Exxon Valdez Settlement

[JJ EA]

My client is the beneficiary (wife) of an Alaska fisherman. She received a settlement payment in 2009. She has the option of putting all of the settlement income into an IRA. I'm questioning how the legal fees would be treated if she did that. She was allocated $40,000 of settlement income and $10,000 of legal fees and received $30,000. She can put the $40,000 on line 21 and the legal fees on Sch A, subject to 2%. If she puts the $40,000 into an IRA, it seems like she would lose the Sch A deduction because the income is not taxable in 2009. Would she be able to treat the amount deducted as legal fees as basis in her IRA?

Thank you for any thoughts on this.

JJ EA

[Burke]

If she only got $30,000 ($40,000 less $10,000 legal fees), then that is all she would have to put in an IRA unless she came up with $10,000 out of her own pocket. Are you saying it will be treated as earned income so as to be eligible for an IRA? She got a 1099 of some sort for $40,000? Or they are going to deposit it directly into an IRA for her? If it is not taxable when received, then she has no basis, and she has no deduction for the legal fees for income not taxed.

[Kram BergGold]

Really?

How can you put more than $5,000 or $6,000 into an IRA in one year?

[Burke]

How can you put more than $5,000 or $6,000 into an IRA in one year?

You can't if you are depositing it yourself. But from the info in the OP, he said "she has the option of putting it all into an IRA." Is this something this particular settlement is offering her under its terms? I assumed he got this info from the settlement papers. Where did this info come from? I just recently had a client offered a severance package and he said one of the options was to put the whole amt into his 401k. Never heard of this before, but I haven't seen the paperwork.

[Koss]

Exxon Valdez

Special treatment is available for awards under the Exxon Valdez settlement.

The following text is from IRS Publication 525, Taxable and Nontaxable Income:

Exxon Valdez settlement income. Include in your income on Form 1040, line 21, or Form 1040NR, line 21, any qualified settlement income you receive as a qualified taxpayer. See Statement, later. Qualified settlement income is any interest and punitive damage awards that are:

Otherwise includible in taxable income, and

Received in connection with the civil action In re Exxon Valdez, No. 89-095-CV (HRH) (Consolidated) (D. Alaska).


You are a qualified taxpayer if you were a plaintiff in the civil action mentioned earlier or you were a beneficiary of the estate of your spouse or a close relative who was such a plaintiff and from whom you acquired the right to receive qualified settlement income.

The income can be received as a lump sum or as periodic payments. You will receive a Form 1099-MISC showing the gross amount of the settlement income paid to you in the tax year.

Contributions to eligible retirement plan. If you are a qualified taxpayer you can contribute all or part of your qualified settlement income, up to $100,000, to an eligible retirement plan, including an IRA. Contributions to eligible retirement plans, other than a Roth IRA or a designated Roth contribution, reduce the qualified settlement income that you must include in income. See Statement, later. For more information on these contributions, see Publications 560, 575, and 590.

Legal expenses. You may be able to deduct attorney fees and court costs paid in connection with the civil action. Depending on the facts and circumstances, these expenses are either claimed on Schedule A (Form 1040) or Form 1040NR (Schedule A), or deducted in figuring the income you report on Form 1040, line 21, or Form 1040NR, line 21. If the qualified settlement income was received in connection with your trade or business (other than as an employee), you can reduce the taxable amount of qualified settlement income by these expenses. In all other situations, you can only claim these expenses as a miscellaneous itemized deduction subject to the 2%-of-adjusted-
gross-income limit on Schedule A (Form 1040), line 23, or Form 1040NR (Schedule A), line 11. For example, an employee or the surviving spouse or beneficiary of a deceased plaintiff would claim the expenses as a miscellaneous itemized deduction subject to the 2% limit. See Statement, next.

Statement. If you report on Form 1040, line 21, or Form 1040NR, line 21, qualified settlement income that is less than the gross amount shown on the Form 1099-MISC, you must attach a statement to your tax return. The statement must identify and show the gross amount of the qualified settlement income, the reductions for the amount contributed to an eligible retirement plan or allowable as legal expenses not reported as a miscellaneous itemized deduction, and the net amount.

This is all very interesting, but it does not appear to answer the original question. JJ's client is the spouse, or beneficiary, so she cannot simply back out the legal fees. The only way for her to deduct the legal fees is on Schedule A.

The question remains whether she can take this deduction on Schedule A even if she puts the entire amount into an IRA. And what exactly is the "entire amount"? The gross amount of $40,000 or the net amount of $30,000?

Here's my take on this so far:

As a starting point, the entire 40K has to be reported on Line 21, and 10K can be deducted on Schedule A subject to the 2% limitation.

She has the option of putting up to 40K into an IRA. But if she only received 30K, it is correct that she would have to come up with 10K out of her own pocket in order to contribute the entire settlement to an IRA.

Regardless of whether she chooses to do this, I think the formula is fairly straightforward:

For every dollar of the settlement that she contributes to an IRA, you reduce the amount of income reported on Line 21. If she contributes 30K to an IRA, then you still need to report 10K as income on Line 21.

Even if she contributes 40K to an IRA (by adding 10K of her own money to the net proceeds), I still think she can deduct the 10K of legal fees on Schedule A.

Her basis in the IRA is irrelevant.

If she puts the entire net amount of 30K into an IRA, she has to report as income on Line 21 the remaining 10K. She didn't actually get that 10K. It was eaten up by the legal fees, so she can still deduct it on Schedule A.

If she puts 40K into an IRA, then Line 21 will have zero taxable income. But now she's actually paying the legal fees out of her pocket. So she can still deduct the 10K on Schedule A.

BMK

[JJ EA]

Thank You Koss

I was getting confused by the options my client has with this settlement. I see now that the legal fees are deductible on the Sch A, subject to 2%, no matter which option she chooses.

She received a 1099-Misc for $30,000. The Fund sent a letter of explanation with Punitive Damages of $40,000, legal fees of $10,000, and check amount of $30,000. I think the 1099 is incorrect. At www.exspill.com, under "News", Feb 9-1099 info there is a link to a letter ruling by the IRS re: 1099: " The Fund should report qualified settlement income (punitive damages and interest) in Box 3 of 1099-Misc. The 1099-Misc received has the gross amount minus the legal fees in Box 3.

I will try and reach someone at the Fund attorneys' office and ask them to review the ruling to determine if a corrected 1099 should be issued.

Thank you for helping me think this through.

JJ

[Koss]

Publication 525

JJ EA wrote:

Thank you for helping me think this through.

No problem... I found the entire topic to be fascinating.

I'm not kidding. I guess this just shows how much of a nerd I really am.

Mark Goldberg wrote:

How can you put more than $5,000 or $6,000 into an IRA in one year?

Easy. Have your livelihood ruined by Big Oil, and Congress will make that $5000 limit disappear in a heartbeat.



What's really funny is that when I first saw the subject line of the original post, I wasn't even going to touch this thread. This may well be the most arcane and esoteric topic that I have ever waded into on this board. I stay away from topics that I know nothing about, unless it seems like something I might actually run into in my own practice. This one doesn't exactly fall into that category.

I live in Ohio, for pete's sake. I have never had a client from Alaska, and I probably never will. There's probably more than a few folks out there who are thinking, Jeez, this guy needs to get a life...

But an earlier thread on EIC and compensation for fiduciary functions, started by tonia2021, cited IRS Publication 525, Taxable and Nontaxable Income. I was participating in that thread, so I began looking at Pub. 525. While searching for the relevant text, I ran across a bold print reference to the Exxon Valdez settlement.

And I thought, Hmmm, that looks interesting...



BMK