of legal settlement proceeds
I know that a legal settlement related to income
production is taxable. However, is the taxable amount net of legal
expenses or are all settlement amounts taxable? And are legal expenses
an itemized deduction subject to the 2 percent floor on Schedule
A? -- Michael
You have run into one of the hot topics of the last few years.
Most folks that receive a taxable legal settlement
have signed away 33 percent to 40 percent of it to their attorney.
If, for example, you sue for job discrimination and receive a $100,000
settlement, the attorney will cut you a check for $60,000, which
is the amount that you may think you should report on your tax return.
Well, the Internal Revenue Service's position is that you actually
received $100,000 and have $40,000 in miscellaneous itemized deductions.
The bad part of this is twofold. First, miscellaneous
itemized deductions are subject to reduction by 2 percent of your
adjusted gross income, which is artificially increased by the $40,000
in attorney's fees. So automatically you have $800 in lost deductions.
But the really bad part of having so much in miscellaneous
itemized deductions is that you may wind up having to pay the alternative
minimum tax. Miscellaneous itemized deductions are not deductible
in calculating AMT. While AMT offers a substantial exemption, you
certainly don't want to have to pay a 26 percent to 28 percent flat
tax on money you did not receive.
The IRS's position is that you've assigned part of
your income, but that only means you have a deduction, not a reduction
to income. More and more courts are siding with the IRS on this
issue. In addition, according to a recent article I read, even if
the issue were to be decided by the Supreme Court, the IRS's position
would probably be sustained. At this point it would take an act
of Congress to address this inequity, but with current deficits,
it is doubtful that Congress would be willing to give away any revenue.