4 Things You Need to Know About Reporting 1099 Legal Fees
Over 15 million U.S. workers enjoy the perks of being self-employed, according to the Bureau of Labor Statistics' most recent data. From small businesses to independent contractors to freelancers, self-employment continue to rise globally due in part to the freedom and control it provides.
However, as your own boss, you also have the responsibility to pay and file your 1099 contractor taxes on-time. Along with estimated taxes, business deductions, and self-employment tax rates, you are additionally responsible for completing and filing Forms 1099.
Like any law or regulation, the 1099 legal fees rules, reporting requirements, and tax treatment change from time to time. This year is no exception. Beginning with the 2020 tax year, the Internal Revenue Service (“IRS”) has changed how taxpayers report attorney's fees.
Here are four things you need to know about reporting legal fees on 1099s beginning with the 2020 tax season.
What is the Form 1099-NEC?
Multiple types of Form 1099s exist; however, two of the most common are Form 1099-MISC information returns and, starting for the 2020 tax year, Form 1099-NEC. Small businesses, independent contractors, and other self-employed individuals must understand the new Form 1099-NEC filing rules to satisfy their tax reporting responsibility.
You should use the Form 1099-NEC to report non-employee compensation, such as independent contractor compensation. Non-employee compensation includes fees, commissions, benefits, prizes and awards, and other forms of payment, as identified by the IRS. Any payment payable to a lawyer is reported even if all the client’s money is used to close a real estate deal. It is still taxable income.
More specifically, a Form 1099-NEC is used when:
- You have a payee who is not your employee;
- The services paid for relate your business or trade;
- The recipient of the payments is an individual, partnership, corporation, or estate; and
- You must issue forms 1099 if the payments equal $600 or more for the course of your trade in the calendar year.
To use IRS Form 1099-NEC, you must satisfy all four of these conditions above. Fees paid to attorneys, law firms, and other professional services are included as non-employee compensation, effective for the 2020 tax year.
The Form 1099-NEC is not a new tax form. These forms were used prior to 1982, and the IRS decided to reintroduce it, allowing small businesses and self-employed workers to separate certain payments, such as those to their attorney, from other payments, such as office rent. Keep in mind, though, that because the IRS re-introduced Form 1099-NEC, that Form 1099-MISC has a new look as well, which is where attorney fees were documented between for the tax years falling between 1982-2019.
Let’s look at specifically who needs to file a Form 1099-NEC.
Who Needs to File a Form 1099-NEC?
If your business paid an attorney or a law firm $600 or more for services related to your business, then you will need to complete and file a Form 1099-NEC. Under IRS guidance, the term “attorney" includes a law firm or any other legal services provider on behalf of your business or trade.
Remember, that 1099-NECs is for services that contribute to your business, not your personal affairs. Thus, if an attorney or law firm provides services to your business, such as helping you incorporate, you must use the 1099-NEC. If you use an attorney or law firm's services for your estate planning or divorce, for example, then these types of services are considered personal and are not reported on the 1099-NEC.
How Do I Complete and File a Form 1099-NEC?
Before you enter information into your 1099s and calendar the deadlines below, send a Form W-9 to each vendor, including your business attorney or law firm. You want to confirm that you have the right information on each vendor, such as formal business names, addresses, and tax identification numbers. By having the correct information for subsequent tax forms, such as Forms 1099-NEC and 1099-MISC for miscellaneous income, you’ll avoid frustrations, such as going back and correcting entries.
Generally, payments made to corporations, including limited liability companies taxed as S- or C-corporations, are exempted from being reported on the Form 1099-NEC. However, $600 payments made to professional service providers—including attorneys and law firms-- are not exempted, thus reportable on the 1099-NEC in Box 1.
It does not matter if the law firm is a sole proprietorship, a limited liability company, a partnership, or a corporation. It also does not matter how big or small the law firm is. If legal services are provided to your business for $600 or more, you must satisfy the Form 1099-NEC rules or face a potential penalty (further discussed in the last section).
By reporting non-employee compensation in Box 1 of the 1099-NEC, the IRS is tipped off that the recipient of those fees reported may be a self-employed individual, thus subject to self-employment tax in addition to federal and/or state income tax. Self-employed individuals pay 100% of self-employment tax, where W-2 employees pay half, and their employer pays half.
The total self-employment rate is currently 15.3%, comprising 12.4% for Social Security tax and 2.9% for Medicare tax. For the 2020 tax year, Social Security tax only applies to your first $137,700 of compensation, where there is no limit for Medicare tax.
