How to prevent tax reporting pitfalls in settlement agreements

Michelle La Count, Client Services Project Director:  After weeks, months, and even years of hard-fought wins and negotiations, litigators may be tempted to employ boilerplate tax reporting language as they are drafting the settlement agreement. However, doing so could equate to increased costs for the administration or even delays at distribution.

When drafting a settlement agreement’s tax reporting provision, first consider the type of awards for possible tax implications.

If the award includes interest, is it a discernable portion of the payment? If the settlement agreement states awards are “inclusive of interest,” but does not include a formula, the Internal Revenue Code may treat the interest differently than if a specific interest percentage is written into the agreement based on the base award, which will require reporting if the interest portion meets the 1099-INT reporting threshold.

Will the award potentially yield a “windfall,” which could be considered income? This is particularly important where there is a planned pro rata distribution of the settlement fund to class members. This is because, if the claims rate is low, it becomes more likely that the award amounts will increase, thereby reaching the reporting threshold and requiring 1099s.

Next, consider the likelihood of whether the award will yield reportable amounts, which are changing in 2026 for certain 1099 types.

Determine whether an IRS Form W-9 or a substitute W-9 should be included as part of the claims process. If not, is sufficient time built into the distribution schedule to allow for notification and collection of W-9s after calculation of the claims? This is important in the event some or all of the awards will require 1099s to be issued.

What about using backup withholdings only? Even with backup withholdings, it is required to have attempted to solicit the necessary W-9s. Otherwise the Qualified Settlement Fund may be subject to IRS penalties if there is inaccurate taxpayer identification number data provided.

Addressing the need for W-9s earlier in the claims filing or review process may save time at distribution, and these considerations could save the class thousands to tens of thousands of dollars in mailing, review, and follow-up costs. Even more importantly, you will avoid months of delays with thoughtful drafting with an eye toward tax reporting best practices.

How the new 1099 threshold affects settlement reporting

Stephanie Saba, Senior Disbursements Manager: It is important to stay up to date on the ever-changing IRS tax reporting requirements to ensure compliance and proper reporting.

The IRS requires certain payments issued from settlement funds to be reported as income to the recipient. These payments must be reported on either an IRS Form 1099-MISC or an IRS Form 1099-NEC.

The IRS Form 1099-MISC is used to report settlement award payments issued to a class member or gross proceeds to an attorney, such as attorneys’ fees and expenses.

The IRS Form 1099-NEC is used to report settlement fund payments for non-employee compensation such as fees and commissions on services performed on behalf of the settlement.

The 2025 reporting threshold for both forms was $600 or more paid to the recipient within the calendar year. With the adoption of the “One Big Beautiful Bill Act” passed on July 4, 2025, the reporting threshold has changed for these forms, effective January 12026. The reporting threshold is now $2,000 or more paid to a recipient within the calendar year. This change will reduce the number of tax reporting forms that will need to be issued in future settlements.

It is important to note that regardless of the IRS reporting threshold, all income should be reported on an individual or corporation return even if a form is not provided to the recipient and the data is not submitted to the IRS from the payer due to threshold limits.

Empowering claimants to provide information for tax reporting obligations                       

Ricky Borges, Senior Client Services Manager:  Settlements often require the collection of personally identifying information (PII) such as addresses, payment information, and potentially Social Security numbers to fulfill tax reporting requirements. Therefore, attorneys need to understand how important it is that class members feel confident that the claims process is legitimate and secure.

This starts with outlining administrative responsibilities in the settlement agreement to reflect the integrity of the administration process and to build class member confidence.

To combat the reluctance to provide PII and foster trust, administrators must clearly communicate the legal foundation of the settlement, including court approval and oversight, to reinforce its authenticity.

Providing class members with accessible documentation through the settlement website, FAQs, and other contact channels provides transparency and reduces skepticism. 

AThis is because, if the claims rate is lowdministrators should also highlight the use of secure data handling practices, such as encryption, limited access protocols, and compliance with privacy regulations to reassure claimants that their information is protected.

Fraud prevention efforts must also be part of the communications process. This includes warning class members about potential scams, verifying identities through secure portals, and ensuring that all outreach, whether by mail, email, or phone, is branded consistently and traceable to the official settlement administrator.

Administrators should also collaborate closely with clients to align messaging and ensure that all class member communications reflect the integrity of the process.

Ultimately, the goal is to create a class member experience that feels safe, informed, and respectful. By combining robust security measures with empathetic communication, settlement administrators can build confidence in the legitimacy of the settlement process and encourage class members to participate fully and comfortably.

This not only protects the integrity of the settlement distribution and all applicable tax reporting requirements but also upholds the reputation of all parties involved.

Consequences of inadequate tax planning in settlements

Tice O’Sullivan, Disbursements Consultant: There are certain types of settlements where it is clear and obvious that tax reporting is needed, such as wage/back pay settlements or cases where interest is being paid as part of the award. Similarly, there are settlements where no tax reporting is necessary, such as securities and antitrust cases.

For most settlements, however, it is not obvious whether tax reporting will or will not be needed. Before finalizing a settlement agreement, it is always advisable to get advice from a tax professional on whether the awards will be tax reportable. 

To determine whether an award is taxable, you must ask if the award is a reimbursement of a prior out-of-pocket expense, or if it’s new money to the class member. If it’s new money, it is likely that the award is reportable.

The IRS takes the position that all income is taxable, absent an exception, such as a damages award for injury or physical illness. Other damage awards, including for emotional distress, can be considered taxable to the class member and need to be reported on an IRS Form 1099 at year end.

Having clarity on the taxability of awards is essential before the settlement agreement is finalized and approved by court.

The administration of the settlement can also be impacted by whether awards are taxable. If awards are taxable, the parties must consider whether Social Security numbers can be obtained from the defendant, if the claim forms will need to include a section for class members to provide their Social Security number or, in a settlement without a claims process, if a letter to class members will be needed to obtain their Social Security number.

It is possible for an award to become taxable unexpectedly. In this scenario, the award is known to be taxable, but the estimated award amount is below the reporting threshold due to the projected number of claims filed. However, if the number of claims filed falls below the expected amount causing a pro rata increase, this could lead to award amounts exceeding the reporting threshold. This can result in unanticipated mailings to class members to request their Social Security number, having to apply backup withholding to awards, and subjecting the settlement fund to misreporting penalties for not gathering Social Security numbers before making a payment.

Planning for these scenarios before the settlement agreement is finalized will eliminate downstream administrative challenges before a class member is able to receive their award.