Recently, the issue of how to handle tax reporting of client settlement checks paid in trust to an attorney for the client. I asked accountants and attorneys, and I could not find an answer that made me feel comfortable. This morning, I contacted Terri L. Smith-Ashford the Director of Banking & Operations for Lawyers Trust Fund of Illinois, and she directed me to the following article with the most pertinent passages copied below:
Attorney or Client: Tax Reporting of Client Settlements
For taxable settlements, the defendant is required to issue a 1099 to the plaintiff under § 6041. In addition, if the proceeds are jointly payable to attorney and plaintiff, the defendant is required to issue a 1099 to attorney under § 6045 as amounts paid “in connection with legal services.” As a result, both attorney and plaintiff receive 1099s for the entire settlement amount. For nontaxable settlements jointly payable to attorney and plaintiff, the defendant is excused from issuing a 1099 to the plaintiff but will still need to issue a 1099 to the attorney for the entire amount. To avoid a situation whereby the IRS interprets the entire settlement as income to the attorney, the attorney can simply request a separate check payable to plaintiff for damages and one payable to attorney for attorney’s fees and reimbursable costs: only the amounts paid to attorney are reportable under § 6045.
All taxpayers need to issue 1099s for payments to attorneys, including payments from attorneys to other attorneys, as well as for payments under the $600.00 rule. In litigation, this is the responsibility of the defendant or the defendant’s insurance company. One way to avoid the necessity of requesting separate checks from the defendant or the defendant’s insurance company is to request a single check in the entire amount to “Attorney in trust for Client.” The attorney deposits this check into the attorney’s client trust account. Net settlement proceeds paid from the client trust account to the client are neither payments in the course of business nor payments to an attorney “in connection with legal services.” Consequently, the attorney does not need to issue a 1099 to the client when distributing these amounts.
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