The general intent of the Internal Revenue Code is to tax net profits -- not gross revenues. You are therefore generally allowed to deduct certain expenses -- particularly those expenses necessary to operate and fund a business. You may also deduct medical bills and certain insurance premiums, to the extent they exceed 7.5 percent of your adjusted gross income (10 percent if you are subject to the alternative minimum tax, or AMT) or other miscellaneous expenses, to the extent they exceed 2 percent of your income. Certain deductions are disallowed under AMT rules, however, and for those with very high incomes. Some deductions that are permissible as business deductions are disallowed as personal deductions, however.
Deductibility of Legal Settlements
Generally, the cost of a legal settlement is deductible for a business as a business expense and not subject to a 2 percent floor. Payments made in a legal settlement on a personal matter, however, are generally not deductible.
Compensatory Vs. Punitive Damages
Compensatory damages are those designed to make the plaintiff as financially whole as possible and are not intended to punish or deter bad behavior. Punitive damages are sometimes awarded by juries to punish the defendant or to send a signal to other companies in the industry. Under current law at the time of publication, damages awarded by a court and paid by a business are deductible whether they are punitive in nature or compensatory. However, some have proposed eliminating the deductibility of punitive damages. If such a measure becomes law, there will be a powerful incentive to settle disputes out of court on favorable terms to the plaintiffs.
Personal Deductions
Generally, you cannot deduct legal expenses or damages paid, or money paid in an out-of-court settlement, for purely personal disputes. To qualify for a deduction, the settlement must be a reasonable and necessary business expense. The deduction on some expenses must be amortized over a number of years, however, under capital depreciation rules.
Claiming the Deduction
Sole proprietors and partnerships claim the deduction by listing the settlement as an ordinary business expense on Schedule C of Form 1040. You cannot use a Form EZ for this purpose. Corporations and limited liability companies filing taxes as corporations must use Form 1120 for C corporations or Form 1120-S for S corporations and limited liability companies. Again, simply list the settlement as an ordinary business expense on these forms.