The IRS has explained the tax treatment of legal fees paid under settlement agreements with employees who brought suit against employers.  The fees may be taxable and they may actually be subject to employment taxes.  How you report those fees to the employees and to the IRS is determined by a four-step process:

 

1.  The character of the payment and the nature of the claim must be determined

2.  It must be determined if the payment constitutes an item of gross income

3.  There must be a determination as to whether the payments are wages for employment tax purposes

4.  The appropriate form (1099-MISC or W-2) must be determined

 

From here it gets a bit complex.  If part of the amounts paid to the claimant are includable in income, even attorney’s fees that are paid directly to the attorney are includable in income too.  There are some instances where the fees can then be deducted but it is important to consult a tax specialist to review the code sections to verify what applies to your situation.

The IRS takes the position that payments constituting severance pay, back pay and front pay are wages for employment tax purposes.  Attorney fees included in these types of judgments, if they are specifically broken out by the court, are not included in wages.  They are however included in income.  If the attorney fees are not specifically broken out in the agreement they are considered part of wages.  This means that you might have part of a payment to include on Form W-2 and part of a payment to report on Form 1099-Misc.    You might also have amounts reported on Form W-2 that are really attorney fees but that must be included for employment tax purposes.   To make the process even more confusing, if attorney fees are part of the settlement and paid directly to the attorney they are still reportable on one 1099-Misc issued to the claimant along with the rest of the income generating settlement that is not allocable to wages.

The best course of action when you have this type of situation is to contact your CPA before issuing any forms.  Have her review the settlement as well as the nature of the payments and determine what amount is reportable to whom on which form.