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Taxation of legal settlement proceeds


Dear Tax Talk,
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

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Dear 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.


-- Posted: Jan. 8, 2004




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