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Seemingly innocuous missives from the IRS can hide sinister weapons. Good examples of this phenomenon lurk in the recently issued final regulations on Form 1099 reporting for payments made on behalf of others. These so-called “Middleman” regulations are effective Jan. 1, and they contain disturbing surprises for lawyers (T.D. 9010, July 26, 2002, 67 Fed. Reg. 48756). The Middleman regulations are aimed at escrow agents and others who make payments on behalf of others. But, deep in the belly of the regulations are reporting rules for payments involving attorneys and their clients. First, some background. There’s a well-publicized rift in the circuits on whether attorney fees paid to a plaintiff’s attorney are includible in the plaintiff’s income. Some circuits require a plaintiff to include attorney fees in income, while others allow him to exclude those fees and report only the net amount he receives. Compare Sinyard v. Commissioner, 268 F.3d 756 (9th Cir. 2001), cert. denied 122 S.Ct. 2357 (2002), with Estate of Clarks v. United States, 202 F.3d 854 (6th Cir. 2000). When attorney fees are included in the plaintiff’s income, the plaintiff can generally take a tax deduction for the fees. But, the benefit of this deduction is often reduced (and can be virtually eliminated) because of the alternative minimum tax. So netting is always better. Up to now, reporting rules have not required defendants to issue a Form 1099 to the client for the attorney fees. It seemed likely that the IRS would settle this controversy only through final regulations labeled for “attorney fees” under � 6045(f) of the Internal Revenue Code. That section expressly requires most payments to attorneys to be reported on a Form 1099. Indeed, several sets of proposed regulations expressly on attorney fees were already issued. Had there not been a huge outcry, those regulations would already be law. As it is, the IRS just issued a new set of proposed regulations in May. (REG-126024, May 17, 2002, 67 Fed. Reg. 355064). Though these “Attorney Payment regulations” are not perfect, it seemed lawyers could rest easy for a spell, since they would not become effective until two months after they are finalized. No such luck. The IRS put the new 1099-for-attorneys rules in a plain brown wrapper — the Middleman regulations. This will catch lawyers off guard, particularly plaintiffs lawyers. The Attorney Payment regulations may not be finalized for some time, but the Middleman regulations must be dealt with starting Jan. 1. The Middleman regulations include rules that affect defendants’ reporting obligations. Beginning in 2003, defendants must report settlements includible in the gross income of the plaintiff. Reg. � 1.6041-1(f). This rule applies “whether the payment is made jointly or separately to the payee and another person.” Id. Thus, when a defendant pays a plaintiff, the defendant must issue a Form 1099 to the plaintiff — including the attorney fees — whenever that payment is includible in the plaintiff’s gross income. Reg. � 1.6041-1(f)(2). Example: Attorney represents Client in a claim for lost profits against Defendant. It settles for $140,000. Defendant issues a $40,000 check to Attorney and a $100,000 check to Client. Under the law that applies to the Client, Client is required to include a portion of the recovery that pays his attorney fees in his gross income. The Middleman regulations require that Defendant issue a Form 1099 to Client showing $140,000. MIXED MESSAGES Of course, defendants settle cases all over the country, and this issue is tough. The 3rd, 4th, 7th, 9th and 10th U.S. Circuit Courts of Appeal have decided that attorney fees are taxable to the plaintiff. The 5th, 6th and 11th Circuits have decided they are not. The regulations require a defendant to report the amount that is includable in the plaintiff’s gross income under “applicable law.” Must the defendant analyze the tax law on attorney fees before it reports a payment? Yes, and this is trickier than it seems. Not only have some circuits not yet ruled on this issue, the IRS has assumed a restrictive stance — it contends that even in those circuits permitting a plaintiff to exclude attorneys fees, that rule applies only in certain states within those circuits. (Alabama, Michigan and Texas. See “IRS MSSP Audit Guide for Lawsuit Awards and Settlements” (2001), 2001 TNT 18-6.) The basic 1099 rule is that payments of $600 or more made in the course of a trade or business must be reported. The Middleman regulations, a subset of this general rule, apply to persons making payments on behalf of another (so-called “middlemen”). The Middleman regulations define which “payor” must report the payment. A person making payment on behalf of another is a “payor” if he either: 1. Performs management or oversight functions in connection with the payment, or 2. Has a significant economic interest in the payment. Reg. Third, Fourth, Seventh, Ninth and Tenth 1.6041-1(e)(1). This “management and oversight” prong will often trigger reporting to lawyers and clients. Unfortunately, the Middleman regulations only define this term in the negative. “Management and oversight” does not include performance of mere administrative or ministerial functions such as writing checks at another’s direction. This leaves much gray area. Indeed, any lawyer making payments on behalf of another who has discretion over the payment amount, timing, or services provided should look carefully at the Middleman regulations (or else just report the payments). The latter — just report whenever in doubt — may be one of the IRS’ most insidious messages. REPORTING DUTIES Section 6045(f) of the code explicitly imposes reporting obligations on attorney payments in addition to the regular $600 reporting rule. Section 6045(f) generally requires information reporting for any payment made to attorneys with respect to legal