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Barbara
Barbara, Tax Preparer
Category: Tax
Satisfied Customers: 952
Experience:  Tax Preparer for 16 years; 25+ years experience as a real estate/corporate paralegal.
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In 2012 I settled a lawsuit and received a large sum of which

Customer Question

In 2012 I settled a lawsuit and received a large sum of which 40% immediately went to my attorneys.

The grounds (and filings) of my suit were a breach of contract with the damages being the difference between the formula stock price I received from the corporation when I was obligated to sell my private shares back to them, and the value of those same shares 2 months later when the company went public. The claim of breach was because "all material facts .... prospects of company...etc" were not revealed as stipulated per my sale agreement. The company had been clandestinely dealing with the acquiring company WHILE buying my shares. No punitive damages or any other type were sought. The damage was therefore equal only to the loss of additional capital gain on the stock I would have enjoyed had I held them.

We settled out of court. Since my 40% legal fees were a direct expense in producing a capital gain which I otherwise would not have realized, I wish to calculate my tax on the net gain rather than on the gross and then deduct the legal expense. There is a very large $$ incentive to do so.

Researching the subject I found this: "Except in rare cases, such as a compensatory recovery of self-employment income, (for example, commissions that are reported on Schedule C) or recovery of capital gain income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the 2 percent floor and AMT."

I believe this to be one of those "rare cases". How should I proceed?
Submitted: 1 year ago.
Category: Tax
Expert:  Barbara replied 1 year ago.

bkb1956 :

Thank you for allowing me to be of service to you regarding your tax question. Please see the attached regarding legal fees. You would calculate your tax on the gross amount and then itemize your legal fees on Schedule A, which would be subject to the 2 percent floor and AMT. http://www.forbes.com/sites/robertwood/2010/09/22/the-only-good-legal-fees-are-tax-deductible-legal-fees/. Please let me know if you require further information or clarification.

Customer:

Thank you for the generic answer that in no way addressed the specifics of the question, ignored the unique aspects of the situation and further deferred to a generic web posting. That in no way explained to me why or why not I could justify this course of action.

bkb1956 :

I apologize if you feel that I gave you a generic answer, but that is the answer. I did not ignore the unique aspects of your situation, and did research at different levels. I sent you a reference which I thought would be the most concise and easy to understand answer to your question. Your taxable income is the gross amount, and you would then itemize your legal fees on Schedule A because those legal fees were, as you said, a direct expense in producing a capital gain which you otherwise would not have realized. To use your net amount and then deduct your legal fees as an expense would be considered "double dipping."

Customer:

? ...then deduct your legal fees.... who said that?

bkb1956 :

In your question, you stated you wished "to calculate your tax on the net gain rather than on the gross and then deduct the legal expense."

Customer:

I specifically asked about, and quoted passages from applicable situation. "recover of capital gain income".. Calculation of tax on net (with no deduction for fees) or on gross (and then deducting fees). Sorry if that wasn't clear. Not trying to get both.

bkb1956 :

Then I misunderstood what you were saying. You can forward me the reference material that you found, and I will gladly review it and get back to you.

Customer:

I'll have to find the source... the quote in my original posting was copy/paste from a search on the deductibility of fees. What makes this unique is the cause of action; recovery of capital gain as a result of breach of contract. As such, without lawyers I could not have incurred the gain. Also, had no "crime" been committed, I would have realized said gain and owed taxes on it (capital gain).

Customer:

This is no different than the top line deductibility of transaction expenses.

bkb1956 :

I understand what you're saying. Can you give me some time to research this further for you and then let you know?

Customer:

That would be fine. Thank you. I understand that many questions can be immediately answered, but this is one of those "exceptions". It is very specifically tied to the "recovery of capital gains" and as such the cause of action, the alternative outcome and other factors come into play. I myself am neither a lawyer nor tax expert, but have considerable interaction with both over the tenure of my career as a chemical consultant. An understanding/precedent of the "recovery of capital gain" exception to the schedule A deduction would be extremely helpful. I don't mind taking a chance if there is a good explanation as to why behind it.

bkb1956 :

I understand. I will continue to research this, and get back to you later tonight or first thing tomorrow AM. Thanks for your patience on this.

Customer:

Thanks.

bkb1956 :

Great news! I found the source you originally quoted in your question on the IRS website. Please see "Deduction for Attorneys' Fees" at http://www.justanswer.com/tax/7jb1j-2012-settled-lawsuit-received-large-sum.html. "Except in rare cases, such as a compensatory recovery of self-employment income (for example, commissions that are reported on Schedule C) or recovery of capital gain income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the 2 percent floor and AMT. (This, of course, assumes that the lawsuit proceeds have been taxed at gross in the taxpayer’s income.)" Since you did recover capital gain income, you would report the gross amount and the legal fees would be deductible. Sorry for the confusion on this.

bkb1956 :

Please review my latest answer to you and let me know if you require further information. If not, I would greatly appreciate you revising your rating of my answer so that I can receive credit for answering you. Thank you.

Customer:

The link you posted didn't open.... and looking at the URL, it looks like it is a link to my own question. I think you might have copied the wrong one? To circle around to the beginning again, being a tax/legal professional, are you agreeing that the gross proceeds of my settlement should have the 40% legal fees subtracted from them and the result is the taxable amount? Since this is not a Schedule A item, is it reported on Schedule D with the cost basis simply elevated to reflect the 40% expenses? I'd really like to see the link that you intended to use as evidence before taking this position with the IRS. Thanks.

bkb1956 :

I found what you cited in your original question on the IRS website. Here is the correct link http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Lawsuits,-Awards,-and-Settlements-Audit-Techniques-Guide I just continued to read further where it states that "it is assumed that the lawsuit proceeds have been taxed at gross in the taxpayer's income." You would utilize Form 8949 http://www.irs.gov/pub/irs-pdf/i8949.pdf and Schedule D. Please let me know if this is not clear. Thank you.

Customer:

It is only very briefly discussed in IRS publications. I found Woodward v. Commisioner, 397 US 572 (1970) that says: ...."has long been recognized, as a general matter, that costs incurred in the acquisition or disposition of a capital asset are to be treated as a capital expenditure". Further, "In cases where litigation involves the defense, acquisition disposition or improvement of capital property, the origin of the claim, not the taxpayer's primary purpose in litigating the claim, is the prevailing test to determine whether fees can be deducted or capitalized." - Marilyn Calister & Siobhan Foley, The Metropolitan Corporate Counsel, December 2009. So I think I'm correct in form 8949 & Schedule D since my suit was very specifically documented to be a recoup of lost capital gains and no other cause. Thanks.

Barbara, Tax Preparer
Category: Tax
Satisfied Customers: 952
Experience: Tax Preparer for 16 years; 25+ years experience as a real estate/corporate paralegal.
Barbara and 8 other Tax Specialists are ready to help you
Expert:  Barbara replied 1 year ago.
I totally agree with you. It was my pleasure to assist you, and I truly appreciate you changing your rating. If you have any questions in the future, please put "for bkb1956" in the subject line.

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