Question: Last year, I hired an attorney to help me negotiate my severance package. When we were finally finished, I asked for one more thing: that my employer also pay my attorney’s legal fees. They agreed to pay the first $5,000 of the legal bill.
Recently, I received a tax Form 1099 saying that I was responsible for paying income taxes on that $5,000. Is this right?
Answer: Dear Ashley: I am not a trained and experienced tax attorney, so I don’t offer tax advice. But, on this point of tax law, because it is related to severance, I can give you a clear answer: both you and your attorney must pay taxes on the same $5,000. Here’s why:
1. When someone pays the bills of another person, it is the same as giving the other person the money. So, whether it is your friend, your cousin or your employer, it is no different if he or she pays your rent – or your legal fees – of $1,000, or gives you the $1,000 so that you can pay your rent – or legal fees – by yourself. Whether the $1,000 is paid to you or to your landlord – or your attorney – it is, in effect, the same result.
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2. If the “payor” is a friend or family member, the payment is presumed a non-taxable gift to you; if the payor is a business associate or an employer, it is presumed to be taxable income. This legal presumption is entirely consistent with common sense, (Most of law is common sense.) These presumptions can be overcome by making a clear written record to show there is a different intention.
So, for example, if your brother wants to give you a loan, and make sure you don’t later say “I thought it was a gift!”, then he must prepare a promissory note, and have you sign it, and in this way create evidence that, even though you are his brother, this is not intended to be a gift, but rather, a loan. In law we call this “overcoming a rebuttable presumption.”
In the same way, if a business acquaintance or employer wants to make you a gift, then he or she would be wise to put his or her intention to make a gift into writing, to establish that this transfer of money is entirely outside any business transaction, and purely personal, that is it was given to without any expectation of repayment, but out of love and affection. In that is done, the payment will be deemed a gift, and cannot be included as a business expense by the business colleague or employer. Again, that would be what is called in law “overcoming a rebuttable presumption.”
There does exist one broad exception to this “rebuttable presumption” in the employment relation: your employer’s payment of the cost of certain benefits, such as health insurance, life insurance and disability insurance premiums. The tax law provides these are not taxable payments, because our Congress wanted to encourage employers to engage in this generous behavior.
3. Severance is a business transaction that takes place in the employment context, not an expression of love (just in case you had not already noticed that.) For this reason, payment by your employer of your legal fees to your attorney is considered your income, and must be reported to the government as your income and taxed as your income.
Every now and then I find an employer, and smaller employers in particular, are not aware of this rule, and does not issue dual Forms 1099.
4. But how come BOTH you and your attorney must pay taxes on the same $5,000? Let us go back to the economic reality of what is happening . . . it involves three steps:
First, in effect, your employer is paying your legal fee obligation and, so, the payment is considered income to you.
Second, in effect, your attorney is getting paid for his or her work, and so it is also taxable income to him or her.
Third, since your employer did not take out deductions and withholding taxes from the $5,000, you now have to pay taxes on the entire $5,000, not on a lesser sum. Bottom line result: both you and your attorney have to pay taxes on the same $5,000.
One possible bright side of this, but it is one you must discuss with your accountant or income tax preparer: In certain circumstances, the $5,000 payment by your employer to your attorney might be considered a tax deductible item for you, and so it might be used as to lower your overall tax burden, either all of it or some of it. Again, since I am not a qualified tax attorney, this is something you must look into on your own.
Sorry for the unfortunate news, but that is how it works. The requirement that the employer send to both you and your attorney the Form 1099 comes from a U.S. Treasury Regulation that was put into effect in about 2005. It is not good news, but it is the truth, and at least it is one small part of the tax law that does make some sense.
Hope this helps. Good luck in paying your taxes!!
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