Attorney's fee's handled how with LTD settlement?

[Guest lindy]

When one has a LTD settlement in mediation, and your lawyer took the case on contingency how is that played out in the tax world?

I do understand that the entire LTD settlement is considered NON-TAXABLE if for compensatory damages for physical illness/injury.

Just not sure how that is figured in with the lawyers fee's?

Example: I get $50K. Lawyers expenses/charges $10K, if I had to pay tax would I do it on $40K. Or of course if it is non-taxable totally I wouldn't have to do anything..

I hope this makes sense. Thanks a million.

[Guest hank]

Good question, lindy. We have an opinion of tax counsel that says when we settle a case like yours we do the following (using your figures):

1. Issue a 1099-Misc to you for 50,000; and

2. Issue a 1099-Misc to your attorney for 10,000.

We always issue two checks: one made payable to the plaintiff AND the attorney (under plaintiff's taxpayer ID), and a second made payable only to the attorney (under the attorney's tax ID). More importantly, our settlement documents specifically state that it is our call as to the proper tax reporting.

[Guest Harry O]

I disagree with the previous response. The payment of your attorneys fees is income to you. You have a contractual obligation to pay your attorney $10,000. The result would be no different than if the payor agreed to pay your mortgage for 6 months.

There have been some cases in a few states (Alabama, Michigan off the top of my head) where the courts have held that the attorney had an equitable interest in the lawsuit under applicable state law. This has been limited to very few states. Moreover, the Tax Court has said that the attorney fees payment is includible in your income and the IRS obviously takes this position.

So, in most cases you are taxed on the payment. In addition, since your underlying recovery is tax-free, you cannot deduct the $10,000 of attorneys fees included in your income.

[Guest hank]

Harry -

If you look at the figures in the original post and then look at my post, you'll see that the participant IS being taxed on the whole amount (including the attorneys' fees). You and I don't disagree.

TOTAL SETTLEMENT = $50,000

Attorney's Fee = $10,000

Net to Plaintiff = $40,000

Plaintiff gets a 1099-MISC for $50,000, the attorney gets a 1099-MISC for $10,000.

[Guest lindy]

Gentlemen, I am totally confused. Cognitive problems anyway but boy this one has got me going.

OK, on settlement it is supposed to be totally tax-free because it is damages for physical illness (Compensatory damages) Also in IRS Pub. 525 states no tax on the above. THEN- I have 50/50% split premiums with employer for this benefit with AFTER-TAX $. So I guess I have to pay 50% tax on what is received because of that contribution part?? THEN:

Why on earth would I have to pay tax on my attorney's portion?

THEN: Per a case in 5th US Circuit Court of Appeals in July 2000, in Texas somewhere, it states that "Parties not taxed on Part of awards paid for Contingent Fees". Supposedly, whether you live in Texas or Alabama, taxpayers shouldn't have to pay fed. income tax on the portion of the damage awards that goes to their lawyers under "contingent -fee agreements".

What does all of this mean? Help...

Also where would ANY CLEAR IRS Rule be for this. I thought Pub. 525 made it very clear..Maybe some other rule or law?

[Guest Harry O]

Hank - I'm sorry, your post did report the attorneys fees to the individual. (But why would you report the entire underlying award for physical injuries?)

Lindy - You are correct that TX is a state similar to Alabama as far as the taxation of attorneys fees is concerned. If you live in TX, congratulations on your good fortune! The difference in results depending on which state you live in (or more accurately, depending on which Federal Circuit you live in) is one reason why the Supreme Court will eventually settle this question.

I don't know enough about the underlying facts of your lawsuit and settlement to offer any thoughts on its tax treatment. Arguably, the entire settlement could be tax-free regardless of how you paid your share of the premiums. Someone would need to closely examine your initial claims and the subseqeunt settlement agreement. Of course, if your settlement agreement already says that 50% will be reported to the IRS as taxable, then you will have a hard time sustaining any other position.

Finally, if 50% of your award is taxable, only 50% of your attorneys fees (if you are fortunate enough to live in TX or a similar state) will be deductible.

