A Taxing Settlement

This week, Gail explains the tax implications of a legal settlement received from an employer; the law provides some relief, but it's limited!

Dear Gail,

Last 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 co-workers.

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 the next two weeks so it would be completed on time. I was the only one who refused to do this. A month after the project was wrapped up, I was told I wasn’t a "team player," and I was fired.

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. What upsets me is my tax preparer says I have to pay income tax on the whole amount! Is this correct?


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, an employer cannot fire you because of your race, color, religion, gender, age, height, weight, marital status, or if you are disabled. In addition, some states extend protections to certain veterans. A number of states prohibit firing someone because he/she is gay/lesbian.

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 don’t cover every situation. I’m assuming your case was 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 reinstating 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 going too deep, 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 pay-back worth significantly more than just customary legal fees.)

According to CCH, a provider of tax law and sofware, legal fees that you incur because of this type of litigation are deductible as a “miscellaneous itemized expense.” So, to the extent they exceed 2-percent of your adjusted gross income, they will reduce the amount of your settlement that is subject to income tax. For example, assume your AGI was $100,000 and this was the only miscellaneous itemized expense you had. $100,000 x 2 percent = $2,000. This is the amount you cannot deduct. Thus, you would be able to deduct $28,000 out of the $30,000 you paid the attorney.

By the way, if you are subject to the Alternative Minimum Tax, the American Jobs Creation Act passed by Congress last year includes you a bit of relief in this area. While you generally lose all miscellaneous itemized deductions when computing your AMT, attorney fees incurred in connection with an unlawful discrimination suit are deductible. This applies to fees paid after Oct. 22, 2004.

Hope this helps,


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