Do I have to Pay Tax on Judgments, Settlements, and Awards from Lawsuits?

We often get asked “Do I have to pay tax on that?” So, what are the consequences of judgements, settlements, and awards from lawsuits?  A  recent California Office of Tax Appeals (OTA) demonstrates the tax consequences of a lawsuit are not always clear cut and obvious.

The Appeal of Sadatnejad and Marconet, 2024-OTA-625P case involved an accountant that allegedly embezzled over $6 million from his clients.  The clients took the CPA and the clients’ investment advisor to arbitration.  The arbitrator ordered the CPA to pay over $5 million to the clients and the arbitrator also found the investment advisors to be liable. 

The investment advisors sought to attach the accountant’s assets as part of the lawsuit.  The accountant argued against the attachment during the lawsuit claiming the assets were not part of the accountant’s trade or business.  (Under California Law, certain assets cannot be attached if they relate to “the conduct by the defendant of a trade, business, or profession.”  The accountant later went on to claim a tax deduction of over $5 million on his tax return because of the arbitration award.  At issue in the case was whether the accountant could deduct the $5 million he paid for allegedly embezzling client money. 

Legal feels and legal damage awards can be tax deductible if they are incurred as part of a taxpayer’s trade or business.  The line between business and personal expenses is not always clearly defined.  In the Sadatnejad case, the accountant’s alleged activities were not entirely personal in nature.  The accountant in Sadatnejad was sued for allegedly misappropriating client funds.  The OTA found the alleged activities were not part of the accountant’s trade or business because (1) the accountant argued in his lawsuit that the funds were not part of his trade or business and (2) the OTA determined handling client’s money was not part of what accountant’s usually do. 

The case is not as clear cut as one would think.  The fact that the accountant allegedly engaged in egregious criminal conduct does not necessarily mean his legal expenses would not be deductible.  In one case the US Tax court allowed a taxpayer to deduct legal fees incurred defending rape allegations made by a prospective employee. 

Legal expenses can be deducted if a taxpayer can show they are incurred in connection with a trade or business.  In this case, the OTA determined the Accountant’s alleged misappropriation of the clients’ funds were not in connection with a trade or business. 

This case could have easily had a different outcome if the fact pattern were different.  For example, if the accountant had an established financial management business, the accountant could have claimed the arbitration award as an expense against his financial management business income.  The accountant also could have had a better argument to show how the alleged misappropriation was part of a trade or business if he had not argued the opposite in court.  The OTA case did not really delve into whether exact meaning of “trade or business” in the tax code differs from the meaning of the term in the Code of Civil Procedure that limits attachments in lawsuits.  To quote Stairway to Heaven, “Sometimes words can have two meanings.”   

The Internal Revenue Code and California Revenue & Taxation code touch nearly every single facet of our lives.  Lawsuits are no exception.  Lawsuits can have large tax ramifications for the unaware. 

At RJS LAW we help clients with all types of tax problems including tax problems that may have arisen from litigation.  Give us a call at 619-595-1655 for a free consultation if you have tax questions about a lawsuit involving you or your business.   

Do I have to Pay Tax on That? Written by Joseph Cole, Esq., LL.M.