When finalizing class action settlements, or paying damage awards after a class action judgment, it is important to be mindful of the taxation of these payments and the related IRS information reporting requirements triggered by these payments. In general, businesses and persons engaged in a trade or business are responsible for filing Form 1099-MISC to report payments of over $600 per calendar year to the IRS and to the payee. This requirement includes reporting of settlement payments and damage awards. Form 1099-MISC allows the reporting of several different categories of income. For example, taxable damages paid to a plaintiff are reported on Form 1099-MISC, Box 3. In a class action lawsuit, taxable payments made to plaintiffs must be reported using the following guidelines.
Form 1099-MISC, Box 3 – The Other Income box should be used to report payments for (1) punitive damages, (2) damages for non-physical injuries or sickness (including emotional distress or mental pain and anguish), (3) liquidated damages received under the Age Discrimination in Employment Act of 1967, and (4) all other taxable damages. In addition, an award of back pay of wages is generally reportable on Form W-2 and is subject to the normal payroll withholding rules for employee compensation. Product liability claims must be broken down based on the types of damages being paid.
Some examples of other taxable damages (reportable on Form 1099-MISC):
- Other taxable damages generally include a payment that would replace income that would be taxable when received, such as a damage award for lost profits.
- If a damage payment replaces a payment that would not have been taxable when received, then that payment is probably not reported on Form 1099-MISC.
- If the payee took a deduction, such as a medical expense or attorney fee deduction, for an expense which is recovered as damages, then the recovery of those costs constitutes taxable damages reportable on Form 1099-MISC.
- Damage award payments to reimburse for medical expenses related to emotional distress are taxable if the medical expenses was previously deducted for tax purposes.
- Payments for damage to reputation, defamation of character or libel are other taxable damages.
- Accrued interest paid on damages is always taxable.
Examples of nontaxable damages (not reportable on Form 1099-MISC):
- Payments to compensate for personal physical injuries or physical sickness (including lost wages, medical expenses (if not previously deducted), pain and suffering).
- Expenses, such as medical expenses or legal fees, reimbursed which were not previously deducted for tax purposes.
- The value of injunctive relief.
We recommend that you consult with a tax attorney to determine the proper reporting of any class action settlement or damage award payments. To ensure compliance with requirements imposed by the IRS in Circular 230, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or other matter addressed herein.