Almost any time money changes hands in America, there are tax issues. The Internal Revenue Code (I.R.C.) is over 2,600 pages long, and contains fives times as many words as the Bible. The federal tax rules and resources within the CCH Standard Federal Tax Reporter exceed 75,000 pages, enough to fill a small library. More daunting than its length, the U.S. Tax Code is so hopelessly complex that even most lawyers don’t understand its nuances and can’t do their own taxes. It is no wonder, therefore, that when it comes to subrogation settlements and disbursing settlement checks, there is no uniform set of procedures to follow, and lawyers, subrogation professionals, and claims practitioners are left scratching their heads. Some insurance companies and defense attorneys demand Form W-9’s or other Internal Revenue Service (I.R.S.) documentation in connection with a settlement without even understanding why.
A typical subrogation settlement could involve a lawyer hired by a subrogation vendor to collect an auto collision subrogation claim along with the deductible paid by the insured of the vendor’s client, a national auto insurance company. The lawyer eventually settles the subrogation suit with the liability carrier for the negligent tortfeasor. The vendor requests that the settlement check be issued in its name. Defense counsel sends the subrogation lawyer a proposed release along with instructions to provide a Form W-9 for the vendor. The vendor refuses to forward a Form W-9, arguing that out of the settlement funds the deductible will be reimbursed to the insured, attorneys’ fees will be paid to the lawyer, a small portion will be retained by the vendor as a fee, and the balance will be paid to the subrogated insurer. The settlement stalls and everybody admits they are confused over what should happen – and why.
The payment of a settlement imposes I.R.S. reporting obligations on the parties, which depend on the nature of the settlement proceeds and the claims being made in the lawsuit. There are two ways for a party settling a lawsuit to report the settlement to the I.R.S. – Form W-2 and Form 1099-MISC. The Form W-2 is issued by a defendant employer in an employment claim for any portion of the settlement which is paid as compensation for wages. The employer treats it like a payroll check, withholding applicable taxes, Social Security, and Medicare (Federal Insurance Contributions Act (“FICA”) taxes). I.R.C. § 6051. The defendant employer will also have to remit the matching taxes, representing 7.65%. The plaintiff will, therefore, receive a payment less than the portion of settlement allocated to the withholdings on the lost wages. Any other non-wage damages paid as part of the settlement are reported by the employer on a Form 1099-MISC.
For settlement of lawsuits that are not employment claims, the party paying the settlement reports to the I.R.S. using a Form 1099-MISC, one of several types of Form 1099. The I.R.S. uses Form 1099 to distinguish different types of income that a taxpayer (e.g., independent contractor) may receive other than payment from a regular job, as shown on a Form W-2. The Form 1099 is known as an “information return”, and is one of the I.R.S.’s main weapons in fighting underreporting by plaintiffs receiving settlement funds. Those paying for the work are responsible for issuing a Form 1099 to the taxpayer, as long as the taxpayer makes over $600. The I.R.S. requires all taxpayers, including insurance companies paying out settlements, to file a Form 1099 in connection with certain transactions which involve a payment of $600 or more, and may assess penalties for failure to do so. The Form 1099 is completed in duplicate, with one copy going to the I.R.S. and the other to the taxpayer receiving the payment. This gives the I.R.S. the means necessary to match the payments and/or expenses from one taxpayer with receipts and/or income to another. A party making a payment must report it with a Form 1099-MISC if the following four conditions are met:
- Payment is made to someone who is not an employee;
- Payment is for services in the course of a trade or business (including government agencies and nonprofit organizations);
- Payment is made to an individual, partnership, estate, or in some rare cases, a corporation; and
- Payments have been made to the payee of at least $600 during the year.
Within the Form 1099 itself, there are two choices. Box 3 is for “other income,” including taxable damage awards, and Box 7 is for “non-employee compensation” over $600. For settlements, obviously, Box 3 is used. When a settlement includes compensation for lost wages not paid by the employer, the party paying the settlement uses Box 7. When the settlement is being paid by a liability insurance company, which is typical, no Form W-2 will be issued because the plaintiff doesn’t work for the insurance company – only a Form 1099 will be issued.
