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Your deduction may be Schedule C, or it may be nothing at all

March 10, 2010

One of the first things people figure out about tax returns is that deductions on Schedule C are better than deductions on Schedule A. A legitimate Schedule C deduction is fully-deductible whether you itemize or not, for regular taxes or alternative minimum tax. If the deduction is instead an "unreimbursed employee business expense," it is only deductible if you itemize, only to the extent your "miscellaneous" deductions exceed 2% of your adjusted gross income, and it isn't deductible at all in computing your AMT.

A Montana investment advisor, a Mr. Purdy, figured out the difference. He worked for Merrill Lynch, where he received a W-2 and filed his returns as an employee for three years. Relationships soured and he sued Merrill Lynch, eventually getting a $393,000 settlement, $120,000 of which went to his attorney.

The taxpayer deducted the attorney fees as a Schedule C deduction for a new investment advisory business he set up. The IRS had other views. The Tax Court this week came down on the side of the IRS:

In addition, the parties treated Mr. Purdy as an employee. The two agreements Mr. Purdy signed consistently mentioned his employment with Merrill. Merrill paid Mr. Purdy a salary, withheld Federal and State taxes, and issued Mr. Purdy a W-2 every year. Mr. Purdy received benefits of the kinds an employee would receive, including health insurance and a retirement plan. Mr. Purdy reported the wages he earned as an employee consistently each year he was working at Merrill and even reported the settlement award as wages despite having been fired. At no time did he report any self-employment income from Merrill. Moreover, he claimed unreimbursed employee business expenses while he was working at Merrill. Mr. Purdy's tax returns during his tenure at Merrill never included a Schedule C related to his financial adviser activities and instead included his expenses related to his advising as unreimbursed employee business expenses...

Accordingly, we find that Mr. Purdy incurred these legal fees as an employee, not as an independent contractor, sole proprietor, or partner

This highlights a big problem that lawsuit winners often face. They are taxable on the whole lawsuit proceeds, but if the lawsuit arises from employment, the legal fees are a Schedule A deduction -- and if you have alternative minimum tax, that's often the same as non-deductible. After the lawyers and the IRS are done, the lawsuit winner may get the smallest cut of the awards. Moving the deduction to Schedule A cost Mr. Purdy about $42,000.

Cite: Purdy, T.C. Summ. Op. 2010-26.