The employer-employee relationship can often lead to disputes. These disputes are often settled out of court.
Whether it’s a wrongful termination claim, a defamation lawsuit, or other employment-related litigation, these settlements often involve significant attorney’s fees. The taxpayer receives a settlement check, but a substantial portion goes directly to their legal counsel under a contingency fee agreement.
This common scenario creates a complex tax situation. The IRS typically requires the entire settlement amount to be included in gross income, even the portion paid directly to attorneys. This means taxpayers must pay tax on money they never actually received, potentially creating a disporportionately large tax bill.
The question in these situations is whether the attorney’s fees can be deducted to offset the income inclusion. There are rules that allow just that. The U.S. Tax Court case Mennemeyer v. Commissioner, T.C. Memo. 2025-80, gets into these issues. It considers a fact pattern whereby attorney’s fees were paid from settlement proceeds and whether they can be deducted above-the-line in a dispute related to an employer and defamation.
Facts & Procedural History
The taxpayer in this case worked as a financial specialist at PNC. Her employment was terminated in December 2013. Following the termination, PNC filed a document with the Financial Industry Regulatory Authority (“FINRA”) stating that the taxpayer was dishonest, which led to her dismissal. This filing made it difficult for the taxpayer to find employment in the securities industry.
The taxpayer filed a claim with FINRA in December 2015 for defamation, wrongful termination, unfair competition, tortious interference with business expectancy, and expungement. Through arbitration, she was awarded $300,000 in compensatory damages and $1,500,000 in punitive damages. PNC subsequently filed a petition to vacate the arbitration award in federal district court.
In April 2018, the taxpayer and PNC reached a settlement agreement whereby PNC agreed to pay $1,510,000. Of this amount, $997,466 was paid directly to the taxpayer, and $512,534 was paid to her attorneys under their contingency fee arrangement.
On her 2018 income tax return, the taxpayer reported $498,733 of the PNC award as taxable income. This was approximately half of what she directly received. The IRS audited her return and determined that the entire settlement amount, including the attorney’s fees, should be included in her gross income. This resulted in a sizeable tax bill. The taxpayer petitioned tax court to challenge the IRS’s determination.
How Are Legal Settlements Taxed?
When a taxpayer receives a settlement payment, the tax treatment can vary based on the nature of the underlying claim that gave rise to the settlement.
Section 61 of the tax code defines gross income broadly as “all income from whatever source derived.” This expansive definition includes settlement proceeds unless a specific statutory exclusion applies.
The most significant exclusion for settlement proceeds is in Section 104(a)(2) of the tax code. This provision excludes from gross income “the amount of any damages received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness.” This exclusion covers medical expenses, pain and suffering, and other damages directly attributable to physical harm.
The exclusion under Section 104(a)(2) is quite narrow in scope. The statute specifically states that emotional distress is not considered a physical injury or physical sickness unless it manifests in physical symptoms or illness. Damages for emotional distress alone, defamation, economic losses, punitive damages, or other non-physical injuries are generally taxable income.
Consider a typical employment dispute where an employee claims wrongful termination and defamation. Even though the employee may have suffered significant emotional distress and economic harm, the IRS will often assert that the damages don’t qualify for the Section 104(a)(2) exclusion because they don’t stem from personal physical injuries or physical sickness. There has been a lot of litigation involving cases just like this.
When Can Attorney’s Fees Be Deducted Above-the-Line?
The question for settlement awards is often whether the attorneys fees can be deducted and how.
Recognizing the potential unfairness created by charging tax on the portion of the settlement that goes to the attorney for their attorney fees, Congress enacted Section 62(a)(20) of the tax code. This provision creates a special above-the-line deduction for attorney’s fees. When it applies, it allows taxpayers to directly reduce their gross income rather than claiming the fees as itemized deductions subject to various limitations.
Section 62(a)(20) permits an above-the-line deduction from gross income “for attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination.” This deduction is particularly valuable because it reduces adjusted gross income, which can affect the taxpayer’s eligibility for various credits and deductions that are based on adjusted gross income levels.
This is why these above-the-line deductions are significantly more advantageous than itemized deductions. They reduce gross income directly, without being subject to the standard deduction limitation or other restrictions that apply to itemized deductions. For many taxpayers, this often means the difference between being able to use the deduction and losing it entirely.
It should be noted that the deduction applies to both attorney’s fees and court costs, provided they are paid in connection with qualifying claims. The fees can be paid directly by the taxpayer or on behalf of the taxpayer, which covers situations where attorneys are paid directly from settlement proceeds.
What Qualifies as “Unlawful Discrimination”?
This brings us to the question as to whether their legal claims fall within the definition of “unlawful discrimination” under Section 62(e) of the tax code. This definition is broader than many realize and it can extend well beyond traditional discrimination claims.
Section 62(e) defines “unlawful discrimination” to include violations of specific federal anti-discrimination statutes listed in subsections (1) through (17). These include well-known laws such as Title VII of the Civil Rights Act of 1964, the Americans with Disabilities Act, the Age Discrimination in Employment Act, and the Family and Medical Leave Act.
However, the definition extends much further through the catch-all provision in Section 62(e)(18). This subsection covers any provision of federal, state, or local law that provides for the enforcement of civil rights or regulates any aspect of the employment relationship.
The employment relationship provision in Section 62(e)(18)(ii) is particularly broad. It covers laws that regulate “any aspect of the employment relationship, including claims for wages, compensation, or benefits, or prohibiting the discharge of an employee, discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.”
This expansive language covers many employment-related claims that might not initially appear to be discrimination cases. Wrongful termination claims, wage and hour disputes, defamation related to employment, and retaliation claims can all potentially qualify under this provision.
How Did the Court Apply These Rules?
Okay, so back to this court case. The IRS determined that the full settlement award was taxable. It also concluded that the attorneys fees were not deductible as an above-the-line deduction.
Having determined that the settlement was taxable income, the court then addressed the attorney’s fees issue. The taxpayer raised an argument that if the attorney’s fees were required to be included in her gross income under the assignment of income doctrine, she should be entitled to an above-the-line deduction for those fees under Section 62(a)(20). The IRS did not respond to or address this argument in the case. As a result, the U.S. Tax Court held that the IRS had waived any objection to the above-the-line deduction claim by failing to address it.
The court then made an affirmative finding that the taxpayer’s claims against her former employer fell within the broad category established in Section 62(e)(18)(ii). The court specifically found that her claims related to her employment relationship with PNC and included claims for lost wages. The defamation claim was particularly relevant because it affected her ability to find employment in her chosen field, making it an employment-related claim rather than a purely personal defamation case.
The Takeaway
As this case shows, several categories of employment-related claims may qualify for the above-the-line attorney’s fee deduction. This can include wrongful termination claims, defamation claims related to employment, wage and hour disputes, retaliation claims, and other claims affecting future employment prospects. The key determination is whether the underlying legal claims relate to employment, civil rights, or one of the specific federal statutes listed in Section 62(e)(1)-(17). With proper planning, one can go a long way in ensuring that only the amount of the settlement actually received is subject to tax. This is important for anyone involved in employment-related litigation resulting in taxable settlements.