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Birmingham Bar Association Bulletin | Winter 2014

Tax Law Mike Baker, Managing Partner, Dent, Baker & Company You Nailed The Settlement. But What About Reporting Damages? Make sure you’re understanding and reporting what you should You worked hard to get a solid settlement for your client. But before you shake hands and walk out the door there’s one more thing. You need to talk about the potential tax consequences of that settlement. Generally, I find there is no clear understanding of who has responsibility for reporting and for the ultimate client outcome. I recently took a call from a plaintiff ’s attorney involved in a wrongful termination settlement. Both sides in the case had come to a settlement agreement but there was some talk of not characterizing the damages as wages in order to avoid payroll taxes. The plaintiff asked his attorney about tax reporting for the settlement. Neither the client nor the attorney fully understood the law or the significant consequences of filing an incorrect tax return. While reporting of business damages is fairly straightforward, the same cannot be said on the individual side. 1099-MISC basics— blocking and tackling IRS Form 1099-MISC is used to report income other than salary or wages. In the legal profession, most reporting responsibility falls to the defendant or insurer rather than to the plaintiff ’s attorney. But not always. Compliance requires an understanding of when payments are taxable, as well as how to correctly file based on the nature of the payment or damages. Generally, a Form 1099-MISC filing is required when payments of $600 or more are made. Consider the example of Company Q, which in the ordinary course of business pays a settlement of $5,000 through the claimant’s attorney. In this case Company Q may be required to issue a 1099-MISC to the attorney. The claimant’s attorney might also be required to issue 1099s if the attorney hires experts or other professionals and pays them more than $600 each. While there is a reporting exception for payments made to corporations, that exception does not apply to legal services. Taxation of legal damages—a house divided The first step in correctly reporting pursuant to a settlement is to understand the nature of the claim. The IRS is wise to improperly characterized settlement proceeds. Agents are trained to seek out unreported and misclassified damages by requesting and examining underlying documentation. When most people (including many lawyers) hear the word compensatory they think nontaxable. But in fact, this only means that an individual was compensated for a loss. Damages for physical sickness or injury are tax free whether they are negotiated by settlement or result from a court verdict. The IRS has held that compensatory damages received as a result of physical sickness or injury are excluded from income. Emotional distress alone is not treated as a physical injury. To be tax free, the damages must be attached to an illness or injury. If someone is injured in an accident and damages for emotional distress are included in the award, they are also tax free. Alabama is unique with regard to wrongful death and punitive damages, only allowing punitive damages in the case of a wrongful death. In 1996, Congress attempted to clarify that punitive damages are taxable, but lawmakers did allow a narrow exception in states where damages are limited to punitive damages. 12 Birmingham Bar Association


Birmingham Bar Association Bulletin | Winter 2014
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