How is settlement income reported?

If you receive a taxable court settlement, you could receive Form 1099-MISC. Your liquidation income will be reported in Box 3, for other income.

How is settlement income reported?

If you receive a taxable court settlement, you could receive Form 1099-MISC. Your liquidation income will be reported in Box 3, for other income. This is particularly true for federal income tax matters and the proper characterization of a settlement payment. For example, characterizing a settlement payment as a payment for damages due to defamation or a payment in lieu of loss of profits results in revenue for the payee.

In contrast, characterizing that same payment as a payment for physical injury or a return of principal does not imply any tax for the recipient. With ordinary income tax rates as high as 37 percent, the difference in characterization in these cases can result in a lot of income tax or no income tax at all. The settlement agreement must also explicitly state how the settlement will be reported. In reality, when settlement money goes to a lawyer's trust account, it is treated for tax purposes just as the lawyer receives it and the client receives it.

An additional consideration for an employer to protect itself with respect to the taxation of a settlement is an indemnity clause. But if you first sign the settlement agreement and then request a delay in payment, you will have a constructive receipt. Finally, the IRS states that attorneys' fees for wage claims are in themselves wages subject to labor taxes, unless the settlement agreement expressly provides for an allocation for attorneys' fees. Although the claimant will generally pay taxes on the entire settlement, including amounts paid directly to the lawyer, the claimant is likely to be entitled to deduct attorneys' fees.

If the plaintiff is going to attempt to claim that the settlement proceeds are excludable from their taxable income, the burden is on them to prove this position to the IRS. And a final point to consider and advise the plaintiff is that, while attorney fee payments are generally included in the plaintiff's gross income, they can often be deducted “above the line” when calculating the plaintiff's adjusted gross income. Correctly evaluating the income and employment tax aspects of the agreements, as well as the correct reporting of settlement payments, is essential to obtaining the best possible outcome. More importantly, the IRS memorandum makes clear that the way the settlement agreement is drafted and how settlement payments are made can affect both parties' tax liabilities.

Knowledge of the taxes and deductibility of settlement payments made to claimants and their attorneys, as well as the reporting requirements for such payments, will allow both parties to maximize profits and avoid unnecessary taxes and penalties for non-compliance with the Internal Revenue Code. If the settlement agreement is explicit and denies a Form 1099, you can say that Form 1099 violates the settlement agreement. Any pre-trial or post-trial interest in settlement money is taxable and may influence taxes on some attorney's fees. These payments must be reported on a Form W-2 and the check must be processed as if it were a payroll check that allows deductions from income taxes, FICA and state withholding.

The two main methods of reporting the settlement to the IRS are Form W-2 or Form 1099-MISC. You can do this by reviewing court-related documents or other relevant settlement documentation for this information.

Elise Thorne
Elise Thorne

Incurable music advocate. Professional bacon scholar. Devoted zombie practitioner. Zombie nerd. Professional tea nerd. Devoted bacon geek.

Leave Reply

Required fields are marked *