Who Gets, and Who Sends a 1099 when There are Third Party Payers or Third Party Payees
Payments to certain parties are not always received by those parties. Sometimes payments have been assigned to other parties, who accept the payments on the payee's behalf. This is called the assignment of income.
On the other side of a transaction, someone may make payments on behalf of someone else. This is addressed in 1099 reporting rules as the middleman regulation. Knowing how to handle each of these situations can help prevent filing errors that could cost you money. Marianne Couch, Esq., of Balance Consulting, provides definitions and explanations of how to handle 1099 reporting when assignment-of-income or the middleman regulation come into play.
Assignment of Income
Assignment of Income, also known as the "Fruit of the Tree" Doctrine, is when the beneficial owner of the income assigns a third party, such as a factor, to receive the payment on their behalf. The beneficial owner is the party obligated to pay taxes on the payment, usually the original payee. The beneficial owner owns the income and is the party that should receive the 1099. While another party's name might be on the check, the beneficial owner should get the 1099 because it is their income and they have to pay taxes on it.
The case cited most frequently in assignment-of-income situations is the 1930 case, Lucas v. Earl. In this case, a wealthy couple created a contract where the husband assigned half of his income to his wife to avoid paying taxes on the full amount. The courts and the IRS did not question the contract, but instead made it clear that "fruits cannot be attributed to a different tree from that on which they grew." The income still belonged to the husband and he still had to pay taxes on the full amount.
Assignment of income can also occur in a situation in which payments are made to an accomplished individual in exchange for services performed and that payee wants the payment to be donated to a charity or nonprofit organization. This assignment of income directs that a charitable contribution be made. The income is assigned to the charity.
However, to the IRS, the payment is still compensation to the actual service provider, the payee. The service provider should get the 1099 as opposed to the exempt charitable organization. The name and social security number of the payee are needed and the amount of the payment is reported in Box 7 on the 1099 MISC. If the personal information of the payee cannot be obtained, then you have to withhold 28 percent on the payment as required by the IRS. The entire amount of the payment is still reported on the 1099, with the backup withholding amount reported in Box 4.
Backup withholding can cause client-management issues. The service provider may decline to give you the information needed to report on the 1099, causing you to have to do the 28 percent backup withholding on the payment. In return, the service provider may refuse to perform the services. The best way to avoid this situation is to make sure the contract between you and the payee is clear on the tax reporting requirements and how it is going to be done. Get your legal and tax departments involved in the process. Address the tax reporting issues in the contract ahead of time. The more that you can deal with the issues at the beginning of the process, the easier the process will be when it is time to report.
There may come a time when an agent must be used to contract clients. Let's say you hire a performer for your company Christmas party. Chances are you are going to be dealing with the performer's agent. You will probably have to get the performer's W-9 information from the agent and you might even have to write out the performer's check to the agent. Even so, the payment is still the performer's income. The performer is still the beneficial owner and must receive a 1099.
Similarly, you might hire an agent to find a performer for your company Christmas party. In this case, the agent you hire is going to be the receiver of your payment, and therefore, the beneficial owner of the income and your service provider. As long as the agent is not exempt for some reason, that is who must receive the 1099.
Assignment-of-income issues also arise in legal settlement payments. When a check is issued to settle a lawsuit, first determine the nature of the payment to see if there is a reporting obligation. If the payment is to compensate the claimant or the plaintiff for physical injury, a medical expense or reimbursement, or what the IRS calls a fixed and determinable amount of income, the payment is not going to be reportable to the claimant. If there is any other claim, such as for defamation or emotional injury, where there is no physical injury, then the payment is going to be reported in Box 3 of the 1099 MISC.
If a payment you make is to the claimant and their attorney to settle a defamation claim, not including any physical injury claims, then you have two separate 1099 forms to fill out. For the 1099 to the claimant, you enter the entire amount of the payment into Box 3. In the 1099 to the attorney, you report the entire amount in Box 14. If you cannot obtain from the claimant and/or the attorney the information you need to report, then the backup withholding requirement still applies.
The Middleman Regulation
The middleman regulation addresses filing responsibility and is used by the IRS to determine who is penalized when a required 1099 is not filed. Suppose you have paid your agent, who has paid the performer's agent, who then pays the performer. Who sends the 1099 MISC to the performer? First, look to see if the reporting obligation has been addressed in the contract. If the contract does not address the issue, then you must look to the "middleman" regulation to determine who is supposed to issue the form 1099.
The IRS looks at two main categories after finding out all who were involved in the transaction. First, they look to see who had management or oversight over the payment. Such person would have principle control over the conditions under which the payment was made. Second, they will see if any of the people involved in the transaction had a significant economic interest in seeing that the payment was made. If the answer is 'yes' to either statement, then that person has the reporting obligation.
The IRS determines management or oversight by who had a great amount of discretion over the disbursement of funds. Management or oversight belongs to the party that decides:
- To whom funds are paid
- When funds are to be paid
- How much of the payment is to be made
- If there are conditions to be met before payment is released
These factors determine a great amount of control over the payment; therefore, this party with this control has the 1099 reporting obligation.
The other aspect is whether someone in the transaction had a significant economic interest in the payment. A significant economic interest is a monetary interest that could be jeopardized if the payment is not made.
In another twist, suppose the payment goes through the hands of the performer's agent and the agent withholds a commission. Who reports the agent's commission? The performer does, because the agent is the performer's service provider, effectively paid by the performer. Even though the commission was not dispersed, the commission amount withheld must still be reported in Box 7 of a 1099-MISC to the agent, as a non-employee compensation payment.
Liens, Levies, and Garnishments
The IRS may at one time require an employee's wages to be levied of a certain amount. You, as the employer, take the amount out of the employee's check each time the employee gets paid. However, the entire amount still shows up on the employee's W-2. Since the employee is still the beneficial owner of the income. The IRS has just assigned itself to that portion of the employee's income. Do not separately report the levied amount on a 1099.
Perhaps there is a creditor serving a lien against a vendor's payments and you have to make the check payable to the creditor as opposed to the vendor. There is no separate reporting to the creditor required; the amount is still reported on the vendor's 1099. Even if only a portion of the wages goes to the creditor, the entire amount is still reported on the vendor's 1099. The vendor still remains the beneficial owner of the income.
Suppose you get a court order to garnish an employee's wages. The check is made payable to the court, but the amount will still show up on the employee's W-2. No separate 1099 is sent to the court. The employee remains the beneficial owner of the income even though the funds were diverted to the IRS.
These same situations must be dealt with carefully when working with attorneys. If the amounts garnished or levied from an employee's wages or a vendor's payment are paid to an attorney, the amounts are separately reported to the attorney. The amounts are still included on the employee's W-2 or the vendor 1099, but you must also issue a 1099 MISC for the attorney, reporting the amount in Box 14. There is an exception to this rule, however. If the attorney is a federal bankruptcy trustee, there is no 1099 reporting required on the trustee. If the attorney is just accepting funds, then the 1099 requirement exists.
Reminder: There is no Form 1099 corporate exemption for legal services, so you must report to the attorney/law firm, even if that law firm is incorporated.
To make this process easier for you and your department, you need a system that does not automatically put the name from the check directly on the 1099 because they are not always the same. Manual intervention will probably be needed to make sure reporting is done correctly. You do not want to be liable for incorrect reporting or not meeting the backup withholding requirement. The IRS does not look kindly on this, and you could end up with accrued interest penalties, penalties for failing to deposit taxes and all other standard penalties for failing to report.