Taxability of Settlement from Brokerage firm regarding IRA | Ed Slott and Company, LLC

Taxability of Settlement from Brokerage firm regarding IRA

My client received a settlement in a complaint filed against a financial advisor and the handling of my clients IRA's. She received an award of $225,000 of which my client received 60% and the attorney received 40%. $135,000 was deposited in a seperate IRA at a bank. My client received a 1099-MISC (other income) for the full $225,000. Questions: 1) Is the $225,000 taxable? (It was awarded based on loss of capital and not punitive.) 2) How is this handled on the 2008 1040? (whether taxable or not.) 3) Was the depositing of the $135,000 into a separate IRA allowed? Please comment...

I would show the 225,000 on line 21 (with explanation) reduced by 135,000, the amount of the IRA rollover. The IRS has approved the rollover of settlements based on losses from an IRA account in several letter rulings. That leaves taxable gross income of 90,000. But the 90,000 also qualifies for a misc. itemized deduction for legal costs to realize taxable income, subject to the 2% of AGI limit and possible AMT reductions.

Thanks for the reply: Doing that pops her with a $17,898 amt tax. Can you reference any of the letter rulings.

Following is a link to Ed's Dec 2006 newsletter. Scroll down to p 46 for a list of the PLRs and his observations on this subject:

Thanks for your expertise! Poor lady will end up with less than 50% of the settlement. Attorney should have advised her to sue in the name of the IRA and have settlement paid directly to the IRA and the IRA custodian pay the attorney. I guess the attorney wanted to make sure he got his share.

She may want to ask her lawyer whether she can take the position that the $225,000 is the IRA's, and that the $90,000 fee was the IRA's expense.

The settlement check was made payable to the law firm f/b/o clients name (without any reference to the IRA) and then the lawyer sent a 1099-misc. What choice is there now?

I have a client who received a settlement of $200,000 from their brokerage firm.  After legal fees were deducted the net amount of the check was $133,000. this was paid to my client from the attorney escrow acct.  The original claim indicated as a result of churning and unsuitable investments my client sustained thefollowing losses:$600,000 in his company pension plan$400,000 in his IRA Account$300,000 in his joint account with this wife.The final settlement doesn't indicate what the payment was for.Is this capital gain, ordinary income or return of principal. 

The law firm should provide more info about these payments, and should break the award down into 3 separate checks. The IRA portion can be endorsed over for deposit to the IRA account from which the loss occurred, or to the succeeding IRA account if the IRA custodian has changed. These are known as restorative payments and the IRS has ruled on a number of occasions that these awards can be redeposited into the respective accounts as rollover contributions. As such, for retirement accounts there is no current income. Taxes will be due when distributions are taken from the IRA or pension plan. The pension plan portion should also be allowed to be deposited back to the pension plan, depending on the current status of that plan. I think that if the award relates to a specific taxable brokerage investment that has since been sold or became insolvent, this should be reported as a capital gain on Form 8949/Sch D. Specifics can vary, but it seems that more detailed information from the legal firm will be required for the entire award to be properly reported or handled correctly Larger IRA custodians should be familiar with the concept of restoractive payments. If there is a bordeline situation, a PLR might be required by the custodian to accept the rollover contribution, but due to their increased costs effort should be made to avoid a PLR.


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