If a Form 1099 (Box 7) is chosen, the defendant will issue the settlement check to the plaintiff for the full amount allocated to lost wages. The defendant will not deduct any state, federal, or FICA taxes from this payment and it will not remit any matching FICA taxes. At the end of the year, the plaintiff will receive a Form 1099 with the amount of the settlement allocated to lost wages reported in Box 7, and will owe income taxes along with self-employment taxes on that money.
In addition to the $600 rule, anybody who makes a payment to an attorney in “connection with legal services” or in the course of business must issue a Form 1099, regardless of whether the legal services were performed for the person making the payment. I.R.C. § 6045. For example, payments made by attorneys to other attorneys who serve as local counsel, fee splitting, or referral fees. This rule also applies to when a settlement is paid by the defendant liability carrier to an attorney or to an attorney and plaintiff jointly. The liability carrier is required to issue a Form 1099 only if the underlying claim is taxable to the payee.
If the underlying claim is taxable, the carrier must issue a Form 1099. I.R.C. § 6041. Therefore, it is possible that both the attorney and the client receive a Form 1099 from the carrier paying the settlement for the whole settlement amount. Congress enacted a special rule requiring reporting of “gross proceeds” paid to attorneys and law firms, which must be reported in Box 14 of Form 1099-MISC. I.R.C. § 6045. If the underlying claim is non-taxable and jointly payable to the attorney and the client, the carrier is excused from issuing a Form 1099 to the plaintiff, but will still need to issue a Form 1099 to the attorney for the entire amount. If the settlement check is payable to and deposited in the attorney’s trust account, a Form 1099 is not necessary.
Condition 3 for filing a Form 1099 above reflects the fact that only taxable payments to individuals or partnerships must be reported. Settlement payments made to a corporation are usually not required to be reported on a Form 1099. This includes S and C corporations, as well as LLC’s which have elected to be treated as a S corporation by filing Form 2253 or treated as a C corporation by filing Form 8832. Only the following payments made to corporations must be reported on Form 1099-MISC:
- Medical and healthcare payments reported in Box 6;
- Fish purchases for cash reported in Box 7;
- Attorneys’ fees reported in Box 7;
- Gross proceeds paid to an attorney reported in Box 14;
- Substitute payments in lieu of dividends or tax-exempt interest reported in Box 8; and
- Payments by a federal executive agency for services (vendors) reported in Box 7.
The instructions for the Form 1099 say that the only exceptions are payments for medical and healthcare payments, attorneys’ fees, and gross proceeds paid to an attorney. It should also be noted that any payments made by credit card are not subject to being reported on a Form 1099. Although payments to corporations are exempt from Form 1099 rules, payment of attorneys’ fees are an exception. The rule that payments to lawyers must be reported on a Form 1099-MISC trumps the rule that payments to corporations do not have to be. Any payment for services of $600 or more to a lawyer or law firm must be reported on a Form 1099-MISC, regardless whether the law firm is a corporation, LLC, LLP or general partnership. If a law firm pays fees to co-counsel or a referral fee to a lawyer, it must issue a Form 1099-MISC regardless of how the lawyer or law firm is organized. Moreover, any client paying a law firm more than $600 in a year as part of the client’s business must issue a Form 1099-MISC.
No reporting is necessary by the law firm if the law firm merely passes on settlement funds to their clients. The liability carrier is considered the payor. If the settlement check is made payable to the law firm’s trust account, Treasury Regulations treat this just like a joint check, and both the client and the law firm will receive a Form 1099-MISC for the entire amount.
