Do 1099-MISC forms leave you puzzled and concerned? You are not alone.

The federal tax code and corre-sponding regulations require lawyers to send 1099-MISC forms to certain individuals and non-incorporated business entities that receive disbursements from the lawyer’s trust fund for legal awards and settlements. Lawyers are perplexed regarding the proper way to report such disbursements.

What is clear is that failure to file a required 1099-MISC form makes a law firm liable for a $100 penalty-$50 for the payee copy and another $50 for the IRS copy-along with other possibly significant civil penalties for assisting other taxpayers in evading proper tax liability. In spite of the penalties, many firms still fail to comply with the requirement because of poor record keeping and uncertainty about the rules. Other firms reportedly choose to pay the fine rather than risk having a client blame them for calling the IRS’ attention to their tax return.

Thinking Out of the Wrong Box

An often-asked question is whether the 1099-MISC reporting requirement can be satisfied by entering the required amount in Box 15 (comments box)? The answer is no. The 1099-MISC (2002) instructions clearly state that reportable disbursed damages must be placed in Box 3 (other income).

Under those same instructions, lawyers should report disbursements of awards and settlements only if they are federally taxable. If a reasonable argument exists that some, or all, of a disbursement is not taxable, the firm can appropri-ately choose not to report that amount on Form 1099-MISC.

Taxability

What kinds of awards and settlements are taxable? Making that determination can be complex so each firm should get expert tax and accounting advice tailored to its specific needs. With that said, there should be some basic criteria for the taxability of damages within the 1099-MISC instructions.

The Box 3 instructions do provide that criteria (paragraph 1 under “Other items to be reported...”). The convoluted explanation, however, appears to be left over from when IRS writing was known for its obscurity. A more simplified explanation would be welcome. In the interim, however, the following is an unofficial attempt to render Form 1099-MISC Box 3 instruc-tions comprehensible.

Exceptions

Do not report these disbursements for damages:

• Those that should be reported elsewhere, such as Form W-2 for back pay damages (if deemed to be taxable wages per IRS Pub. 957).
• Those for a de minimis amount (i.e., if all combined disbursements to the client for that calendar year total less than $600 per IRC Section 6041).
• Those for “nonphysical injuries (emotional distress) under a written binding agreement, court decree or mediation award in effect on, or issued by, Sept. 13, 1995.”
• Subject to the above exceptions (and other reporting exceptions if applicable):
• If certain damages are punitive in nature, DO report them, regardless of what the damages are for.
• If certain compen-satory damages stem from personal physical injury or sickness or emotional distress that directly resulted from physical injury or sickness DO NOT report the compensatory damages.
• If compensatory damages are for emotional distress due to a non-physical cause, DO report them — but only to the extent that they exceed the amount actually paid by the client for medical care “for the emotional distress.”
• If compensatory damages are for nonphysical injuries other than emotional distress, DO report the damages.

IRS guidance statements or other sources might help in deciding whether the cause of emotional distress was “physical” or “nonphysical.”

In analyzing taxability, criteria unrelated to 1099 should be assessed. In a suit for pollution-damaged land, for example, the settlement might be regarded as a tax-free return of capital, at least to the extent that a landowner has a tax basis in the affected property.

Advising Your Client

Do not wait until January to think about the taxability of the prior year’s awards and settlements. That issue should be reviewed with clients at the beginning of each case. Unless the entire award or settlement will clearly not be taxable, have your client complete and sign an IRS Form W-9. At deadline time, that form will spare you from scrambling to ensure you have your client’s correct legal name, address and taxpayer ID number.

Here is another useful tip: calendar-year-filers must send Form 1099-MISC to clients by Jan. 31 of the year following the year in which the disbursement was made. The IRS copy, however, can be submitted as late as Feb. 28. That extra month allows time to make corrections.

Paul Keating is a certified public accountant with the accounting firm of Brayman, Houle, Keating & Albright, PLLC in Nashua. This article, in slightly different form, appeared in the firm’s newsletter, Profit Counselor, and is reprinted with permission.

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