California tax law

[taxquestionasker85]

California tax law

[JotikaT2]

Generally, unless you meet an exception as listed in this link, legal settlements are taxable.

However, since you were able to retain the car and are still liable for any exisiting loans, only the portion of the settlement that exceeds your adjusted basis in the property would be taxable.  If you paid in $28,000, but received a settlement of $25,000, then the amount you received is less than your basis and it would not be taxable.  Please see IRS Publication 4345 for more details.

[Opus 17]

Unfortunately, the total settlement is $40,000, and you can't take a tax deduction for personal legal fees.

Also, the $28,000 you say you have paid so far probably includes interest or finance charges, that does not count as part of your cost basis.  Your cost basis includes what you have paid for the car, including legal costs that are mandatory regardless of financing (like sales tax and other government fees) but not financing.

If you receive more than your cost basis, that is a taxable gain.  As long as you had the car more than one year, it is a long term capital gain which is taxed at a lower rate than ordinary income.  Report the transaction as if you sold the car to the manufacturer for $40,000.  Subtract your cost basis (what you paid not counting interest) and the difference is taxable income.  You will pay a lower capital gains tax rate on your federal return, but California does not have a discounted tax rate for capital gains so any gain will be added to your other regular income for state taxes.  

[taxquestionasker85]

I like both answers and they seem to suggest the same concepts. However, one of them suggest the 15k is taxable to me. If my lawyer receives the 40k and he gets 1099'd, and then gives me the 25k, why would i pay taxes on his 15k? Reminder, i wont be getting a 1099 out of all this (because lawyer says its not requried, which i dont understand)

[Opus 17]

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@taxquestionasker85 wrote:

I like both answers and they seem to suggest the same concepts. However, one of them suggest the 15k is taxable to me. If my lawyer receives the 40k and he gets 1099'd, and then gives me the 25k, why would i pay taxes on his 15k? Reminder, i wont be getting a 1099 out of all this (because lawyer says its not requried, which i dont understand)

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Because the settlement amount is $40,000 to you, and then you pay the lawyer.

If you need more detailed explanation, it's because the lawyer has no cause to get paid and no claim on the manufacturer except as your agent, someone who is working for you.  The manufacturer is not paying anything to the lawyer as a lawyer, as the lawyer has provided no services to the manufacturer, the lawyer is providing services to you.  It's your settlement money, the lawyer is getting a cut of your money.

Prior to 2017, you could take a partial tax deduction, but that was eliminated as a trade off for other changes like lowering the marginal tax rates for everyone.  Now, you could only take a deduction as a business expense if this is a business owned vehicle (in which case all bets are off on taxability too, because you have to account for depreciation and other factors). 

As for the 1099, I would expect the manufacturer to issue a 1099-MISC to you for the full $40,000, with the understanding that it is between you and the IRS to work out the taxable portion.  Businesses are supposed to issue 1099s for payments over $600, but maybe there is an exception for Lemon Law settlements that I don't know about.  If there is no 1099, then reporting any part as taxable is on the honor system, with the kicker that if you are audited, and the IRS finds you deliberately understated your income, the penalty is back taxes, plus 25% penalty, plus 1% per month from whenever they audit you back to the due date of the return, plus interest at 8% APR.  

[taxquestionasker85]

@Opus 17 , your explanation was thorough and very logical. Thank you for the great support!

[Mike9241]

@JotikaT2 This was a leased vehicle. so, unless it was a capital lease under the tax laws, the taxpayer does not have a tax basis. Also, they got to keep the vehicle and presumably are still liable for any remaining lease payments.  

However, if this was a business vehicle the lawyer's fee likely would be deductible to some extent depending on business vs personal use. 

[Opus 17]

@Mike9241 

@taxquestionasker85 

I missed that the owner keeps the vehicle.  That adds one extra element.

I also want to clarify the cost basis.  As far as I know, with a lease you "buy" a fraction of the car, possibly with finance charges, and there is a set price to buy out the remainder of the car at the end of the lease if you want to keep it.  So the customer's basis would be the lease price for the first half (or whatever) fraction of the car, not including finance charges.