A Form 1099is generally issued in January of the year after payment. They must be sent to the taxpayer by the end of January. The I.R.S. copies of the forms are not due at the I.R.S. until the end of February. However, beginning in 2017, the due date for Forms 1099-MISC, which report non-employee compensation in Box 7, has been changed to January 31. Because the I.R.S. will not criticize anyone for issuing more Form 1099s than necessary, it is becoming common for parties to issue Form 1099s even where they are not strictly necessary. However, failure to file a Form 1099 can be used by the I.R.S. as evidence that the party being paid was, in fact, an employee of the payor, leading to all sorts of other problems that should be avoided at all costs.
Form 1099 requires Taxpayer Identification Numbers of the payees of the settlements. In order to help all these parties fill out the Form 1099 that must be completed, there is another form that helps provide them with information about the recipient of settlement funds. Form W-9 is an I.R.S. form usually used by a business to collect basic information from an independent contractor to whom it is paying more than $600, including name, address, and Social Security Number/Taxpayer Identification Number. A Form W-9 is also often required of a plaintiff when a lawsuit is settled in order to allow the liability carrier to properly report the settlement payment to the I.R.S. It helps the insurance company paying the settlement to obtain the information necessary to produce a Form 1099 at end of the tax year, which it sends in to the I.R.S. to document the payment. It then becomes an issue between the I.R.S. and the plaintiff receiving the settlement to determine if it constitutes taxable income. The Form W-9 is a means to ensure that the payee of the settlement is reporting its full income.
Attorneys are frequently asked to supply their own Taxpayer Identification Numbers and other information to the liability carrier paying a settlement. If an attorney fails to do so, he or she is subject to a $50 penalty for each failure to supply that information. The payments to be made to the attorney may also be subject to back-up withholding. Of course, some defendants may simply refuse to fund a settlement without the required I.R.S. forms and will threaten to simply pay the settlement funds into the registry of the court.
Taxation of Settlement Funds Generally
So when is a settlement taxable? Let’s start with some basics. Settlements and judgments are taxed the same. I.R.C. § 61 specifies that all income from any source is taxable, unless specifically excluded by another Code section. Personal injury recoveries are excluded from gross income only where specifically exempted by statute, regulation, or judicial authority. Section 104 excludes from gross income specific types of recoveries, generally arising out of an injury or sickness. These include:
- Amounts received under worker’s compensation acts as compensation for personal injuries or sickness;
- Amounts received through accident or health insurance for personal injuries or sickness;
- Amounts received as an annuity, pension, or allowance for personal injuries or sickness that result from active service in the military; and
- Amounts received by an individual as disability income for injuries directly resulting from a terrorist or military action.
The Small Business Job Protection Act of 1996 revised § 104(a)(2) to also exclude from taxable income recoveries from lawsuits, settlements, and awards. However, it does not exempt punitive damages from gross income, except as allowed by § 104(c), amounts received as reimbursements for medical expenses previously deducted under Code § 213, Rev. Rul. 79-247, or payments to businesses. Section 104(c) states that the taxable treatment of punitive damages does not apply to punitive damages awarded in a civil action for wrongful death, if applicable state law allows only for punitive damages. Any interest on settlement payments will also be included in gross income, because it has no relation to the underlying physical injury or physical sickness.
Settlements and judgments are taxed according to the origin of the claim – the nature of the damages for which the plaintiff was suing. If the lawsuit is against competing businesses for lost profits, a settlement will constitute lost profits, taxed as ordinary income. If a person is laid off at work and sues for discrimination seeking wages, the recovery will be taxed as wages. A lawsuit by a condo owner against a negligent building contractor, however, typically won’t be taxed as income. Instead, the recovery will be treated as a reduction in the owner’s purchase price of the condo. These rules are full of exceptions and nuances that are beyond the pay grade of a humble subrogation attorney. In general, however:
- Recoveries for personal physical injuries and physical sickness are tax-free.
- Symptoms of emotional distress are not “physical.” However, recoveries attributable to emotional distress in connection with a physical injury or physical sickness are tax-free.
- Medical expenses are tax-free.
