Characterization matters. This is particularly so for federal income tax matters and the proper characterization of a settlement payment. For example, the characterization of a settlement payment as a payment for damages due to defamation or a payment in lieu of lost profits results in ordinary income to the recipient. Conversely, characterization of that same payment as a payment for physical injuries or a return of capital results in no tax to the recipient. With ordinary income tax rates as high as 37-percent, the difference in characterization in these instances can result in either a lot of income tax or no income tax at all.
The IRS is well aware that parties to a settlement agreement will often attempt to play games with the characterization of a payment. But, how does the IRS keep track of these payments and also determine whether the recipient has properly characterized a settlement payment as taxable or non-taxable? The answer lies primarily in the Internal Revenue Code’s intricate tax reporting regime.
Section 6041 and the Form 1099 Requirement.
Section 6041 of the Code and its regulations require businesses that make certain payments to file an IRS Form 1099 with the IRS and also provide a copy of the Form 1099 to the recipient of the payment. More specifically, under section 6041 and the regulations, a business must file a Form 1099 when the business makes a payment of $600 or more to another person in the tax year, provided the payment represents fixed or determinable gains, profits, or income. If a business fails to comply with the Form 1099 reporting requirements, the business can be subject to penalties for the failure.
Through this reporting regime, the IRS has the ability to both determine the identity of the taxpayer who received the payment and also whether the taxpayer reported that income on his or her federal tax return. In instances where there is an omission of income—i.e., the income from the Form 1099 is not reported on the tax return—the IRS will usually flag the return and select it for examination.
The Form 1099 reporting regime works remarkably well. Indeed, federal courts have universally recognized that “information returns . . . help the government locate and check upon recipients of income and the amounts they receive.” Gierbolini Rosa v. Banco Popular de Puerto Rico, 930 F. Supp. 712, 716 (D.P.R. 1996, aff’d, 121 F.3d 695 (1st Cir. 1997). Federal courts also correctly note that the information returns themselves do not create a tax obligation—rather, any obligation associated with the items on the information returns are independently determined between the recipient and the IRS, if the IRS challenges the reporting. Id.
Forms 1099 are a Common Dispute in Settlement Negotiations.
Because Forms 1099 are not required in all instances, settlement discussions associated with the issuance or non-issuance of a Form 1099 can be hotly debated amongst the parties. As an initial matter, the recipient of the settlement payment will routinely request that the payor not issue a Form 1099, which permits the recipient additional flexibility in reporting the items on the recipient’s income tax returns. On the other hand, the payor will routinely seek to issue a Form 1099 (even if none is required) so as to avoid any potential penalties for failure to file the information return.
The recent decision in In re Coppola, No. 17-14944 VFP (Bank. Sept. 30, 2020) provides a good illustration of these types of disputes. In that case, the debtor settled a dispute with a bank for $20,000. Because the debtor owed her attorney for legal representation, all parties understood that the $20,000 payment would be directed to the attorney and not the debtor. When the bank sought to acquire taxpayer identification information through Forms W-9 from the debtor, the debtor’s spouse, and the debtor’s attorney to issue appropriate Forms 1099, the debtor argued that the bank should only issue the Form 1099 to her attorney. According to the debtor, the payment should be reported to her attorney because the debtor received no economic benefit from the payment.
The court flat out disagreed. Under applicable regulations, the recipient of a settlement payment and the attorney are generally both issued a Form 1099 with respect to a payment, regardless of whether the recipient has an outstanding obligation to pay the attorney for legal fees. Given these authorities, the court ordered that the debtor, her spouse, and her attorney all complete and execute Forms W-9 to permit the bank to issue appropriate Forms 1099 to all parties.
Taxpayers should tread carefully before they enter into settlement agreements with other parties. Indeed, at a minimum, they should carefully consider how the settlement payment will be treated for federal income tax purposes and whether the party will issue information returns, such as Forms 1099, which can be transmitted to the IRS and the recipient well after the payment is received. After the settlement agreement has been executed, taxpayers are at the mercy of what was agreed upon in the existing settlement agreement.