Carole Holliday v. Comm., TCM 2021-69

Carole Holliday filed a malpractice lawsuit against her divorce attorney. She claimed that her divorce attorney’s representation constituted negligence and gross negligence and that he breached the duty of fair dealing and his fiduciary duties “by influencing * * * [her] to mediate and enter into a transaction that was not fair to * * * [her] under the circumstances” and by not pursuing an appeal. The malpractice defendants agreed to pay Ms. Holliday $175,000. Ms. Holliday’s malpractice attorney received the settlement check, deducted his fee of $73,500, and transferred the remaining $101,500 to Ms. Holliday.

Taxpayer reported zero income from settlement. On her tax return, Ms. Holliday reported other income of zero. She acknowledged the receipt of $101,500 through an attached Form 1099-MISC Summary and a Line 21 Statement on which she reported “Other Income from Box 3 of 1099-Misc” of $101,500. But the Line 21 Statement then subtracted $101,500 with the description “Misclassification of Lawsuit recovery of marital assets,” resulting in total other income of zero.

Court found the settlement proceeds taxable. Ms. Holliday claimed that the settlement proceeds were a nontaxable return of capital because they compensated her for the portion of her marital estate that she “was rightfully and legally entitled to but did not receive because of the malpractice of her attorney.” The court found that the settlement proceeds were taxable income because they compensated her for the alleged failings of her divorce attorney.

How much is taxable? The settlement consisted of $175,000, of which Ms. Holliday’s malpractice attorney retained $73,500 as a fee for representing her in the lawsuit. The full amount of the settlement proceeds, including the fee the taxpayer paid her malpractice attorney, is includible in gross income. The legal fees are not deductible because they are miscellaneous itemized deductions disallowed by the TCJA.