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George Saenz, the Bankrate.com Tax Talk columnist Taxes on wrongful termination suit

Dear Tax Talk,
Are the funds from a wrongful termination suit settlement taxable? It did not go to court. It was settled out of court by agreement. Also, do I have to pay taxes on the amount paid to the attorney?
-- Kathy

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Dear Kathy,
Even though your claim was settled out of court, it does not change how it is taxed. The basis of your claim determines its taxation. Awards for personal injuries are considered taxable income. Wrongful termination suits usually involve claims for personal injuries and not physical injuries. Personal injuries such as age discrimination and emotional distress (i.e., sexual harassment, race discrimination) do not count as physical injuries even though they may lead to physical problems such as headaches and stomach disorders. An unlawful discrimination claim under various federal, state and local laws will usually result in the inclusion of the award in income.

Under prior law, the deduction for contingent attorney fees was unclear. Usually if you pay legal costs associated with securing a claim to taxable income, you can deduct these costs as miscellaneous itemized deductions reduced by 2 percent of your adjusted gross income. However, in the case of large settlements and upward to 40 percent contingent fees, this treatment caused a lot of settlements to disappear between income taxes and attorney fees. The reason is that miscellaneous itemized deductions are not deductible for alternative minimum tax. Hence, you ended up paying taxes on your attorney fees. IRS pursued this treatment vigorously in many court cases and won more times than it lost.

Effective for settlements after Oct. 22, 2004, Congress clarified the law to allow the deduction for attorney fees in unlawful discrimination claims as an adjustment to AGI rather than as a miscellaneous itemized deduction. Under the new law you will not end up paying AMT on the attorney fees.

Based on the 2006 Form 1040 instructions if you have attorney fees associated with an unlawful discrimination claim described in Section 62(e) of the Internal Revenue Code, you should deduct these on line 36 of Form 1040. You would describe them on line 36 as "UDC."

To ask a question on Tax Talk, go to the "Ask the Experts" page, and select "taxes" as the topic.

Bankrate.com's corrections policy -- Posted: April 4, 2007
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