Professional Services Accounting ARTICLE -

1099 Reporting Rules for Client Funds in Escrow

Target Audience: Legal Professionals, Professional Service Firms, Law Firm Partners, Law Firm Accounting

This article addresses the IRS rules surrounding reporting of amounts received and disbursed from Escrow funds held by a law firm on behalf of a client. 

General Rules for Payments made on behalf of a client

The general rules concerning disbursements made from a client’s escrow account on their behalf are contained in Treasury Regulations §1.6041-1(e), as follows:

(e) Payment made on behalf of another person

(1) In general. A person that makes a payment in the course of its trade or business on behalf of another person is the payor that must make a return of information under this section with respect to that payment if the payment is described in paragraph (a) of this section and, under all the facts and circumstances, that person—

(i) Performs management or oversight functions in connection with the payment (this would exclude, for example, a person who performs mere administrative or ministerial functions such as writing checks at another's direction); or

(ii) Has a significant economic interest in the payment (i.e., an economic interest that would be compromised if the payment were not made, such as by creation of a mechanic's lien on property to which the payment relates, or a loss of collateral).

(2)  Determination of payor obligated to report. If two or more persons meet the requirements for making a return of information with respect to a payment, as set forth in paragraph (e)(1) of this section, the person obligated to report the payment is the person closest in the chain to the payee, unless the parties agree in writing that one of the other parties meeting the requirements set forth in paragraph (e)(1) of this section will report the payment.

Therefore, if a law firm is hiring a third party service provider, such as an expert witness, on behalf of a client, the firm would normally be the payor obligated to issue a 1099-MISC to the service provider. 

Specific Examples concerning settlements received

The scenarios below review the rules regarding 1099-MISC reporting in four situations where the firm successfully represents a client plaintiff and receives a settlement payment from a defendant.  The first two scenarios address taxable settlements, the second two address non-taxable settlements.

Scenario 1 – Full amount of Settlement received into Escrow (check payable to client)

1. Receipts of funds from defendant
   • If the settlement is taxable to the client plaintiff, then the defendant must issue a 1099-MISC to the client.  The defendant must issue a 1099-MISC to the client for the full amount. 
2. Use of funds to pay service providers such as expert witnesses, other lawyers, etc. 
   • If the law firm is responsible for hiring service providers such as expert witnesses or other lawyers and makes payments to these service providers from the escrow funds, then the law firm must prepare and issue a 1099-MISC to these service providers. 
3. Transfer of law firm fees
   • The client has an obligation to issue a 1099-MISC to the law firm with respect to the attorney fees paid from the escrow funds.
4. Transfer of remaining proceeds to plaintiff
   • Because the defendant issued the plaintiff a 1099-MISC for the full amount, the law firm does not have to issue a 1099-MISC to its client for monies disbursed to the client from the escrow account.

Scenario 2 – Part of Settlement received into Escrow, law firm separately receives remainder of settlement to cover their fees.

1. Receipt of funds from defendant
   • If the settlement is taxable to the client plaintiff, then the defendant must issue a 1099-MISC to the client for the amount paid to the escrow and the amount paid to the law firm for legal fees.
2. Receipt of amount for legal fees from defendant
   • Defendant must issue a 1099-MISC to the law firm for the legal fees.

Scenario 3 – The Settlement is not taxable to the client (check payable to the client)

In this scenario, the defendant issues a check payable to client for the settlement. 

1. Receipt of settlement from defendant
   • Since the settlement is not taxable, the defendant does not have to issue a 1099-MISC to the plaintiff.
2. Payment of legal fees to law firm by plaintiff
   • The client should issue a 1099-MISC to the law firm for the fees paid.

Scenario 4 – The Settlement is not taxable to the client (check payable to the law firm)

In this scenario, the defendant issues a check payable to the law firm for the settlement. 

1. Receipt of settlement from defendant
   • Defendant must issue a 1099-MISC to the law firm reporting the gross proceeds paid in Box 14.
   • Since the settlement is not taxable, the defendant does not have to issue a 1099-MISC to the plaintiff.
2. Payment of legal fees to law firm by plaintiff
   • The client should issue a 1099-MISC to the law firm for the fees paid.

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