Question:        I will be soon be entering into a settlement agreement with my former employer for wages that were wrongfully withheld from me. Can I deduct the legal fees I have spent on this case?

Answer:           The answer depends on the nature of the claim. If the employer discriminated against you in some form or another, you may be entitled to a tax deduction for the attorney’s fees you have paid. If your claim is based on a contractual matter or an employment matter that did not involve discrimination, then no tax deduction will be allowed.

The deduction of legal fees is governed by a doctrine known as the “origin of the claim”.  This means that you must first look to the nature of the claim that was asserted against the employer. The ability to deduct legal fees will depend upon the basis for which damages are sought to be recovered. 

Settlement claims for wages paid by an employer for unpaid salary, wrongful termination or any other reason are taxable to the employee wrongfully denied payment. These wages will be subject to both income tax and payroll tax, the later consisting of both Social Security tax and Medicare taxes. As for the legal fees the employee incurs in recovering the wages wrongfully denied, if the claim is grounded in employment discrimination such as age, sex or racial discrimination, there may be an opportunity to deduct the fees paid to counsel. This deduction is allowed in arriving at the employee’s adjusted gross income and can be claimed, regardless of whether or not the employee itemizes deductions. Absent an employment discrimination claim, legal fees for the recovery of lost wages will not be allowable in determining the employee’s adjusted gross income.

Historically, legal fees paid for the production or collection of income have been deductible as miscellaneous itemized deductions. The 2017 Tax Act eliminated the deduction for miscellaneous itemized deductions, thereby eliminating the opportunity to deduct legal fees incurred for an employment claim outside the employment discrimination context. If the 2017 Tax Act expires and is not extended, then persons in your situation in the future may be allowed to claim legal fees as a miscellaneous itemized deduction. Under current law, no such deduction is allowed.

The origin of the claim doctrine means that the tax treatment of attorney’s fees will in large part be based on the legal complaint initiating the lawsuit.  For wages paid pursuant to a negotiated settlement for which a lawsuit was not filed, correspondence and other communications between an employee and the employer will be scrutinized. Other factors must be considered as well.  

For cases that are settled, the language of the settlement agreement will be probative but not conclusive. For example, a lawsuit filed for lost wages on a contractual basis will not give rise to a deduction for legal fees merely because the settlement agreement claims that the payment is based on age or sex discrimination if there was no allegation of discrimination, whether in the complaint or otherwise. One must look back to the nature of the original complaint or allegation to determine the basis upon which legal fees are claimed. While seldom do plaintiffs’ attorneys focus on taxes at the time they commence litigation, that is precisely the time when taxes should be considered.

You should take a close look at the nature of the claim you made against your former employer. Carefully reviewing your specific situation will determine whether or not a tax deduction will be allowed for the legal fees you have incurred.

The Tax Corner addresses various tax, estate, asset protection and other business matters. Should you have any questions regarding the subject matter or if you have questions, you want answered, you may contact Bruce at (312) 648-2300 or send an e-mail to [email protected].