Coordination with Form 1099-MISC
Certain attorney and law firm payments are reported in Box 10 of the Form 1099-MISC, not the Form 1099-NEC, if:
- The payments are made to an attorney or law firm in the course of your business or trade in connection with legal services that are not directly provided by an attorney, such as those payments related to a settlement agreement with another person or business;
- The payments amount to $600 or more; and
- The payments have not been reported in Box 1 of the Form 1099-NEC.
All the backup withholding amounts for anyone for whom you have withheld income taxes under a backup withholding ordermustbe reported.
Note that this Box 10 is only for paying specific fees to attorneys, no other professionals. Let's look at an example. Your business is involved in litigation with a person or another business, and all parties agree that your business is at fault in the lawsuit, causing damages in the amount of $85,000. Further, everyone agrees upon settling the lawsuit for $100,000, instead of going to trial. You pay the other party’s attorney the $100,000 settlement payments amount to distribute accordingly. Finally, in helping you navigate through this legal maze, you paid your business attorney $25,000 for her services.
So, how do you report these amounts to the IRS? Let’s take one at a time.
- You report the $85,000 (damages) in Box 3 of the 1099-MISC;
- You report the $100,000 (settlement check) in Box 10 of the 1099-MISC as gross proceeds paid to an attorney; and
- You report the $25,000 (attorney fees) in Box 1 of the 1099-NEC as non-employee compensation.
One exception to the rules for Forms 1099 applies to payments for physical sickness or personal physical injuries settlement checks.
Legal Fee Deductions
As you’re gathering information on your reportable legal fee amounts for your 1099-NEC or 1099-MISC, keep in mind that you may deduct these fees as ordinary and necessary expenses for your business. For example, if you have legal fees that are directly related to operating and running your business, you may deduct those fees on Form 1040, Schedule C. If you have legal fees related to solving a tax issue for your business, then you may also deduct those on Form 1040, Schedule C.
However, personal attorney fees are typically not deductible, just as they are not reportable on either the 1099-NEC or 1099-MISC. For example, you cannot deduct legal fees related to child custody, personal injury, estate planning, or divorce.
After you complete Form 1099-NEC, you should send a copy to recipients no later than February 1, 2021, while filing a copy with the IRS, electronically or on paper, by the same date. Unlike an automatic extension for the provision of 1099-MISC copies to recipients, as further discussed below, no automatic extension for Form 1099-NEC exists. Still, an extension may be granted under specific cases of hardship.
After you complete Form 1099-MISC, generally, you should send a copy to recipients no later than February 1, 2021, while filing a paper copy with the IRS no later than March 1 or filing electronically no later than March 31. However, for the 2020 tax year only, if you identify gross proceeds paid to an attorney, such as settlement payments, you can provide a copy to recipients no later than February 16, 2021, instead of February 1, 2021.
What Happens If I Don’t File a Form 1099-NEC?
So, what happens if I forget to file a Form 1099-NEC or 1099-MISC with the IRS? Or what if I forget to send a copy to the attorney? Aren't they just informational returns?
In general, the IRS does not like to be ignored. If they say something is due, it’s due. However, most penalties for non-intentional failures to file timely are small. Your liability is based on how many days late you are in filing the form. For example, if you are more than 30 days past the due date for filing your 1099-NEC with the IRS in a calendar year, you will be fined $50 per form. If you file your tax return or after August 1, 2020, you will be fined $270 per form.
Intentional violations are an entirely different animal. For example, if you know that a Form 1099-NEC is required and you intentionally fail to file the form, the IRS may fine you $550 per form, which is hefty if you intentionally failed to file several 1099 forms. The maximum penalty for late filing or failing to file your 1099 forms, including both the 1099-NEC and 1099-MISC, is $1,113,000 for small businesses. The IRS defines a small business as average revenues of $5 million or less.
Further, in addition to the IRS, many states have 1099 requirements as well. For example, California and Virginia participate in a joint state/federal program for all 1099s, where Tennessee and New York do not have any state filing requirements. Be sure to check your state requirements as well, in addition to those required by the IRS.
Tax filings are typically not on the top of most businesses’ fun list. However, they are a requirement of running a trade or business, and well, let’s face it, of making money. If you’d like to reach out to get some professional advice, be sure to hire an accountant or download an app like Keeper Tax, helping you stay on the straight and narrow while giving you the tax confidence needed as a business owner or independent contractor.