Dear Tax Talk:
I read a previous post that you answered regarding tax liability for the settlement of a lawsuit. I have a similar issue, but with an interesting twist. This may be too long and complicated for you to address, and I do plan on seeking the advice of my attorney and accountant. But it is an interesting situation and I thought you might enjoy mulling it over.

In 2005 I invested a large sum of money in order to buy a 25-percent interest in a privately held firm. In order to obtain the money, I took a lump sum distribution from my IRA, with the resultant tax and penalty.

The owner of the business did not deliver my shares to me, as he was prevented from selling shares by a prior agreement he had with another shareholder. He took my funds in bad faith because he was short on cash and he hoped that he could string me along long enough to deal with the other shareholder and eventually provide me with my shares. I did not discover this until after I filed a lawsuit.

After 12 months without him returning my money or providing me the shares in the firm, I sued. I asked for the return of my initial investment and the tax liability I incurred, including penalty and interest (from an installment agreement) along with earnings lost during the period he had my funds. Of course, my loss was far greater because of the forward-looking lost opportunity, so I sued for that as well.

We settled the matter in May 2007. The owner agreed to return my initial investment, and to pay an amount that equaled the tax liability, penalty and lost earnings, along with a very small amount above what my real loss equaled.

I have now received a 1099 miscellaneous income statement from the business, showing the total for what we settled the lawsuit. This does not seem correct to me, as a significant portion of that amount is the money I provided to him for the investment. Because I withdrew that money from my IRA, I have already paid taxes on it, along with penalty and interest. I can see where I am responsible for taxes on anything above and beyond my initial investment, but not on the initial investment.