Table of Contents
Important Notice: This Article has not yet been updated to reflect the TCJA (Tax Cuts and Jobs Act) please contact Peter E. Alizio or consult with a tax professional to obtain more accurate information.
I. Will a Lawsuit Award or Settlement be subject to Income Tax?
The Internal Revenue Code defines gross income as income from whatever source derived unless specifically excluded by another code section. Personal Injury Awards are specifically excluded from gross income (see IRC §104: Compensation for Injuries or Sickness). Therefore, if you received money as a result of incurring a physical injury that amount would not be subject to personal income tax. This statement holds true even if the settlement was to compensate for lost wages which clearly would have been subject to income tax (not to mention Social Security and Medicare tax). However, both Interest and Punitive Damages are taxable regardless of whether it is part of a personal injury settlement or judgment.
Emotional distress is not a physical injury or physical sickness with regards to IRC §104. However, damages received for emotional distress may be excluded from gross income if the emotional distress was caused on account of a personal physical injury; or to the extent of any amount paid for medical care attributable to emotional distress.
Tax Benefit Rule: If you claimed a tax deduction for medical expenses (out of pocket) on a prior year tax return and subsequently receive a personal injury award/settlement, the damages allocated to medical expenses will be taxable to the extent of the prior year medical tax deduction.
Return of Capital: If a lawsuit is initiated to recover for damages to a capital asset, the proceeds may not be income but rather a return of capital. In this case, proceeds received will simply lower the taxpayer’s basis in the capital asset. Any amount received over the basis would be a capital gain.
Summary: In general if your lawsuit award/settlement is not on account of a personal physical injury or sickness, the proceeds will be included in gross income and are taxable!
II. Contingent Fee Agreements
Under a contingent fee agreement, the attorney will only get paid if he wins or settles the case. This arrangement will benefit individuals who may not have the means to pay an attorney. The attorney does take a risk working on a contingent fee basis but if he wins or settles, he will be entitled to a percentage of the total award or settlement.
Issue: The GROSS amount of the proceeds must be reported as income on your tax return.
Example: If there was a $1,000,000 settlement it is not uncommon for multiple checks to be written at settlement: one to the individual for $800,000 (80%) and the other to the attorney for $200,000 (20%). When the individual files his tax return, he must report the full $1,000,000 as income even though he only received $800,000. He will be entitled to a tax deduction for legal fees on his tax return, but this deduction will be subject to limitations causing him in essence to pay taxes on money he never received.
The good news is contingent fee agreements are regularly used in personal injury cases which result in non-taxable awards and settlements. Beware of the tax consequences of entering into a contingent fee agreement if it is not a personal injury case!
Summary: An individual who entered into a contingent fee agreement must report the gross amount of proceeds in income regardless of only receiving the net amount after legal fees.
III. Are Legal Fees Tax Deductible?
The answer is it depends! Are these legal fees personal or incurred by a trade or business? Should they be deducted as a business expense or capitalized?
Legal Fees incurred by an Individual (Not Trade or Business): Individuals are entitled to a miscellaneous itemized deduction (subject to a 2% AGI limitation) for legal fees incurred for (1) production or collection of income; (2) management, conservation, or maintenance of property held for the production of income; (3) in connection, determination, collection or refund of tax.
The problem is the 2% Adjusted Gross Income (AGI) limitation. In order to receive a tax benefit, all the taxpayer’s miscellaneous itemized deductions in the aggregate must exceed 2% of his AGI. In addition to the 2% AGI limitation, these deductions are also subject to other itemized deduction limitations and are added back in determining the alternative minimum tax (AMT).
Example: If a taxpayer incurred $3,000 in legal fees for representation on a tax matter. This would be deductible but only to the extent it exceeds 2% of taxpayer’s AGI. Assuming this taxpayer had an AGI of $100,000, he would only receive a $1,000 miscellaneous itemized deduction ($3,000-$2,000).
