Tax Court has ruled against a married couple who received a tax-exempt legal settlement, ruling that the full amount of their $64,750 payout is taxable income. The case, known as Eiler, 167 TC No. 3, sets a high bar for taxpayers seeking to avoid taxes on legal damages. The decision means the couple must pay income tax on a sum they never actually received in their personal bank accounts.
A High-Stakes Settlement Split
In 2017, the couple entered into service agreements to pursue claims against major credit reporting agencies under the Federal Credit Reporting Act (FCRA). They alleged the agencies reported inaccurate information on their credit reports. The agreements specified that the couple would receive 100% of any statutory damages and 50% of actual and punitive damages, while the attorneys would receive the remainder of the funds.
The disputes were settled in 2019 for a total of $64,750. The couple directly received only $4,700, while the rest was split among three law firms. They reported only the $4,700 on their personal tax return. The IRS later issued a notice of deficiency, challenging the couple’s reporting.
The Arguments Presented
The taxpayers made two arguments to the Tax Court to reduce their tax liability. First, they asserted that the portion of the payment representing attorney’s fees should be excluded from taxable income based on special fee-shifting rules under the FCRA. They contended that because the fees did not follow a typical contingent fee structure, the funds should be tax-exempt.
Second, the couple claimed they were entitled to an above-the-line deduction for claims involving “unlawful discrimination” under the FCRA. This argument presented an issue of first impression for the courts.
The court rejected both arguments. It ruled that the FCRA’s fee-shifting provisions did not apply to this situation. Additionally, the court determined that the actions did not involve claims of unlawful discrimination. As a result, the full $64,750 is treated as taxable income, and no deductions are allowed for the attorney’s fees.
This outcome creates a significant burden for plaintiffs in class-action or group litigation scenarios. Historically, when a plaintiff group settles a case, the settlement funds are often funneled through attorneys, leaving the individual claimants with a fraction of the total amount. If a taxpayer relies on the portion they actually pocketed to determine their tax liability, they face a double penalty: they owe taxes on money they never received, and they lack the funds to pay that tax bill.
Legal Settlement Tax Strategy
The tax treatment of legal expenses can differ depending on the nature of the expenses. Taxpayers and their advisors must carefully analyze the structure of any settlement to ensure compliance with the law.
Retirees must also pay close attention to their end-of-year tax planning. Retirees face key year end tax decisions that could significantly impact their net income. The filing deadline approaches quickly, and errors in reporting complex settlements can lead to costly penalties.
