Lawsuit Legal Fees

[whdw41a]

There is a lawsuit going on which is not requesting damages nor is it a contingency lawsuit.  The lawsuit is requesting that the defendant provide a benefit that was part of the agreement that the defendant did not deliver.  The plaintiff, an individual, has been paying the lawyers am hourly fee which is paid monthly by invoice.   The plaintiff is expected to prevail and it is also expected that the Judge will awarded legal fees to the Plaintiff, as it is very obvious the defendant intentionally deprived the plaintiff of the benefit to which they were entitled.   The question is if the court orders reimbursement of legal expenses is the taxpayer (Plaintiff) liable to pay tax on the reimbursement of legal fees paid if the defendant issues a 1099-Misc for the expenses?  The fees being reimbursed span several years. 

It is also possible that the defendant might choose to settle before the trial by offer some type financial compensation instead of the benefit including reimbursement for legal fees.  If this happens can the reimbursement piece deducted from the settlement since this is not a contingency case. 

[Mike9241]

A recovery is a return of an amount you deduc-ted or took a credit for in an earlier year. The most common recoveries are refunds, reimbursements, and rebates of itemized deductions. You may also have recoveries of nonitemized deductions (such as payments on previously deducted bad debts) and recoveries of items for which you previously claimed a tax credit.
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.

if you deducted the legal fees paid any recovery up to the amount deducted would be taxable. Whether any amount not specified as a recovery of the fees is taxable depends on the nature of the lawsuit.

When determining whether a settlement or judgment is taxable or not, it is easiest to start with the premise or generality that virtually all judgments or settlements are taxable. The general exception to this general rule is that settlements and judgments where the underlying claims are based on some type of personal injury or sickness.

Settlement funds and judgments that compensate for physical injuries or sickness are generally excludable from taxable income. However, an exception to this rule is that funds used to compensate for medical expenses that were previously deducted for a tax benefit in prior tax years may not be excludable as income, even if the funds are based on an underlying physical injury or sickness.

Another red-herring that tends to be audit fodder is compensation for emotional distress. Compensation for emotional distress is excludable from taxable income if the distress compensated for flows directly from some type of underlying physical injury or sickness. However, compensation for emotional distress as a standalone tort claim, or that is not based on some actual physical injury or sickness is actually considered taxable income. Lastly, punitive damage awards are also generally taxable, even if they are based on a physical injury or sickness.

[Opus 17]

I assume you are the plaintiff?

Remember that personal legal expenses are never deductible (for 2018-2025).  So I assume this is in connection with a business.

First, any recovery of an item you previously deducted as an expense is a taxable recovery. (i.e. the legal fees).

Judgements for settlements for personal injury and pain and suffering due to personal injury are not taxable.  But any other judgement or settlement must be treated according to what the original contract--that the judgement is enforcing--would have been.  For example, the contract called for you to be paid to perform a service, which would have been taxable business income, then the settlement is taxable business income.  

The entire amount of the 1099-MISC may not represent the taxable amount, that is up to you to determine based on your own records. 

[whdw41a]

Thanks for your answer - This is not a business lawsuit and no deductions have been made for the case as I understand legal fees are not normally a deductible expense for an individual unless the case involves an injury which this does not.  I have been paying the lawyer every month for the past 2 years.   When the case is settled and if we have a favorable ruling which we expect, the defendant will need to deliver access to a fringe benefit they blocked me from.  This is a no cost item to the defendant.  I also expect that the judge is going to be harsh on the defendant because the defendant was less than honest and caused the issue which they could have resolved without going to court.  We have asked the Judge to grant reimbursement for legal expenses and I expect the Judge will order the defendant to reimburse me for my legal expenses.  I am not sure if the defendant, a major company, will issue a 1099-Misc or not.  I wouldn't be surprised if they did just to cause more issues for me.  There is a possibility that the defendant will try to settle before the trial as big companies do not do well in front of Jurys especially when it is easy to prove they are wrong.  In that case they could offer some other type of settlement that could involve items that have a quantifiable value plus legal expenses.   I would expect to pay taxed on the item other than legal fees if that actually happens. 

[Opus 17]

@whdw41a 

If this is not a business lawsuit, then you are in tax trouble. The settlement is taxable, and since the tax reform of 2017, you can’t deduct legal fees from the settlement. So if you are awarded a settlement of let’s say $10,000, and the entire $10,000 is paid to your attorneys, you will still be on the hook for $2200 or more of income taxes because the entire amount is taxable to you.  If you have already paid the attorneys, and the entire settlement will come to your pocket, then it will be fully taxable, but you will at least be partly reimbursed for your expenses.

You may want to consult with a professional tax advisor before you make any final decision. You may also want to seek a larger, financial reward, in lieu of the denied fringe benefit.  

[whdw41a]

I think you are right about consulting a tax professional on this one.  This is different than a contingency case where legal fees are not part of the settlement but they  are an expense in obtaining a settlement.  The suit is seeking to have the defendant deliver a no-cost benefit that they have refused to provide. If the Jury tells the defendant to deliver the no-cost item there is technically no compensation or damages awarded.  Basically what the defendant would be delivering is the right to purchase services at a discount.  Because it is the right to purchase services it is not possible to quantify a value.  The court ordering the defendant to pay legal expenses is also not technically compensation it is reimbursement.   If it is settled out of court there is also no compensation or damages.  The only thing the defendant gains is the right to say they weren't order to deliver the benefit which might open up the potential for similar lawsuits to be filed.  In think this a gray area which I need a firm answer on because we are not talking a small sum. I am not sure the attorneys can modify the filing that requests reimbursement to include compensation for tax liabilities.  If granted the judge is making the decision not the Jury.