Note: The Internal Revenue Code does provide special tax treatment for legal fees associated with a claim of unlawful discrimination or legal fees associated with a whistleblower. In these situations, the legal fees will not be treated as a miscellaneous itemized deduction but rather an ‘above the line’ deduction only limited by the amount of the award or settlement received. (see IRC §62(20) and IRC §62(21))
Legal Fees incurred by a Business (Trade or Business): The Internal Revenue Code (§162) allows a tax deduction for all ordinary and necessary expenses incurred while carrying on a trade or business. In general, legal fees arising from business activities may be fully deductible without limitations.
Legal Fees to Deduct or Capitalize: A general accounting practice is to capitalize expenses for items with a useful life of more than one year. The theory behind this practice is to take the expense over the useful life of the asset vs. the entire expense in the year incurred. Certain legal fees should also be capitalized instead of deducted; such as legal fees incurred to purchase a capital asset.
Summary: Certain legal fees may be deductible as a miscellaneous itemized deduction. Unfortunately, after limitations, phase-outs, and the alternative minimum tax (AMT), many taxpayers will not see much of a tax benefit from these deductions. Alternatively, legal fees incurred by a trade or business may be fully deductible in the year incurred or capitalized.
*Please note, you are only entitled to a tax deduction if the deduction relates to taxable income. If you won a personal injury settlement that is non-taxable, the legal fees associated with that settlement are not deductible. If a settlement contains both taxable and non-taxable components, the ratio (taxable/total) should be applied to legal fees in determining the tax-deductible portion.
IV. “Origin of the Claim”
The tax treatment of legal fees matter! A self-employed individual will want to treat legal fees as an ordinary and necessary business expense as opposed to an itemized deduction. The reason for this is legal fees reported on Schedule C (profit or loss from business) are not subject to any of the limitations of Schedule A (itemized deductions). A business may also want to deduct legal fees in the year incurred as opposed to capitalizing and amortizing the expense over time.
Well, what happens when the IRS and taxpayer disagree on the tax treatment? Many courts have adopted the Origin of the Claim doctrine. Lawsuits and litigation can last for years and be seen as an everyday ordinary and necessary business expense. However, under the Origin of the Claim doctrine, the underlining claim or activity that generated the lawsuit would determine the tax treatment. The Origin of the Claim is regularly seen in the two following situations: (1) in determining if legal fees are personal or business; (2) whether legal fees should be deducted or capitalized.
Examples 1: In Commissioner v Tellier (383 U.S. 687), the taxpayer was criminally charged and found guilty of mail fraud and violating the Security Act of 1933. At face value, these legal fees would be non-deductible! Under the Origin of the Claim, the charges against Tellier were born from his business activity as a security dealer and therefore an allowable business deduction.
Example 2: In Woodward v Commissioner (397 U.S. 572), the taxpayer was obligated (under state law) to buy out minority shareholders. The minority shareholders brought an appraisal action to have a court determine the FMV of shares to be sold; causing the taxpayer to incur legal fees. Under the Origin of the Claim, the appraisal action arose from the obligation to purchase stock; thus, the legal fees incurred should be capitalized and added to the basis of the stock purchased.
V. Summary
The tax treatment of legal fees resulting from litigation should be determined by looking at the origin of the claim or transaction in which the dispute arose.
This article only discusses some of the tax issues with regards to lawsuits. There may be other issues not addressed in this article. It is important to consult a tax professional regarding your specific situation. If you would like additional information, please see IRS: Publication 4345 and IRS: Lawsuits, Awards, and Settlements Audit Techniques Guide.
Disclaimer: This article may or may not be correct, complete, or current at the time of reading. This article is offered for general information and educational purposes only. This article is not intended to be tax or legal advice
Peter E. Alizio is a CPA, Tax Attorney, and owner of Alizio Law, PLLC. When he is not solving IRS and NYS tax problems he likes watching football and playing amateur chef. He also enjoys meeting new people, preferably over coffee, whiskey or cigars.