Unless it involves injuries from an accident, just about everything is taxable as income. Now the question becomes how it is taxed. If a lawsuit involves damage to a house, a recovery by the homeowner may be treated as a capital gain. Depending on the homeowner’s tax basis (home’s purchase price, increased by any improvements and less any depreciation), the settlement may be treated as a recovery of basis, not income.
If the settlement is with the plaintiff’s employer and includes lost wages, the employer paying the settlement will be required to report the payment on a Form W-2 and withhold applicable income taxes and Social Security taxes. If the settlement is taxable income other than employee wages, the payment will be reported on a Form 1099-MISC. A settlement agreement should specify whether a Form W-2 or Form 1099 will be issued to the recipient. The average personal injury settlement is around $24,000. Therefore, a typical settlement allocation might look like this:
Lost Wages: $5,000
Medical Bills: $5,000
Pain and Suffering: $14,000
Total Settlement: $24,000
The lost wages (or lost profits) are taxable. The rest of the settlement is not. When you factor in attorneys’ fees, whether hourly or contingent, the plaintiff will be considered to have received 100% of the recovery, even though 40% attorneys’ fees were paid. Those fees are then treated as miscellaneous itemized deductions.
Taxation of Subrogation Recoveries
Most subrogation professionals don’t know and don’t care about the tax treatment of the recoveries they obtain for a living. However, an article about subrogation and the I.R.S. wouldn’t be complete without some discussion of the issue.
Workers’ compensation benefits paid to an injured employee, including a lump-sum settlement, are not taxable to the employee at the federal, state, or local level. I.R.S. Publication 907 (Jan. 4, 2017). Although a New York employee is required to report workers’ compensation benefits on their New York W-2 tax documents, the actual benefit payments are not included in the person’s gross pay. Workers’ compensation benefits are considered to be non-taxable insurance settlements. In certain situations, however (e.g., employee receives both Social Security Disability benefits and workers’ compensation benefits), the Social Security benefits may become taxable.
Subrogation recoveries generally increase an insurance company’s gross income dollar-for-dollar. Therefore, § 832 of the I.R.C. treats subrogation as income subject to the Tax Benefit Rule, which provides that the amount of an expense recovered must be included as income in the year of the recovery to the extent the original expense resulted in a tax benefit. Subrogation is, according to the I.R.S., a recovery of a previously deducted loss. Therefore, while subrogation must be included under taxable income, an insurance company will exclude from taxable income that portion of a subrogation recovery to the extent the previous deduction generated no tax benefit.
If a subrogated insurance company receives a settlement from another insurance company, reimbursing them for a claim previously paid to an insured, this subrogation payment would be reportable to the other insurance company in Box 3 of the 1099 form, provided the other company is not a corporation. Most insurance companies are required to be incorporated, and if that is the case, no Form 1099 is needed. When payments to lawyers are involved, the issue becomes more complicated.
Under I.R.C. § 832(b), underwriting income for a property and casualty insurance company, a component of gross income, is reduced by losses incurred. Losses incurred are, in turn, reduced by any recovered salvage and subrogation. Salvage consists of proceeds from the sale of damaged property for which companies have taken over the title.
Therefore, most subrogation recoveries constitute a taxable settlement. For taxable settlements, the defendant is required to issue a Form 1099 to the plaintiff under I.R.C. § 6041. If the settlement check is jointly payable to the plaintiff and its attorney, the defendant is required to issue a Form 1099 to the attorney under § 6045 as amounts paid “in connection with legal services.” As a result, both the attorney and the plaintiff receive Form 1099s for the entire settlement amount.
Subrogation professionals, recovery vendors, and attorneys representing subrogated carriers, self-insureds, and vendors, should be prepared to address the requirement of providing Form W-9’s and even Form 1099-MISC’s following or in conjunction with settlement of a subrogation claim. Even Albert Einstein once said that, “The hardest thing to understand in the world is the income tax.” And, for somebody who established the theories of general and special relativity, that is saying a lot.
If you should have any questions regarding this article or subrogation in general, please contact Gary Wickert at email@example.com.
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