IRS Audit Guides — Legal Research

IRS Audit Guides — Legal Research

The IRS website includes its Audit Techniques Guides (ATGs). The Guides “focus on developing highly trained examiners for a particular market segment”and “contain examination techniques, common and unique industry issues, business practices, industry terminology and other information to assist examiners in performing examinations.” Not surprisingly, lawsuit proceeds are a “market segment”covered by the Guides.

The Guide for “Lawsuit Awards and Settlements”was “developed during a project in Alabama, which began with media coverage of relevant tax issues. Analyses of newspaper articles revealed that numerous lawsuits were being resolved in the state either by verdict or settlement for substantial amounts. As a result, a separate project relating only to lawsuit Verdicts and Settlements was initiated and approved.”

These are the issues for lawsuit proceeds received after August 20, 1996:

1. Lawsuit proceeds are unreported.

2. All punitive damages are taxable whether received in relation to a physical or non-physical injury (caution: Alabama wrongful death cases).

3. Determine if any of the settlement proceeds are designated as interest, and if so, such interest is reported as income.

4. Verify that amounts excluded from income were received in a case of physical injury. If it was not a physical injury, the only amounts excludable under IRC section 104(a)(2) are out of pocket costs for medical expenses incurred to treat emotional distress.

5. For out of court settlements for physical injury cases, determine if proper amounts were allocated between compensatory and punitive damages.

6. Verify the amount of out of pocket expense excluded for emotional distress in a non-physical injury case (that is, discrimination, fraud, etc.).

7. Verify that the taxpayer reported taxable amounts at gross rather than reporting them net of legal fees paid.

8. Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor), or a capital transaction. This guide does not address the proper treatment of legal fees paid and deducted in taxable years prior to the year of recovery.

9. The legal fees deducted on Schedule A are a tax preference item for purposes of AMT.

10. For purposes of the AMT Credit, the legal fees which created AMT, are not allowed to generate the credit. They are “exclusion”items.

Keep these things in mind when you settle your next suit!

thanks to Bizblawg.

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