Can I Deduct a Paid Judgement on My Taxes?
The tax deductibility of a paid legal judgment hinges on the nature of the original dispute. Discover the criteria used to determine if the expense is eligible.
A paid legal judgment against you or your business can be a complex financial event, especially regarding your tax return. The Internal Revenue Service (IRS) has specific guidelines to determine when such a payment qualifies as a deduction. The ability to deduct a judgment depends not on the payment itself, but on the nature of the activities that led to the lawsuit.
The Origin of the Claim Test
The primary standard the IRS uses to determine the deductibility of a legal judgment is the “origin of the claim” test. This principle, established in the Supreme Court case United States v. Gilmore, dictates that the tax treatment of a legal expense depends on the activity that created the lawsuit. You must look at the initial cause of the dispute, not the potential consequences of the judgment on your finances. The character of the claim, whether it arose from business or personal dealings, is the deciding factor.
For example, if a self-employed consultant is sued by a client for breach of contract, the origin of that claim is their trade or business. Conversely, if the same consultant is sued by a neighbor over a fallen tree on their personal property, the origin of that claim is personal. Even if a large judgment in the personal case threatens the consultant’s business assets, the origin remains personal, and the payment is not deductible.
The initial legal filings, such as the complaint, are often persuasive evidence of the claim’s origin because they outline the basis of the lawsuit. Tracing the expense back to its source is the foundation for determining whether a judgment payment can be written off.
Deductibility of Business Judgments
For a judgment to be deductible, it must be considered an “ordinary and necessary” expense paid or incurred in carrying on a trade or business under Internal Revenue Code § 162. An ordinary expense is one that is common in your industry, while a necessary expense is one that is helpful and appropriate for your business.
Payments made to settle disputes or satisfy judgments arising from the normal course of business operations are deductible. Common examples include judgments related to breach of contract with customers, business-related torts like professional negligence, or certain disputes with employees. If a company faces a lawsuit over the performance of its services, the resulting judgment is seen as a cost of doing business.
The tax treatment of the legal fees incurred to defend against the lawsuit follows the same origin of the claim test. If the judgment itself is a deductible business expense, then the associated attorney fees and court costs are also deductible. Both the judgment payment and the legal fees are considered part of the same business-related event.
Limitations on Deductibility
Several limitations restrict the ability to deduct payments for judgments. The tax code disallows deductions for fines and penalties paid to a government for the violation of any law. This includes penalties for non-compliance with regulations or environmental fines. Even if the violation occurred during business, these payments are not deductible.
A limitation was introduced by the Tax Cuts and Jobs Act. Under Section 162(q) of the tax code, no deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if the payment is subject to a nondisclosure agreement (NDA). This rule applies to amounts paid after December 22, 2017, and also prohibits a deduction for the attorney’s fees related to such a confidential settlement.
Required Documentation and Reporting
To substantiate a deduction for a paid judgment, meticulous record-keeping is required. In the event of an IRS audit, you must be able to prove the amount, payment date, and the business nature of the expense. Key documents to retain include the final court order or judgment, the settlement agreement, and proof of payment, such as canceled checks or bank statements.
The location for reporting a deductible judgment on a tax return depends on the business structure.
- A sole proprietor or single-member LLC reports the expense in Part V, “Other Expenses,” on Schedule C (Form 1040).
- Partnerships report such deductions on Form 1065.
- S corporations use Form 1120-S.
- C corporations use Form 1120.
On these forms, the expense is listed under “Other Deductions.” You must maintain the documentation that supports the entry.