This week, Gail says: You won the lawsuit, now pay taxes on your settlement!

Dear Gail —

Early this year I was fired after 9 years on the job because I didn’t get along with my new boss. My previous boss had retired and her replacement — a young guy out to prove himself — was a tyrant. He’d humiliate you in front of the rest of your coworkers.

Anyway, I’m a single dad and I just can’t work late because I need to get home to make dinner and, frankly, to also make sure my two teenagers aren’t wrecking the house. My employer knew this when I was hired nine years earlier.

Well, my new boss was under a lot of pressure to get a particular project done and insisted we all stay late for two weeks so it would be completed on time. I was the only one who refused to do this. Although I worked like a dog during the hours I was at work, I left at my usual time. A month after the project was wrapped up, I was told I wasn’t a “team player,” that my work wasn’t up to standard, and I was fired.

It was pretty devastating, as you can imagine. Unemployment insurance was less than half of my regular salary. Thankfully, I found a new job about four months later.

On the advice of a friend I hired one of those lawyers who doesn’t charge you anything unless you win the case. The good news is I just won a “wrongful discharge” suit against my former employer for $150,000. I’m thrilled. I don’t even mind giving the attorney 1/3 of the amount because I wouldn’t have anything if she hadn’t taken the case. What upsets me is my tax preparer says I have to pay income tax on the whole amount! Is this correct?

Peter

Dear Peter —

The short answer to your question is “yes.” But the tax code does provide limited relief. First, though, permit me to back up a bit and explain a concept called “employment at will.”

According to the American Civil Liberties Union, of the 80 million people who work in the private sector in this country, about 25 percent are covered by union contracts that protect them from unjust dismissal. The rest — 60 million — are considered “at will” employees, which means either the worker or the employer can end the relationship at any time, for any reason, or for no reason at all.

There are a number of state and federal laws that provide exceptions to this. For instance, your firing cannot be due to discrimination related to your race, color, religion, gender, age, height, weight, marital status, or disability. In addition, some states extend protections to certain veterans. A number of states prohibit firing someone because he/she is gay/lesbian.

If you win a discrimination suit against an employer, your legal fees are an “above the line” deduction on your income tax return. This means that they are 100 percent deductible. This change came about thanks to the American Jobs Creation Act of 2004.

In addition to legal statutes, the courts have ruled that it is illegal to dismiss an employee for refusing to commit a crime, such as falsifying records. You also cannot be fired if it would violate the terms of your employment contract.

But the laws and court decisions don’t cover every situation. Rather than discrimination, your case sounds similar to one in Texas in which a long-term employee was suddenly fired for violating the company’s anti-nepotism policy — something the company had known about and ignored for 17 years! The employee won.

The ACLU says roughly 2 million people are fired each year. By one estimate, 150,000 involve unjust terminations. If the employee wins the suit, the court has wide latitude in terms of the penalty it imposes on the employer. This may include punitive damages, back pay, estimated future pay, and re-instating a promotion. In addition, the court can require the company to cover the legal costs incurred by the employee.

However, in two recent cases involving contingent fees, the U.S. Supreme Court ruled that even though part of the settlement received by the employee was being paid to his/her attorney, the entire amount was considered “income” to the employee. (Without getting too technical, the Court relied on something called the “anticipatory income” doctrine which says money you receive is still considered your income, even if you assigned all or part of it in advance to someone else.)

Note that if the court had ordered your old employer to pay your legal costs, this would not have happened. Under such (admittedly rare) conditions, you would not — even temporarily — take receipt of this money. Instead, it would go directly to your attorney. But, try to find a lawyer willing to take a chance on a case like yours without the possibility of a payback worth significantly more than customary legal fees.

According to CCH, a provider of tax law and software, even if your case did not involve discrimination (the judge’s decision would state this), your legal fees would be deductible as a “miscellaneous itemized expense.” This category of deduction is limited. You can only deduct your legal fees to the extent they exceed 2 percent of your adjusted gross income.

For simplicity sake, say your adjusted gross income (AGI) income for 2005 is $180,000, which includes both the salary you earned at your new job plus your $150,000 legal settlement. Two percent of $180,000 is $3,600. Thus, the fee paid to your attorney gives you a miscellaneous itemized deduction of $46,400 ($50,000 – $3,600). For the sake of argument, let’s assume this is the only miscellaneous itemized deduction you have this year.

In a perfect world, you might think that this means you would pay income tax on $103,600 of your award ($150,000 – 46,400). However, Mark Luscombe, Principal Federal Tax Analyst at CCH, points out that because of the size of your legal settlement, you get snagged by one of those thorns in the tax code designed to prick “upper income” taxpayers: the phase-out of itemized deductions.* Based on an AGI of $180,000, Luscombe says your miscellaneous itemized deduction of $46,400 will be reduced by $1,022 making more of your $150,0000 settlement subject to income tax.

In this (over-simplified) scenario you would have to pay income tax on slightly more than two-thirds of your legal settlement. I know this isn’t the answer you wanted, but it’s better than being taxed on the entire amount.

If you are subject to the alternative minimum tax (AMT), things get even more complicated. In general, under the AMT you lose all or most of your miscellaneous itemized deductions. However, if the court found your employer guilty of discrimination, your attorney fees would be classified an “above-the-line” deduction on your AMT tax return (instead of a “miscellaneous itemized deduction”) and you could use them to reduce your taxable income as explained above.

I suggest you speak with your attorney so you are clear about this issue. And make sure your tax preparer fully understands the rules about the deductibility of legal fees.

Hope this helps,

Gail

*For the 2005 tax year, the phase-out of itemized deductions starts when your AGI hits $145, 950

If you have a question for Gail Buckner and the Your $ Matters column, send them to yourmoneymatters@gmail.com , along with your name and phone number.