Settlements in legal disputes between employers and employees can vary significantly depending on whether the amounts to be received are taxable. For example, two parties in separate lawsuits can each agree to a settlement of $500,000. But, because one settlement is taxable and the other is not taxable, one party may receive $500,000 and the other may have to pay tax and will receive $300,000. Their motivation to settle can change dramatically when they understand the tax consequences. Many courts and congress have weighed in on what is taxable and when it is taxable. For a discussion of these issues see an earlier series of blog articles.

Another issue that impacts settlement is the taxation and reporting of attorney fees recovered as part of the settlement. Many people receiving payments feel it is unfair that they must include in their gross income the funds paid to their attorneys. The people making the payments are also hesitant about the treatment of these often not sure how the payments should be made and reported. While this may not always be the case, the payee, the payor, and their attorneys, should have a confident and clear understanding of how the attorney fees will be treated.

Last year, the IRS Field Attorneys voiced their opinion in Legal Advise Issued by Field Attorneys (LAFA) 20133501F. They stated there are four things they need to determine before they can decide how to treat the payment.

  1. The character of the payment and the nature of the payment.
  2. Whether the payment is an item of “gross income” as defined by the Internal Revenue Code.
  3. Whether the payment is wages for employment tax purposes?
  4. How should the payment and any attorney fees be reported on information returns (Form 1099-MISC and/or Form W-2).

If the party receives a payment that is included in income, any amount allocated to attorney fees are also included in the party’s income, even if it is paid directly to the attorney. This is even true if the fee award is the result of a Fee-Shifting statute.

Whether a payment is included in wages is important for the party making the payment, as wages are subject to employment taxes. The LAFA states that payments constituting severance pay, back pay, and front pay, are wages. However, the LAFA also recognizes that there are some disagreements about the character of these payments among the federal appellate courts.

The LAFA also states that when attorney’s fees are clearly allocated as attorney fees by a court in a judgment awarding back pay, the attorney’s fees, while included in income, are not wages for employment tax purposes. “However, in a situation in which a court order does not make a distinct allocation for attorney’s fees and the claimant pays the attorney’s fees out of their recovery, the entire recovery, including the amount paid to the attorney, is wages for employment tax purposes. Rev. Rul. 80-364, 1980-2 C.B. 294.

We encourage you to read the LAFA so you are aware of the IRS’s position when evaluating how to treat and report awards of attorneys fees in settlements and verdicts.