Then, because the customer is keeping the vehicle, in addition to any amount over the basis being taxable, the basis is reduced to zero.  The basis may be increased by future lease payments (principal only) and the basis may be increased if the customer pays the buyout on the lease rather than returning it.  That has implications if the customer keeps the car.  Because, if you later sell the car (as a used car) for more than your basis, you have a taxable capital gain.  This doesn't usually happen with used cars but it could here.  

For example, suppose the price of the car with sales tax was set in the lease documents as $50,000, with the lease being for 2 years at $25,000 plus finance charges.  You take the settlement, which reduces your basis to zero, and you have a $15,000 capital gain.  At the end of the lease you decide to buy the car for the remaining $25,000.  Your adjusted cost basis is now $25,000.  Then suppose you sell the car as a used car for $30,000.  $5,000 of that sale is a taxable capital gain because the sales proceeds are more than the cost basis after taking all adjustments into account.  

Alternatively, suppose this model of car suddenly becomes very popular and the dealership offers to buy you out of the lease early for a $5000 payment.  Because your basis is zero after the settlement, the buyout payment would be a taxable capital gain.  

As I said, outside of business vehicles with depreciation, owners of personal cars almost never sell them for more than their cost basis, so this sort of thing almost never comes up.  But you will need to keep track of your basis.

[taxquestionasker85]

Re: California Cash

[Opus 17]

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@taxquestionasker85 wrote:

@Opus 17 @Mike9241 @JotikaT2 

Hi All,

The latest replies were unclear to me... I have a leased car not financed.

But "under the hood", so to speak, a lease is what I described.  Suppose the price of the car is $50,000.  You want to lease it for 3 years, so the dealer determines how much of the car's value you are "using up".  Suppose they set the buyout price at $30,000.  That means that you are "buying" the first $20,000 of the car's value over 3 years.  If the lease is $600 per month, you are paying $21,600, so $1,600 is interest.  (I am ignoring sales tax, a down payment, and other things that will adjust the price upwards, that you can take into account.)

Check your original contract.  There is an interest specified (it might be called a "money factor") and there are prices specified.  Full purchase price, buyout or residual price, and interest rate are all items that can be negotiated if you are a smart buyer.  

In the alternative, if you really own nothing, then the entire $40,000 is taxable to you.

[taxquestionasker85]

cash lw

[JotikaT2]

Based upon what I can read on the contract as the font is a bit hard to read, this does appear to just be a leased vehicle as Mike9241 pointed out earlier in this discussion.  You also state that you do not intend to keep the vehicle but will turn it back in.  You are essentially paying for use of the vehicle as opposed to making loan payments to own the car.  Therefore, you don't have any basis in the car.

Assuming this vehicle was just used for personal use and not as part of a business, you would not have any cost basis in this vehicle and the entire amount of the settlement would be considered taxable.  Please see the link in my original reply for the treatment of legal fees to determine if they are potentially deductible as it will depend upon how they are listed on your settlement paperwork.

@taxquestionasker85 

[Opus 17]

@taxquestionasker85 

I'm not liking this answer.  For the amount of money, you may want to get your own paid professional opinion.

Two points that I suggest considering.

1. Suppose you were renting an apartment, and your landlord caused some damages.  If the landlord offered to give you free rent, plus a little extra, only the extra is taxable income.  Free rent is not taxable because discounts don't create taxable income.  If we assume that you are essentially renting the car, and have not acquired any basis, then I would want to think about the settlement as being "free rent" for the car plus a little extra.  So the only taxable part would be the part that is more than your payments.  However, the settlement could be legally separate from the lease (especially if the settlement is with a different party than the lessor) which could make the entire settlement taxable, and not a 100% discount of the lease payments.  

2. The IRS generally follows "substance over form" doctrine, meaning that if a transaction looks one way on paper but is a different way in real life, the IRS will usually follow real life and not the paperwork.  So I am not 100% convinced that you don't have a basis argument for making some of the settlement non-taxable.

There are enough opinions here that, based on the amount of money, it may be worth hiring your own CPA or enrolled agent to give you an opinion, who will stand behind you if you are audited.