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Unfortunately, the above-the-line deduction for attorney fees does not apply to settlements under Dodd-Franks or SOX. It only applies to reprisal law suits for employment-related reprisal suits. Gary Aguirre wrote a good article on this in The Whistleblower on April 11, 2013. In it, he said:
"Whistleblowers who receive an award from the Securities and Exchange Commission (SEC) or Commodity Futures Trading Commission (CFTC) for disclosing violations of securities or commodities laws are subject to uniquely unfair tax liability. They pay income tax on their entire award, including the portion paid to their attorney under a contingent fee agreement. This is in addition to the income tax their attorneys pay on the same fee.
An example best illustrates the point: Assume a whistleblower receives a $500,000 award from the SEC pursuant to the Dodd-Frank Act. The net award is about $350,000 after the whistleblower pays his attorney $150,000 pursuant to a contingent fee agreement. One might expect the whistleblower to be taxed on the net amount: $350,000. Wrong, the whistleblower would be taxed on the entire amount of the award ($500,000), since taxes would likely be computed using the federal Alternative Minimum Tax (AMT) of 28%, which would include the $150,000 of attorney's fees. It gets worse when the state, e.g., New York, has its own AMT. In this scenario, the unhappy whistleblower could easily net only one-third of his $500,000 award: $166,000.
This problem originates with Commissioner v. Banks, 543 U.S. 426 (2005), where the Supreme Court held the plaintiff's entire recovery of economic damages in a civil rights case was taxable income, including the portion paid to the plaintiff's attorney under a contingent fee agreement. Although the amount paid as attorney's fees may be claimed as an itemized deduction (Campbell v. Commissioner, 134 T.C. 20 (2010)), it is still subject to the AMT (28%) and to the 2% floor on miscellaneous deductions. Banks had disastrous effects for the False Claims Act (FCA) whistleblower in Campbell. In addition to holding that the attorney's fees were taxable to the whistleblower, the tax court tacked on a 20% penalty for trying to circumvent the law. After the events in Campbell, but prior to the decision, Congress enacted an above-the-line exclusion for attorney's fees for FCA whistleblowers (26 USC § 62(a)(20)), but the Campbell Court declined to apply that statute retroactively.
In October 2004, the Civil Rights Tax Relief Act eliminated double taxation in whistleblower reprisal cases, discrimination cases and other employment-related cases. The statute permits an above-the-line exclusion of attorney's fees, meaning the fees are not taxable to the plaintiff. Accordingly, whistleblowers in reprisal cases - including reprisal cases under the DFA - only pay taxes on their net recovery. Likewise, a FCA whistleblower only pays taxes on his net recovery (26 USC § 62(a)(20)). The same is true for a whistleblower who receives an award from the IRS (26 USC § 62(a)(20)). However, since no statutory exclusion applies to the attorney's fees paid by a whistleblower who obtains an award from the SEC or CFTC under Dodd-Frank, he must go the itemized deduction route, which means the 2% floor and the 28% AMT.
There is no apparent reason for taxing the attorneys' fees paid by whistleblowers under Dodd-Frank while excluding such fees from gross income for whistleblowers who obtained an award under the FCA or the IRS's whistleblower program, the model used by Dodd-Frank."
So unless your settlement under SOX or DFA is for employment-related reprisals, you may only deduct the legal fees as a miscellaneous itemized deduction, subject to the 2% AGI limitation. And, if the settlement is large enough, and you wind up in AMT, you will wind up paying tax on the entire settlement.
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