In a prior Freeman Law Insight, we wrote on the significance of addressing the tax effects of any settlement payments early during the settlement negotiations. This is so because the parties are both at the negotiating table during this (potentially final) phase of the litigation, and thus it is generally wise (from a tax perspective) to have the parties agree in writing on the intended tax effects of the settlement payment in addition to whether the defendant intends to issue a Form 1099 related to the payment.
The recent appellate decision of Best v. Barbarotta, 125 AFTR 2d 2020-369 (2d Cir. 1/23/20) illustrates the potential misunderstandings that can occur regarding the federal tax reporting of settlement payments after a settlement agreement has been executed. In that case, the plaintiff, Mr. Best, filed a lawsuit on his own behalf against several individuals involved in his involuntary commitment to a psychiatric treatment center. After several years of litigation, the parties entered into settlement negotiations and eventually executed a settlement agreement. The decision indicates that Mr. Best on several occasions attempted to have the defendants agree not to issue an IRS Form 1099 with respect to his settlement payment of $105,000; however, the settlement agreement he executed provided that the defendants would issue an IRS Form 1099.
Only a month after the settlement agreement ink had dried, Mr. Best apparently had reservations about agreeing to the IRS Form 1099 language. The decision does not indicate why, but Mr. Best may have spoken with a tax advisor who would have informed him that federal courts often view the issuance of an IRS Form 1099 as evidence that the payment should be treated as taxable, at least from the viewpoint of the defendant issuer. See, e.g., Burns v. U.S., 76 F.3d 384 (9th Cir. 1996). Moreover, the tax advisor may have advised Mr. Best of the tax headache he would experience reporting the payment as non-taxable on his federal income tax return, given that the IRS Form 1099 issued to him would have also been submitted to the IRS for tax return matching.
Presumably because of these tax considerations, Mr. Best filed a motion with the court requesting the court strike the IRS Form 1099 language from the agreement. In his motion, he argued, among other things, that the language should be struck because defendants’ counsel had misrepresented to him during settlement negotiations that an IRS Form 1099 was required by federal tax law. Not surprisingly, the defendants disagreed.
The lower court held for the defendants, concluding that they had a good-faith basis for their belief that federal tax law required them to report the settlement payment proceeds as taxable to Mr. Best on an IRS Form 1099. Specifically, the court noted that although settlement payments made on account of personal physical injuries or physical sickness were not taxable under Section 104(a)(2) (and thus not reportable on an IRS Form 1099), any payments by the defendants to Mr. Best strictly for emotional distress were taxable (and thus reportable on an IRS Form 1099). In this regard, the court concluded that because Mr. Best’s amended complaint sought “damages for mental and emotional suffering,” his settlement payment likewise constituted taxable remuneration for emotional distress. In addition, the court reasoned that claims alleging loss of liberty do not typically fall within the exclusion of Section 104(a)(2).
On appeal, the Second Circuit Court of Appeals affirmed the lower court’s decision. Specifically, the court of appeals concluded that the defendants had not committed fraud or misrepresentation during settlement negotiations regarding the issuance of an IRS Form 1099.
Similar to the facts in Best, I have been involved in cases as tax counsel where the defendant refused to agree to a “no IRS Form 1099” clause. Generally, defendants are concerned that they must issue an IRS Form 1099 or face tax penalties for not doing so. However, if the facts support a position that the settlement payment is not taxable under federal tax law, a simple letter informing the defendant of the federal tax law may give the defendant and defendant’s counsel comfort in not issuing an IRS Form 1099. Moreover, even if the settlement agreement has been executed and an IRS Form 1099 has been issued, plaintiffs should bear in mind that it is still possible to convince the defendant to issue a “corrected” IRS Form 1099 reporting the payment as non-taxable, although for reasons discovered by Mr. Best, it is much more difficult to do after execution of the agreement.
Freeman Law aggressively represents clients in tax litigation at both the state and federal levels. When the stakes are high, clients rely on our experience, knowledge, and talent to help them navigate all levels of the tax dispute lifecycle—from audits and examinations to the courtroom and all levels of appeals. Schedule a consultation or call (214) 984-3000 to discuss your tax needs.