[Guest lindy]

Harry and Hank I appreciate you input so much.

I believe to understand that this whole thing depends on the way the premiums were paid? They were split 50/50 after tax so I guess I pay 50% of settlement tax.

Harry, where is the IRS rule on the above? I am realizing that Pub. 525 doesn't mean anything really, depending on the way your premiums were paid 1st..

How do I find which states (ie Tx. and Alabama) that I wouldn't have to pay 50% of attorney's fees would be taxable?? Do you know where the IRS rule/code is on this part, the pay tax on attorney fees is??

Why am I being taxed on HIS (attorney's) share? I don't understand.

Glad you guys are there. Are you both attorney's? or?

[Guest Harry O]

I don't know whether the tax treatment totally hinges on whether you paid 50% of the premium. I would need to examine your complaint and the terms of the settlement agreement.

Section 265(a) disallows expenses incurred in connection with producing tax exempt income.

The portion of the attorneys fees you can deduct are miscellaneous itemized deductions subject to the 2% of AGI floor. This may significantly reduce the value of the deduction. And don't forget that this deduction is not allowed under AMT. So you need to be careful. The AMT can result in a net LOSS to a recipient.

Take Paula Jones for example. She got $800,000 from Slick Willie. She owed her attorneys $600,000. She thought she was netting $200,000 before taxes. Wrong. The $600,000 was not deductible for AMT purposes. So she owed 28% (the AMT rate) of $800,000, or $224,000. SHE OWED MORE IN TAXES THAN SHE NETTED AFTER PAYING HER ATTORNEYS!!! Anyone who signs a settlement agreement without consulting with an experienced tax advisor is asking for trouble (and his attorney should be sued for malpractice).

[Guest lindy]

Harry, I am going to scream. Only kidding. How on earth does anyone get straight on which darn IRS rule/code to use?

How can I find the answer myself how the 50% paid premiums hinge on this whole thing????

Why doesn't Pub. 525 work in this situation? It seems there are so many rules that you can jump from one to another to another and none seem to say which one to use...Eeek..

Please forgive my ignorance. What do you mean by subject to 2% of AGI floor? What is AGI floor?

Also, what do you mean by "this deduction is not allowed under AMT and can result to net loss to recepient?" WHAT IS AN AMT?

(is it amount?)

So, I believe you are saying that my attorney on lawsuit SHOULD

BE advising me to all tax implications? He says he doesn't know, because he isn't a tax specialist...

Great help and examples...I just wish I knew which one prevails or maybe they all do..

[Guest Harry O]

The IRS and many courts take the position that you owe tax on the attorneys fees because the payment released you from an obligation to pay for the attorneys services. No different than if your opposing party agreed to pay your mortgage for 6 months.

AGI is adjusted gross income. Miscellaneous itemized deductions are only deductible to the extent they exceed 2% of your AGI. So if your AGI is $50,000, you may only deduct amounts in excess of $1,000 (the first $1,000 is simply nondeductible).

AMT means alternative minimum tax.

If the dollars involved are large enough, you should consult with a competent tax attorney. Your attorney dropped the ball. No one should negotiate or much less execute a settlement agreement of this nature UNLESS they understand the tax consequences. The bottom line is what the client gets in his pocket after taxes. Unless you know that, how can you execute a settlement agreement? (I will now get off my soapbox. I have seen far too many settlement agreements that were advertised as wonderful to claimants turn out to be worth pennies on the dollar because the lawyers failed to understand the tax ramifications.)

[Guest lindy]

Harry, Now armed with all of this information I should let my attorney know that I am concerned about this tax stuff...I have no idea how it would be structured different so I wouldn't lose most of it???

My accountant friend mentioned I should pay the tax on the settlement immediately (that way I know it's done and paid). What form would I use to do that? (Obviously I will be getting a tax attorney for this!) This would be long before April 2002 filing. So do you use an estimated tax form? Any thoughts?

By the way, your expertise and candor are well appreciated!