Information Reporting for Payments to Attorneys

The Taxpayer Relief Act of 1997 (TRA 97), Section 1021, added Sec. 6045(f), requiring that any person engaged in a trade or business and making payments to an attorney file an information return reporting the payment to the IRS. In May 2002, the IRS issued Prop. Regs. Sec. 1.6045-5. It appears many attorneys and law firm administrators are not aware of the requirements and their complexities, or are otherwise not complying.

Why a Reporting Requirement?

A string of unfavorable media stories in the late 1990s shed light on the problem of attorneys not reporting taxable income. The TRA 97 Committee Report states, the provision will have a positive impact on compliance with the tax laws. Why pick on lawyers? The TRA 97 House Report provides, Although some might consider it inappropriate to single out payments to one profession for additional information reporting, requiring reporting is appropriate in this instance because attorneys are generally the only professionals who receive...payment[s], a portion of which may be income to them and a portion of which may belong to their client. This concept permeates the proposed regulations.

Scope

Although generally, payments made to corporations are not subject to information reporting (usually made via Form 1099-MISC, Miscellaneous Income), Prop. Regs. Sec. 1.6045-5(d)(1) defines attorney  as a person engaged in the practice of law, whether as a sole proprietor, partnership, corporation or joint venture. The exception generally provided for payments to corporations does not apply; thus, payments to law corporations are subject to reporting.

Generally, payments covered by another reporting requirement are not subject to Sec. 6045(f). For example, under Prop. Regs. Sec. 1.6045-5(c), payments of wages by an attorneys employer are not subject to the rules; presumably, these payments are reportable under Sec. 6051 as wages on Form W-2. Further, a partnerships payments of compensation or profits to partners are not subject to these rules, nor are a corporations payments of dividends to shareholders; these are reported under other provisions.

Under Prop. Regs. Sec. 1.6045-5(f), Example 4, a check payable to a plaintiff (not to an attorney) is not subject to the reporting requirements, even if the check is delivered to the attorney.

Example: P Corp., a defendant in a suit for damages, knows that C, the plaintiff, has been represented by attorney A throughout the proceeding. P settles the suit for $500,000. Pursuant to As request, P writes a $500,000 settlement check payable solely to C and delivers it to A at As office. P is not required to file an information return as to A, because there is no payment to an attorney.

Surrendering TINs

Attorneys are sometimes reluctant to surrender their taxpayer identification number (TIN). Prop. Regs. Sec. 1.6045-5(e) and -5(f), Example 6, require attorneys to promptly furnish their TINs to persons subject to the reporting requirements. Failure to do so will subject an attorney to a fine for each such failure and backup withholding.

Example: P Corp., a defendant, settled a suit brought by C for $1 million in damages. Cs attorney, A, did not furnish P with As TIN. P is required to deduct and withhold tax from the $1 million. Thus, P writes a $720,000 check naming C and Cs attorney, A, as joint payees. P must file an information return as to A for $1 million.

Attorneys Payments to Other Attorneys

In many situations, attorneys engage other (outside) attorneys to assist with particular aspects of a case, such as when they need special expertise. Often, the attorney managing the case (the tier-one attorney) receives the settlement and pays the specialist (the tier-two attorney) out of the proceeds. According to Prop. Regs. Sec. 1.6045-5(b)(2) and -5(f), Example 5, if the payer has to file an information return as to the tier-one attorney, the tier-one attorney must file an information return as to the tier-two attorney.

Example: P Corp., a defendant, settled a lost-profits suit brought by C for $1 million, by writing a check naming Cs attorneys, unrelated parties Y, A and Z, as payees, in that order. P delivers the check to As office. A deposits the check into a trust account and makes payments by separate checks to Y of $100,000 and to Z of $50,000, for their attorneys fees. A writes a $550,000 check to C. P must file an information return for $1 million as to A. A, in turn, must file information returns as to Y of $100,000 and as to Z of $50,000.

Joint or Multiple Payees

Unlike most other types of Form 1099 reporting requirements, in which the income is reported to only one payee, Prop. Regs. Sec. 1.6045-5 provides that in some situations, the same income has to be reported to more than one payee.

If more than one attorney-payee is listed on a check, an information return must be filed as to the attorney to whom the check is delivered. If one or more attorneys are listed as payees and the check is either delivered to a nonpayee or to a non-attorney payee, an information return must be filed as to the first-listed attorney-payee.

Obviously, these rules provide opportunities to minimize taxes and fees based on gross income, to the extent the payee has influence with the payer. (Given the confrontational nature of most litigation, any such influence must be exercised during the negotiation process.) For example, in California a fee is assessed on limited liability companies (LLCs) based on gross income; it might be preferable to list the order of the payees and deliver the check is such a way that a Form 1099 would not be filed as to the LLC, but rather, as to one of the other attorney-payees; see Prop. Regs. Sec. 1.6045-5(f), Examples 1 and 2.

Example 1: Employee C, who sued employer P for back wages, is represented by attorney A. P settles the suit for $300,000 that represents taxable wages under existing legal principles and writes a settlement check payable jointly to C and A for $200,000, net of income and FICA tax withholding. P delivers the check to A. A retains $100,000 and disburses the remaining $100,000 to C. P must file an information return as to A for $200,000. P must also furnish an information return to C for $300,000, under other provisions. (A would report gross income of $200,000 and a deduction for client payment of $100,000; C would report gross income of $300,000 and a deduction for legal fees of $100,000. The issue of gross versus net reporting is beyond the scope of this item.)

Example 2: C, who sued P Corp. for damages on account of personal physical injuries, is represented by attorney A. P settles the suit for a $600,000 damage payment excludible from Cs gross income. P writes a $600,000 settlement check payable jointly to C and A, and delivers the check to A. A retains $240,000 of the payment as attorneys fees and remits the remaining $360,000 to C. P must file an information return as to A for $600,000. (A would report gross income of $600,000 and a deduction for client payment of $360,000, showing $240,000 net income.)

Finally, attorneys often receive payments on behalf of others in many different situations. Prop. Regs. Sec. 1.6045-5(d)(2) defines legal services very broadly to include services related to, or supportive of, the practice of law.  The preamble states that this definition was intended to be quite broad, as can be seen in Prop. Regs. Sec. 1.6045-5(f), Example 10:

Example: Individual C files for bankruptcy under Chapter 13 of the Bankruptcy Code. Under a wage-garnishment order, Cs employer, P, withholds $800 from Cs earnings. P remits a check for $800 payable to A, an attorney the bankruptcy court appointed to act as the trustee of Cs bankruptcy estate. P has to file an information return under Sec. 6045(f) as to the $800 payment to A.

Although there are specific exclusions to information reporting, payers should be cautious, as the rules could apply broadly.

From Randall L. Zamarra, CPA, MSA, Daoro Zydel & Holland, San Francisco, CA