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.

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Photo of Tony Oncidi Tony Oncidi

Anthony J. Oncidi is the co-chair of the Labor & Employment Law Department and heads the West Coast Labor & Employment group in the firm’s Los Angeles office.

Tony represents employers and management in all aspects of labor relations and employment law, including…

Anthony J. Oncidi is the co-chair of the Labor & Employment Law Department and heads the West Coast Labor & Employment group in the firm’s Los Angeles office.

Tony represents employers and management in all aspects of labor relations and employment law, including litigation and preventive counseling, wage and hour matters, including class actions, wrongful termination, employee discipline, Title VII and the California Fair Employment and Housing Act, executive employment contract disputes, sexual harassment training and investigations, workplace violence, drug testing and privacy issues, Sarbanes-Oxley claims and employee raiding and trade secret protection. A substantial portion of Tony’s practice involves the defense of employers in large class actions, employment discrimination, harassment and wrongful termination litigation in state and federal court as well as arbitration proceedings, including FINRA matters.

Tony is recognized as a leading lawyer by such highly respected publications and organizations as the Los Angeles Daily JournalThe Hollywood Reporter, and Chambers USA, which gives him the highest possible rating (“Band 1”) for Labor & Employment.  According to Chambers USA, clients say Tony is “brilliant at what he does… He is even keeled, has a high emotional IQ, is a great legal writer and orator, and never gives up.” Other clients report:  “Tony has an outstanding reputation” and he is “smart, cost effective and appropriately aggressive.” Tony is hailed as “outstanding,” particularly for his “ability to merge top-shelf lawyerly advice with pragmatic business acumen.” He is highly respected in the industry, with other commentators lauding him as a “phenomenal strategist” and “one of the top employment litigators in the country.”

“Tony is the author of the treatise titled Employment Discrimination Depositions (Juris Pub’g 2020; www.jurispub.com), co-author of Proskauer on Privacy (PLI 2020), and, since 1990, has been a regular columnist for the official publication of the Labor and Employment Law Section of the State Bar of California and the Los Angeles Daily Journal.

Tony has been a featured guest on Fox 11 News and CBS News in Los Angeles. He has been interviewed and quoted by leading national media outlets such as The National Law JournalBloomberg News, The New York Times, and Newsweek and Time magazines. Tony is a frequent speaker on employment law topics for large and small groups of employers and their counsel, including the Society for Human Resource Management (“SHRM”), PIHRA, the National CLE Conference, National Business Institute, the Employment Round Table of Southern California (Board Member), the Council on Education in Management, the Institute for Corporate Counsel, the State Bar of California, the California Continuing Education of the Bar Program and the Los Angeles and Beverly Hills Bar Associations. He has testified as an expert witness regarding wage and hour issues as well as the California Fair Employment and Housing Act and has served as a faculty member of the National Employment Law Institute. He has served as an arbitrator in an employment discrimination matter.

Tony is an appointed Hearing Examiner for the Los Angeles Police Commission Board of Rights and has served as an Adjunct Professor of Law and a guest lecturer at USC Law School and a guest lecturer at UCLA Law School.