You Decide Week 6 - Mr. Jones

a. How is the $300,000 earnings from a successful litigation he has been working for the past two years treated for purposes of Federal tax income?

The $300,000 is treated as an ordinary income and is taxed in the year received. Even though you have been working on this case for the past 2 years, this earnings should be included under ordinary income on your Federal Tax Return. This income fits into the economic income doctrine which states “all income from whatever source derived” IRC Code Sec. 61(a), and the constructive receipt doctrine, outlining constructive receipt of payments, allows us to treat the payment for this current year only even though it was income from a case that lasted two years.

a. How is the additional $25,000 recovery fee expenses treated for purposes of Federal tax income?

Attorneys commonly pay litigation expenses on behalf of their clients. The costs are then recovered by the attorney out of the settlement or award. This practice is most often used by attorneys who take cases on a contingency fee basis. These attorneys generally use a cash basis of accounting and may deduct those expenses when paid, and the recovered costs are included in income when received. This causes a distortion of income since it can take years to resolve.

Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement in these cases.

b. The following are recommendations in reducing the above taxable amount of income:

• Pay off non-mortgage debt (if your interest rate is higher than your mortgage debt, there are clear financial benefits to paying off this debt first).

• Build an emergency fund (having an emergency fund gives you a financial cushion in case you lose your job or have large, unexpected...