How many options can you consider before you find yourself longing for simplicity? Whatever your answer, part of the desire for less complexity comes from not wanting to make the wrong choice. That’s especially true under current US tax law, which is hardly a model of simplicity, and where making the wrong choice could cost you money.
In T.C. Summary Opinion 2017-2 (Sas), the taxpayer faced three options for deducting legal fees related to a lawsuit against a former employer.
Section 62(a)(20) allows a deduction for legal fees and court costs in connection with any action involving a claim of unlawful discrimination as defined under section 62(e). In addition to requiring a claim for unlawful discrimination, this section “shall not apply to any deduction in excess of the amount includible in the taxpayer’s gross income for the taxable year on account of a judgment or settlement * * * resulting from such claim.”
Section 67(a) allows certain legal fees as miscellaneous itemized deductions subject to a 2%-of-adjusted-gross-income limitation. These include legal expenses incurred in attempting to produce or collect taxable income and legal expenses that are related to either doing or keeping a job, such as those paid to defend against criminal charges arising out of a trade or business.
Section 162 says legal fees are deductible as ordinary and necessary business expenses if the expenses were ordinary, necessary, and paid or incurred during the tax year and were directly connected with, or proximately resulted from, a trade or business of the taxpayer. The deductibility of legal fees under section 162 depends on the origin and character of the claim for which the legal fees were incurred and whether that claim bears a sufficient nexus to the taxpayer’s business or income-producing activities.
The taxpayer received a bonus of $612,000 when she became president and chief executive officer of a bank. She reported the bonus as wage income on her 2010 individual income tax return.
On September 14, 2010, the bank terminated her employment, and on November 3, 2010, the bank filed a complaint against her alleging breach of fiduciary duty and attempting to recover the $612,000 bonus. The taxpayer countersued, claiming employment discrimination.
In 2011, the taxpayer and the bank signed a settlement agreement and mutual releases providing that they each pay nothing and release and dismiss all claims against each other.
The taxpayer paid $25,000 and $55,798 in legal expenses associated with the lawsuit in 2010 and 2011, respectively. On her income tax return for those years, she reported the legal fees as “other income” in negative amounts of $25,000 and $55,798.
During the same years, the taxpayer maintained an accounting and consulting business. On her 2010 federal income tax return, the taxpayer filed a Schedule C, Profit or Loss From Business, reporting her husband as the sole proprietor. In 2011, she reported income from the business on Schedule E, Supplemental Income and Loss, as a co-owner with her husband.
The taxpayer says the legal fees are deductible under section 62(a)(20) as legal fees paid in connection with an action involving a claim of unlawful discrimination. The taxpayer says she included the bonus as income when it was received and was able to retain the bonus because of her counterclaims of employment discrimination. Therefore, her bonus was included in gross income on account of a judgment or settlement relating to her action, meeting the requirement for deductibility under section 62(a)(2).
Alternatively, she argues that the legal fees are deductible under section 162 as ordinary and necessary business expenses. Though the lawsuit was not rooted in the accounting business, the suit would have an adverse effect on her professional reputation which in turn could damage the reputation of the accounting business. Therefore, she says the legal fees were necessary expenses of the business.
The IRS says the legal fees are miscellaneous itemized deductions, subject to the 2%-of-adjusted-gross-income limitation.
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For the IRS.
Contrary to the taxpayer’s view, the “amount includible in the taxpayer’s gross income” cannot reasonably be interpreted to include prevention of potential loss of income that would be includible in the absence of any claim. The taxpayer’s bonus was received and includible in gross income because of her employment with the bank. Under the settlement agreement between the taxpayer and the bank, neither party received any amount includible in gross income.
Assuming arguendo that the taxpayer’s counterclaims were in connection with unlawful discrimination, she did not receive, and did not include in gross income for 2010 or 2011, any amount because of the settlement of her claims.
Because the entire amount of the legal fees was “in excess of the amount includible in * * * gross income for the taxable year on account of” the settlement, she may not deduct any of the legal fees under section 62(a)(20).
While the taxpayer may have been right that the clawback of the bonus could harm her professional reputation and in turn the accounting business, we must look to the origin of the claim, not the potential consequences of a win or loss.
We find that the claims arose from her status as a former employee of the bank, not from the accounting business, and the taxpayer hired an attorney because the bank was attempting to claw back a bonus she received in connection with her employment at the bank.
Therefore, the taxpayer is not permitted to deduct the legal fees as ordinary and necessary expenses of the business under section 162.
We sustain the IRS determination that the taxpayer must deduct the legal fees as miscellaneous itemized deductions subject to the 2% limitation.