Taxes on wrongful termination suit
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?
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."
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