Is extra legal fee reimbursement taxable?

"Kevin" wrote

I'm not sure that's true. The whole award (wages and legal) might be considered income to you with the legal expense going to Schedule A. Legal fees paid to collect income, which the seems to be, are deductible.

Removeps-groups provided me with this link:

seems to be on point."A recovery is a return of an amount you deducted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of itemized deductions.You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year." It includes an example of someone reimbursed for medical expenses a year after he deducts the same expense. Since the first 7.5% of AGI cannot be deducted he only deducted part of the expense; and his reimbursement was only taxable on the part he deducted. It doesn't explicitly say this, but I presume that if he had been reimbursed in the same year that he had the expense, he would have neither a deduction nor an income. (of course, if he had both they would offset each other)

My situation is more complicated, so I am not sure how much I deducted. I am also not sure what to do about "reimbursement" for which I didn't even have an expense.

Or is this section not appropriate?

Wrong, especially if not all events happened in the same year.

Just because you didn't deduct (when you were supposed to) doesn't mean that the amount recovered is excludible in the future year. The ONLY option you had was to itemize on Schedule A or not (and as these fees exceeded any possible standard deduction, you should have elected to itemize).

It's all taxable as a recovery.

You deducted $30k for 2006.

Ignoring the other issues; in 2007 I paid $20,000 in legal fees and recovered $60,000. As I read it, I deduct nothing and pay taxes on $40,000.

If I paid $20,000 in medical expenses and received $20,000 in insurance payments I wouldn't deduct $20,000 (less 7.5% of my AGI) and pay taxes on the $20,000 insurance would I? Seems to me it is the same thing.

The courts have ruled differently. You deduct $20k on Schedule A and include all $60k in income.

It's NOT because at the time you incurred the expense, you were entitled to the reimbursement. In your suit, you didn't have the right to reimbursement at the time of incurring the expense. Reimbursement was awarded later by the court decision or settlement.

Okay, I reread 525 a bit more carefully: "Legal expenses. You may be able to deduct attorney fees and court costs paid in connection with the civil action. Depending on the facts and circumstances, these expenses are either claimed on Schedule A (Form 1040) or Form 1040NR (Schedule A), or deducted in figuring the income you report on Form 1040, line 21, or Form 1040NR, line 21. If the qualified settlement income was received in connection with your trade or business (other than as an employee), you can reduce the taxable amount of qualified settlement income by these expenses. In all other situations, you can only claim these expenses as a miscellaneous itemized deduction subject to the

2%-of-adjusted- gross-income limit on Schedule A (Form 1040), line 23, or Form 1040NR (Schedule A), line 11. For example, an employee or the surviving spouse or beneficiary of a deceased plaintiff would claim the expenses as a miscellaneous itemized deduction subject to the 2% limit."

That would rule out legal fees connected to EMPLOYEE income, but how about severance pay? The income in question was due to being an EX-EMPLOYEE. Had I been an employee I wouldn't have gotten anything.

Okay, I am reaching; but sometimes reaching works.

"Kevin" wrote

Only an employee can become an EX-employee. Therefore the legal expenses are related to employment.

Do you have a citation? If the 60k is a recovery of an an attorney expense previously deducted on Schedule A, is it still fully taxable, or only taxable to the amount of the deduction that reduced tax?

The strange thing is that if you deducted 60k of attorney fees but were in AMT, the deduction got you nothing, so if you have a recovery of that 60k, the fact that it's fully taxable seems a bit unfair. Then again, if the company originally paid the 60k on your behalf, would that amount have been taxable to you?

Above doesn't quite make sense to me, but the law and courts don't always make sense!

More than a bit unfair. I paid full tax on the reimbursement but between AMT and the 2% burden I doubt I got to deduct anything over the years.

That's why I was so excited by your first answer; but I think it is pretty hopeless.

The analysis of the court rulings make exactly that point. Remember the change in the law last year that is effective for 2009 and later?

...And "Fair" is a 4-letter word starting with "F". Your point?

That is correct.

Yes, the $10,000 is taxable.

Prorata, you deducted $25,714 for legal fees.

Here is a part of a letter that I received from a respondent in the IRS Office of Chief Counsel in 1996 and that was published in 1999.

[53] Second, it is true that once a taxpayer has claimed a proper deduction the taxpayer may not in a subsequent taxable year avoid having to include a refund of the deducted item in gross income by amending the taxpayer's tax return for the taxable year of the deduction. See Klinghamer v. Brodrick, 242 F.2d 563 (10th Cir. 1957); Hillsboro National Bank v. Commissioner, 460 U.S. 370, 378 fn. 10 (1983).

Here is the key part for you.

However, where on the original return a taxpayer does not claim an allowable deduction for state income taxes that could have produced a tax benefit, section 111(a) excludes a refund of the undeducted taxes from gross income. McCabe v. Commissioner, T.C. Memo 1983-325; Rev. Rul. 79-315, 1979-2 C.B. 27.

Thus, a taxpayer who anticipates an adverse effect from a refund of state income taxes may simply deduct the correct amount of state income taxes on the taxpayer's original return. If it turns out that the refund would not produce an adverse result by being included in gross income, the taxpayer may amend the original return to claim the entire deduction allowable.

Here is the link to the set of four letters that were published in Tax Notes Today (Tax Analysts)

The rest of the letter from the IRS respondent for the most part was pure garbage. You seem to have a pretty good concept of the Tax Benefit Rule so you might want to read the first letter in the set, my letter of December 8, 1998. You can read the respondent's letter of July 27, 1996 (yes, 1996) for entertainment. The respondent is of the opinion that ? 111(a) and 56(b) (1)(D) of the Interal Revenue Code provides for, respectively, "DOUBLE OR NOTHING TAXATION" of itemized deduction recoveries.

Summarizing:

The $10,000 that was in excess of the legal expenses is taxable.

That leaves $50,000 of legal fee that are (would be) deductible. The $20,000 that you did not deduct in 2007 reduces that $50,000 to $30,000, the amount that you deducted in 2006. However, only $25,714 of the $30,000, produced a "Tax Benefit" in 2006.

Therefore, the $10,000 excess reimbursement for legal fees should be reported as income, I would report it on Line 21. The $26,714 would also be reported on Line 21 as an itemized deduction recovery.

Hope this helps.

Cheers,

WDK