The IRS recently released a memorandum advising taxpayers on the proper tax characterization of attorney’s fee payments in connection with a settlement of or judgment in an employment dispute.

Courts have long held that payments to plaintiffs for their attorney’s fees pursuant to a fee shifting statute belong to the plaintiff, not the attorney.  Thus, when the plaintiff’s underlying recovery is taxable, the plaintiff must also include in gross income the amount received for attorney’s fees.

While such attorney’s fees payment is included in income, the IRS clarified that it is usually not “wages” for tax purposes.  The IRS noted that the distinction lies in whether the settlement agreement or judgment clearly allocates a portion of the payment to attorney’s fees.

Thus, if a court awards an individual a certain amount for back pay, and specifies a separate amount for attorney’s fees, then the attorney’s fees portion is not taxable wages.  The separate amount, however, must still be reported on Form 1099-MISC.  When the court’s order is silent concerning the allocation between the plaintiff’s damages and his or her attorney’s fees, the entire amount must be reported as wages on Form W-2 (unless an exclusion applies, for example, payments for emotional distress not exceeding amounts actually paid for medical care).

The same principles apply to out-of-court settlements.  When the settlement agreement clearly indicates the portion allocable to the plaintiff’s damages and the separate portion allocable to attorney’s fees, then only the damages portion constitutes taxable wages.  The amount paid by the employer separately to the attorney is non-wage income reported to the employee on Form 1099.  When the settlement agreement does not make any such allocation, however, the entire payment constitutes taxable wages (barring any exclusions).

Employers are encouraged to adhere to this IRS guidance when drafting settlement agreements, and to seek counsel regarding the tax implications of employment-related settlements.