Most defendants routinely issue IRS Forms 1099 for legal settlements, which may be directed to the attorney, the client, or both. It is common practice for both the client and attorney to each receive Forms 1099 reporting 100% of the settlement proceeds. This can create the impression that double the settlement amount was paid, but such duplicate reporting is generally required for fully taxable settlements.

A significant exception is that plaintiffs should not receive Forms 1099 for compensatory damages related to personal physical injuries. In cases where an injury claim settles before trial, the attorney should receive a Form 1099 for the proceeds, but the client should not. However, if the case concludes after a verdict and includes punitive damages or interest, a Form 1099 must be issued for the taxable portion, though the exact amount subject to tax may be subject to interpretation.

Regardless of the nature of the settlement, it is advisable to specify in settlement agreements which tax forms will be issued, to whom, and for what amounts. Failure to clarify these details can result in confusion. Many clients are caught off guard each year when they receive unexpected tax forms in January for settlements from the previous year.

Unanticipated Form 1099 Issues

Unpleasant surprises related to Form 1099 can arise in several ways. Plaintiffs may receive a Form 1099 with unanticipated amounts or for income types they did not expect. For example, legal fees are often included: the plaintiff’s Form 1099 typically reports the full amount of the settlement, even if fees were disbursed directly to their attorney. Another issue can occur when a plaintiff receives a Form 1099-NEC instead of a Form 1099-MISC. While both represent taxable income, Form 1099-MISC denotes “other income,” whereas Form 1099-NEC identifies non-employee compensation and subjects the recipient to self-employment tax, which is 15.3%, consisting of Social Security and Medicare taxes.

The 12.4% Social Security portion applies only to the first $176,100 of earnings, whereas an additional 0.9% Medicare tax applies to net self-employment earnings above $200,000 (individuals) or $250,000 (married couples), with no cap on this additional tax. Taxpayers may contest the classification on their tax return, but the final determination rests with the IRS.

Ambiguous Income Recognition

Other than settlements for personal physical injuries, Forms 1099 are issued in most instances. Nevertheless, certain categories of settlement payments should not trigger issuance of Form 1099. Plaintiffs with valid arguments for nontaxable recoveries may wish to avoid receiving a Form 1099, as its issuance may put them at a disadvantage. These considerations underscore the importance of addressing tax implications during settlement negotiations.

If a defendant is uncertain whether any part of a settlement constitutes income to the plaintiff, IRS guidelines indicate that no Form 1099 should be issued. Several IRS rulings affirm that the payor is not required to file Form 1099 if they cannot determine the taxable portion of the payment. Aside from physical injuries, other examples include capital recoveries—such as disputes involving sales prices or property damages—where only the gain above the taxpayer’s adjusted basis is considered gross income reportable on Form 1099.

Capital Recoveries

Common scenarios involving capital recoveries include litigation over real estate, damaged property, or investment account management. In these cases, the tax treatment depends on the taxpayer’s basis in the asset, and only the gain is treated as gross income. The IRS Form 1099-MISC instructions specifically state that tax-free recovery of the recipient’s adjusted basis should not be reported. Payments replacing capital, such as those made for incomplete construction, are excluded from Form 1099 reporting.

Where settlements constitute ordinary income, all legal fees and expenses—regardless of their allocation—are included in gross income and must be reflected on Form 1099, pursuant to Treas. Reg. § 1.6041-1(f). However, in capital recovery cases, legal fees may be treated as capital expenditures, thus increasing the recipient’s basis and reducing taxable gain. Since defendants typically lack information about a plaintiff’s basis and related expenses, they are often unable to accurately report gross income and, per IRS guidance, are not required to issue a Form 1099-MISC in such situations.

This principle has been observed in high-profile cases, such as the California wildfire settlements, where energy companies did not issue Forms 1099 to victims, issuing them only to law firms as required.

Tax Considerations and Indemnity Provisions

Discussing taxation within settlement agreements is vital, though some defendants may be reluctant to assume tax-related risks. Indemnity provisions, commonly used in such agreements, protect defendants by obligating plaintiffs to reimburse any taxes, penalties, or interest resulting from adverse tax determinations. Defendants may also seek indemnity for wage recharacterizations arising from employment disputes, though plaintiffs often resist such terms due to potentially large penalties.

In practice, enforcement of indemnity obligations by defendants against plaintiffs may be infrequent, given practical limitations such as plaintiffs’ ability to pay and concerns over further litigation.

Conclusion

Plaintiffs are advised to carefully consider tax and Form 1099 implications prior to executing settlement agreements. While receipt of a Form 1099 does not preclude taxpayers from subsequently claiming all or part of a recovery as nontaxable or as capital gain, it does increase scrutiny by the IRS. Advanced planning is essential to avoid unwanted tax consequences.