services, even where the services were not provided to the payor. For example, a defendant’s insurer who issues a settlement check to the claimant’s attorney may be required to report the payment. The IRS issued proposed Attorney Payment regulations on May 17, but they don’t become effective until two months after they are finalized (67 Fed. Reg. 355064). That could take years. Meanwhile, the Middleman regulations do apply to attorneys. Confused? Just wait. Here’s an example: Paula Plaintiff settles with Egregious Employer, her former employer. Egregious paid the fees into her lawyer Lawrence Lawyer’s trust account. Lawrence used the funds to pay experts, costs and other litigation expenses. Lawrence decided whom to hire, negotiated the amount of payment, and determined whether the services were performed satisfactorily. Lawrence also had the right to withhold payment in the event of a dispute. After paying his own fees, Lawrence paid the net amount to Paula. 1. Lawrence’s payments to the third parties: The Middleman regulations apply to Lawrence’s payments for experts, costs and litigation expenses. Lawrence made these payments on behalf of Paula, so his reporting duties depend on whether he performed management and oversight functions or had a significant economic interest in the payments. Here, Lawrence performed management and oversight functions, so Lawrence must file 1099s for these payments. Of course, since management and oversight is a question of fact, it is quite possible that an attorney will not be performing management and oversight functions for these types of payments. If the client is responsible for, say, hiring an expert, negotiating payments or approving his work, the attorney making payments to the expert may not be required to report the payment. 2. Lawrence’s payment to Paula: Lawrence paid Paula the net settlement proceeds from Egregious. Thus, he made the payment on behalf of another. The Middleman regulations conclude (without analysis) that Lawrence neither performed management and oversight functions nor had a significant economic interest. Lawrence therefore has no information reporting duties for this payment. Still, since the tests in the regulations involve questions of fact, reporting under � 6041 may still be required when an attorney pays a net recovery to a client. 3. Egregious’ payment to Lawrence: The Middleman regulations instruct Egregious to “see” � 6045(f) for its reporting duties, suggesting that � 6041 does not require Egregious to report the payment. Yet, Egregious is not out of the woods — it must still contend with � 6045(f). If � 6045(f) employed the same definition of “payor” as in � 6041, then Egregious would not be a payor under either section. It could legitimately argue that neither section required it to report the payment. Unfortunately, the Attorney Payment regulations try to force Egregious to report the payment by defining “payor” to include “an obligor on the payment, or the obligor’s insurer or guarantor.” Thus, Egregious is not a “payor” under the Middleman regulations, but is a “payor” under the proposed Attorney Payment regulations. Remember, though, that the Attorney Payment regulations are not yet effective. Until they are, the definition of “payor” under � 6045(f) seems up for grabs. To try to avoid reporting under either rule, Egregious might argue that the definition of “payor” in � 6041 applies to � 6045(f). 4. Egregious’ payment to Paula: The Middleman regulations instruct Egregious to “see” the � 6041 regulations (the general reporting rule). Thus, Egregious must report the payment to Paula if it otherwise qualifies under � 6041. Egregious may be required under the Middleman regulations to report the gross payment to Paula, including Lawrence’s legal fees. This requires Egregious to determine: 1. which circuit’s law applies to Paula; 2. whether, under the law in that circuit, Lawrence’s fees are includible in Paula’s gross income; and, 3. if the plaintiff is in a circuit in which attorney fees are excluded, whether the service is right in restricting that rule to certain states within the circuits. The Middleman regulations are silent on which set of rules applies to payments made by a defendant’s insurer. Perhaps the insurer’s payment is governed by the same rules that apply to Egregious. Yet, there is a factual difference. Egregious’ payments arose from services Paula performed for it. A payment by the insurer would be for services Paula rendered to someone else — Egregious. Thus, the insurer would arguably be making payment on behalf of Egregious. As such, it may (unlike Egregious) be operating under the Middleman regulations. In that event, the insurer’s reporting obligations under � 6041 would turn on whether it performed management and oversight functions or had an economic interest in the payment. 5. Paula’s payment to Lawrence: The Middleman regulations instruct Paula to see the general 6041 reporting rule as well as the particular rule for payments for professional services. Paula may be required to report the portion of Egregious’ payment that constitute Lawrence’s fees to Lawrence, although her reporting duties would be subject to the limitations on the general reporting rule. For example, the payment of the attorney fees by Paula would not need to be reported if it was occasioned by personal reasons such as a divorce. Navigating reporting obligations for attorney-related payments has never been easy. Under these new Middleman regulations, IRS reporting duties turn on unsettled standards, require defendants to answer complex tax questions, and make this whole morass even trickier. Robert W. Wood is the founder of Robert W. Wood Professional Corp., a San Francisco law firm. He is a certified specialist in taxation, and is the author of “Taxation of Damage Awards and Settlement Payments.” Jonathan R. Flora is an associate at the firm.

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