IRS Form 1099 and lawyers: What, me worry?

Most of us receive IRS Forms 1099 every year. These little forms report interest, dividends, real estate sales proceeds, consulting income, retirement plan distributions, tax refunds, and many other categories of income. They are a major source of information for the IRS, and they enable the IRS to quickly match data. Copies go to state tax authorities, too, and they are equally useful in collecting state tax revenues. In fact, these little forms represent the keys to the kingdom, allowing matching of taxpayer-identification numbers and dollar amounts in a flash. That means there is a stark certainty about them. If you receive a Form 1099 reporting income but fail to put it on your tax return, you will almost certainly receive a tax notice (or worse). Because Forms 1099 allow computer matching of tax ID numbers and dollar amounts, the forms have a decided impact on tax compliance and collections. IRS statistics prove this. When a taxpayer receives one of these forms, he or she is much more likely to report the payment on a tax return.

The forms also encourage efficiency in tax collections. IRS collection efforts can be streamlined, even mechanized. It takes no effort for the IRS to spew out a bill to a taxpayer who fails to include a payment reported on a Form 1099. Forms 1099 should never be ignored and should be opened promptly. There are many more Forms 1099 today than ever before. That means there are also more errors. Many errors can be corrected if you act promptly, so open them upon receipt.

Do not wait until you start to do your taxes. What if you don't know if one was issued, say you never got a copy? Perhaps you moved (if you do, tell the payor, and file a change of address form with the IRS). Maybe you received but lost the 1099. You can get a transcript from the IRS that will show all Forms 1099 issued under your Social Security number or taxpayer ID number. Transcripts are useful cross-checks in any event.

Lawyers receive and send more Forms 1099 than most people, in part due to tax laws that single them out. At one point, the IRS initiated a program called Project Esquire, which implicitly recognized that lawyers needed particular tax scrutiny. This program was long ago suspended, but some at the IRS still believe lawyers deserve special audits. One IRS audit guide even instructs IRS agents what to look for when auditing lawyers.

Lawyers make good audit subjects because they often handle client funds. They also tend to have significant income. Independently, the IRS has long had an interest in the tax treatment of litigation settlements, judgments and attorney fees. These concerns coalesce nicely in reporting issues over attorney fees. For this reason, it should be no surprise that lawyers are singled out for extra Forms 1099. IRC Section 6045(f).

That provision requires companies who pay attorneys for services to report the payments to the IRS on a Form 1099. On its face, this may not seem like an important provision in the tax law. Yet this rule has a significant impact on lawyers as recipients and as issuers of Forms 1099. Lawyers and law firms send as well as receive them. In fact, these little slips of paper have become ubiquitous in law practice, and their relevance is not confined to once a year at tax time. Even for lawyers who have an accountant or bookkeeper to keep them straight, any lawyer in private practice -- whether in a large firm, small firm or solo practice -- should know key facts about them.

Generally, Section 6045 of the tax code requires that all gross proceeds paid to an attorney must be reported on a Form 1099. That is true if the lawyer is being paid for services. It is also true for legal settlement agreements. When a lawsuit settles and funds go to the plaintiff's lawyer, the lawyer must get a Form 1099 for the proceeds, even if some, most or all of the money will be passed along to the plaintiff.

Interestingly, though, the purpose of this reporting is not to examine the attorneys' income taxes, since most recoveries received by attorneys are not the attorneys' income, but their clients' recoveries. Instead, the general purpose of this reporting is to document the amount of a plaintiff's gross settlement and to help corroborate a defendant's tax deduction (if any) claimed on the settlement payment.

Section 6045 reporting of gross proceeds paid to an attorney is required even if the settlement is not taxable to the plaintiff (such as a compensatory physical injury settlement). That "no Form 1099 to the plaintiff" rule should apply to capital recoveries too. One example would be a fire loss case where the defendant cannot determine how much is income to the plaintiff, how much as basis recovery, etc. Another example is a founder stock dispute, where the company doesn't know how much is tax basis, which is a moving target with legal fees.

Lawyers receive Forms 1099 on settlements where a recovery is taxable to a plaintiff, too. Defendants are generally required to issue a Form 1099 to both the plaintiff and the plaintiff's attorney. But while lawyers may be discriminated against in receiving Forms 1099, there is much more than a silver lining. Most Forms 1099 lawyers receive are not reported as income on a Form 1099, but are instead reported in a special box, Box 10, which is specifically labeled as "gross proceeds paid to an attorney."

Unlike the other boxes on a Form 1099, the IRS does not assume that amounts reported in Box 10 are income. In my experience, Box 10 reporting rarely results in an audit of an attorney who receives Box 10 reporting. Of course, if the lawyer retains any of the payment for legal fees, that portion is income to the lawyer. Say the lawyer receives a Form 1099 for $1 million as gross proceeds for a settlement, with a 40% fee.

Some accountants think that they should report the $1 million as gross income, then deduct the $600k paid to the plaintiff. But the correct tax return treatment for the lawyer would be reporting just the $400,000 fee as income. That ties into Forms 1099 the lawyer issues too. The lawyer in this example should not need to claim a deduction for the client monies (unless the lawyer chooses to treat the entire $1 million as gross income).

And assuming that the lawyer does not report the client's money as income, the lawyer does not need to issue a Form 1099 for the funds disbursed to the client. For reporting purposes, the lawyer is not the "payor" of the client's recovery. In fact, if there are reporting obligations for this money, that reporting obligation rests squarely with the defendant. There are some limited exceptions to this rule in the tax regulations known as the middleman regulations. But in my experience, most lawyers in the overwhelming majority of cases don't fall under those rules. 