To 1099 or Not? That is Often the Settlement Question

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Matthew L. Roberts

Matthew L. Roberts

Principal

469.998.8482
mroberts@freemanlaw.com

Mr. Roberts is a Principal of the firm. He devotes a substantial portion of his legal practice to helping his clients successfully navigate and resolve their federal tax disputes, either administratively, or, if necessary, through litigation. As a trusted advisor he has provided legal advice and counsel to hundreds of clients, including individuals and entrepreneurs, non-profits, trusts and estates, partnerships, and corporations.

Having served nearly three years as an attorney-advisor to the Chief Judge of the United States Tax Court in Washington, D.C., Mr. Roberts leverages his unique insight into government processes to offer his clients creative, innovative, and cost-effective solutions to their tax problems. In private practice, he has successfully represented clients in all phases of a federal tax dispute, including IRS audits, appeals, litigation, and collection matters. He also has significant experience representing clients in employment tax audits, voluntary disclosures, FBAR penalties and litigation, trust fund penalties, penalty abatement and waiver requests, and criminal tax matters.

Often times, Mr. Roberts has been engaged to utilize his extensive knowledge of tax controversy matters to assist clients in their transactional matters. For example, he has provided tax advice to businesses on complex tax matters related to domestic and international transactions, formations, acquisitions, dispositions, mergers, spin-offs, liquidations, and partnership divisions.

In addition to federal tax disputes, Mr. Roberts has represented clients in matters relating to white-collar crimes, estate and probate disputes, fiduciary disputes, complex contractual and settlement disputes, business disparagement and defamation claims, and other complex civil litigation matters.

To 1099 or Not?

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.

For prior posts on tax issues in the context of litigation and settlements, see A Primer on the Tax Implications of Settlements and The Taxability of Fee-Shifting Statutes.

 

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Need assistance in managing the audit process? Freeman Law’s team of attorneys and dual-credentialed attorney-CPAs regularly represents taxpayers before the IRS and Texas Comptroller. Our team also provides tax return-related representations and helps taxpayers navigate state tax laws. Our Firm offers value-driven services and provides practical solutions to complex issues. Schedule a consultation or call (214) 984-3410 to discuss our tax representation services.

 

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