Pay taxes on unlawful termination award?

Dear Tax Talk,
I received a settlement of $400,000 for unlawful termination — settled out of court. My attorney took $200,000 as contingency plus about $10,000 in legal expenses. How does it work with unlawful termination awards? Do I pay taxes on the remaining $190,000?
— Wagner

Dear Wagner,
It used to be that if you were not careful here, the Internal Revenue Service and the attorney would have walked away with your entire termination award. Thanks to 2004 legislation, that has changed. An award for unlawful termination is considered compensatory and thus must be included in income, usually on line 21 of Form 1040 where it says, “other income.” The award is not subject to self-employment taxes.

It was undecided for many years if an individual could deduct attorney fees for discrimination claims as an adjustment to gross income. Under the tax code, such fees were treated as a miscellaneous itemized deduction, which is not deductible under the alternative minimum tax, or AMT. The effect of including the entire award in income and not being allowed to deduct the portion that was not received created a tax bill that, when combined with the attorney fees, almost equaled the award amount. Obviously, this seemed unfair considering the attorney was subject to taxation on their portion of the award amount, causing no reduction of the tax base. Basically it created a disincentive to file unlawful discrimination lawsuits, and that was bad for business or as the lawyer lobby would say, unjust.

The American Jobs Creation Act of 2004 enacted Internal Revenue Code Section 62(a)(20), which allows an above-the-line deduction for attorney fees and court costs paid in connection with unlawful termination, discrimination and certain other suits. Now we’re back in business. Page 33 of 2011 Form 1040 instructions says to enter the amount of attorney fees on line 36 and on the dotted line next to that enter “UDC,” which I take to stand for unlawful discrimination claim. The entire $210,000 would be deducted on this line, while the $400,000 would be shown on line 21.

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