When a lawsuit results in a settlement, the tax reporting obligations depend on the type of damages paid. In general, compensatory damages for lost wages, business income, or punitive damages are taxable and must be reported to the IRS. Damages related to physical injury or sickness may be excluded from taxable income, but interest and punitive awards are always taxable.
If you are the payer of a settlement, you may be required to issue a Form 1099-MISC to the recipient, reporting the taxable portion of the settlement.
Attorney Fees and 1099 Requirements
Attorney fees are a common source of confusion. Even if a portion of the settlement is paid directly to an attorney, reporting rules generally require that both the claimant and the attorney receive 1099 forms.
- Form 1099-MISC is used to report attorney’s fees when the attorney receives funds on behalf of a client.
- Form 1099-NEC is used to report payments made directly to an attorney for legal services.
This means that in many cases, the same payment may generate two separate 1099s: one to the claimant for the settlement amount and one to the attorney for their portion.
Deadlines for Issuing 1099s
- To recipients (claimants and attorneys): January 31
- To the IRS: February 28 (paper) or March 31 (electronic)
Failing to issue accurate 1099s on time can result in IRS penalties.
Why It Matters
The IRS closely monitors settlement payments and attorney fees to ensure proper tax reporting. Misclassification or omission can lead to compliance issues, penalties, and IRS audits. By understanding the rules, you can ensure both claimants and attorneys are properly reported.
1099-NEC and 1099-MISC Software and Outsourcing
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