Pay taxes on reimbursement I didn't deduct?

I don't think so. It's a reimbursement of expenses, net zero.

I am pretty sure it is taxable if the legal fees were deducted; at least that is what my attorney told me at the settlement.

My question is if I couldn't deduct them because they didn't exceed 2% of my AGI; are they still taxable.

No. See

Tax benefit rule. 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. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year.

And be aware, even if the legal fees did exceed 2% of AGI, the deduction is not allowed under AMT, so if you were under AMT you wouldn't have received a benefit from this deduction.

If only part of the fees was deductible because of the 2% rule, then the reimbursement is only partly deductible in my opinion.

I appreciate your help; you may have saved me some serious money!

Lets say I got legal fee reimbursement of $60,000 in 2007 which covered $20,000 paid in 2007 and $40,000 paid in earlier years.

I SHOULD have paid tax on $40,000 because that is all I deducted in earlier years. The remaining $20,000 is not income because it simply offsets the $20,000 in 2007 legal fees that I haven't deducted.

Is that it? I ran the numbers through Taxcut and it says that I get $8,000 back! (because I paid tax on the entire $60,000 and couldn't deduct the $20,000 in legal fees.)

To take this one step further; if I only got to deduct $15,000 of that $40,000 in earlier years because of either AMT or the 2% of AGI rule, than I only have to pay taxes on $15,000 of the reimbursement; right?

That will take a few hours of work to straighten out, but if it saves me another $10,000...

Although I did my tax return first on Taxcut for 2007 to get organized, I had an accountant actually do it for real because it was complicated and I wanted to make sure I didn't have any errors. He missed this.

But I've already spent the money! Your explanation makes more sense, but obviously that isn't a contraint. Thanks.