Employers frequently ask whether the portion of an employment-related settlement allocated to attorneys' fees must be treated as wages and subjected to income and employment tax withholding and Form W-2 reporting where a plaintiff's claim is based on statute that provides for the recovery of attorneys' fees (a so-called "fee-shifting statute"). The answer was not entirely clear based on conflicting guidance from the IRS. Fortunately the IRS recently confirmed its view in LAFA 20133501F (July 11, 2013) that where a plaintiff's claim is based on a fee-shifting statute, the amount of the settlement that is clearly allocated to attorneys' fees and that is reasonable in amount is not wages for employment tax purposes.
As background, the IRS ruled in Rev. Rul. 80-364 that the portion of a judgment that was separately identified by the court as an award of attorneys' fees is not treated as wages to the plaintiff. The IRS later extended the reasoning in Rev. Rul. 80-364 to settlement payments, concluding that the portion of a settlement payment properly allocable to attorney's fees is not wages if the claim is based on a fee-shifting statute (TAM 200244004, Nov. 1, 2002).
The IRS back-tracked in a 2008 memorandum (IRS PTMA 2009-035, Oct. 22, 2008), suggesting that the IRS might take the position that a settlement amount allocable to attorneys' fees could be treated as wages even under a fee-shifting statute. In light of the uncertainty and because employers are strictly liable for taxes that they improperly fail to withhold, some employers were inclined to be cautious and withhold upon some or all of the attorneys' fee portion of a settlement payment.
Fortunately the IRS never formally adopted this position, and LAFA 20133501F confirms that the IRS continues to apply the reasoning in Rev. Rul. 80-364 to settlement payments:
"When an employment-related claim brought under a fee-shifting statute is settled outside of court and the settlement agreement clearly allocates a reasonable amount of the settlement proceeds as attorney's fees, the amount allocated to attorney's fees, while includable in income, is not wages for employment tax purposes."
While LAFA 20133501F (as well as TAM 200244004) technically may not be cited by employers as authority, at the very least employers should feel more comfortable taking the position that a reasonable amount clearly allocated to attorneys' fees in a settlement under a fee-shifting statute is not wages.
Keep in mind, however, that generally the attorneys' fee portion of a settlement payment is still income to the plaintiffs, and in most cases subject to Form 1099 reporting with respect to both the plaintiffs and their attorneys.
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