The IRS recently issued a private letter ruling that reminds us that not all amounts recovered in litigation are subject to income tax. In PLR 201152010 (December 30, 2011), the taxpayer had attempted to purchase assets from a unit investment trust. Another party interfered with the transaction and, as a result of that interference, the unit holders of the trust did not approve the sale. In order to purchase the assets, the taxpayer had to agree to pay a higher purchase price. After completing the purchase, the taxpayer sued the interfering party in the original transaction, and the court found in favor of the taxpayer, awarding damages in the amount of the additional price the taxpayer had to pay as a result of the interference.

The IRS ruled that this recovery represented a nontaxable return of capital that reduced the income tax cost basis of the purchased assets. The income tax status of litigation recoveries depends on the nature of the taxpayer’s claims in the litigation. In this case, the taxpayer claimed it had to pay more because of the defendant’s interference, and the IRS concluded that the recovery was really just an adjustment of the purchase price paid for the assets and should not be treated as taxable income.

This ruling highlights a very important tax planning point related to litigation: If you are a plaintiff, the nature of the causes of action stated in your complaint will govern the income tax consequences of any judgment or settlement you receive. As was the case here, not all claims give rise to recoveries that are taxable. For individuals, the Internal Revenue Code provides that the plaintiff’s legal fees related to a variety of claims also are deductible “above the line” in computing adjusted gross income. Those fees would be deductible without regard to the alternative minimum tax, the itemized deduction phase out, or the 2 percent floor on miscellaneous itemized deductions. The opportune time to do your tax planning is before you file your complaint.