalty (and I occasionally hear it raised as an argument why a Form 1099 that is probably not necessary should be sent, just out of an abundance of caution), in 22 years of practice, I have never seen the “intentional” failure to 1099 penalty asserted by the IRS, much less collected. Thus, if tax counsel is involved in bargaining over the reporting, issuing tax opinions, etc., I find it hard to imagine the wilfulness penalty being imposed. My experience, at least, bears this out. The wilful failure to file penalty is stiff, and lawyers and accountants ought to at least be aware of its existence, but as a practical matter, it does not seem likely to be a problem in most cases.

Wage Withholding Issues
Although I have barely scratched the surface of Form 1099s, it is worth mentioning that even before the question of Form 1099 reporting is considered, in some types of litigation (employment litigation) the question of whether an amount constitutes “wages” subject to withholding must be considered. This topic merits a separate article. After all, unlike generally applicable for failure to file Forms 1099, penalties for failures to withhold on wages are quite severe. Suffice it to say that in employment litigation, tax counsel should be engaged to determine what amount, if any, represents wages subject to withholding. Not only may the defendant payor have withholding responsibilities, but in some cases the lawyers who receive a gross check on which withholding should have been taken will have that withholding responsibility themselves. Ouch!

Conclusion
The reporting aspects of settlements and judgments have become more complex and the stakes have risen even higher over the last two years. And, it is clearly going to get worse once the IRS finalizes its regulations. To add to everything else, plaintiffs and defendants are becoming more tax savvy and, from what I have seen, are increasingly more likely to bring malpractice actions against lawyers or other professionals who do not bring tax issues to their attention.

So, if the IRS does not get you for failing to comply with their rules, sometimes, your client may have his or her own complaints. The most probable scenario if the tax issues do not get thoroughly addressed and documented in the settlement agreement, the following January when the Forms 1099 hit, either the IRS, your client, or both (yikes!) may come calling.

More Confusion Over 1099s, Vol. 92, No. 9, Tax Notes (August 27, 2001), p. 1215.