The nature of the underlying claim determines whether you can deduct a legal settlement. In most cases, personal legal settlements aren't tax deductible, but you can take a deduction for the legal fees and court costs you incur, as long as the settlement meets Internal Revenue Service requirements. If the settlement payment was a result of a dispute concerning your small business, you might be able to deduct the entire settlement and legal fees, but the settlement must be the result of an ordinary deductible expense.
Deducting Legal Fees
Determine whether your legal fees qualify as a deduction. According to IRS Publication 529, you can only deduct legal fees you incur as a result of your employment, disputes related to income property or business disputes.
Download Form 1040 and Schedule A from the IRS website.
Fill out Form 1040 using your tax forms, but stop once you reach the line labeled "Itemized Deductions or your Standard Deduction."
Multiply your adjusted gross income from Form 1040 by 2 percent, and subtract this amount from your legal fees. You can deduct only the amount of legal expenses that exceed 2 percent of your adjusted gross income. For example, if your adjusted gross income is $50,000 and your legal fees are $5,000, multiply $50,000 by 2 percent, which is $1,000. Subtract $1,000 from the $5,000 in legal fees. Your allowable deductible amount is $4,000.
Complete Schedule A to determine your itemized deduction amount. If your itemized deductions are greater than your standard deduction, which is determined by your filing status, enter the itemized deduction amount in the line labeled "Itemized Deductions or your Standard Deduction" on Form 1040. If your standard deduction is greater, enter this amount in the line. If you opt to claim the standard deduction, you are not deducting your legal fees.
Deducting Alimony Payments
Download Form 1040 from the IRS website.
Determine which portion of your payments is recognized as alimony. You can't include child support payments, noncash property settlements, payments to keep up your property, use of your property or payments that are your former spouse's portion of community property income.
Enter the amount you paid in alimony in the line labeled "Alimony Paid" on Form 1040.
Subtract this amount, and any other adjustments, from your gross income to determine your adjusted gross income.
Small Business Deduction
Assess the underlying claim of your small business settlement. If you paid the settlement as result of a tax-deductible expense, such as unpaid wages or past-due rent, the settlement is tax deductible. If you paid the settlement as result of a nondeductible expense, such as a personal injury lawsuit or a government fine, you can't deduct the settlement.
Download Form 1040 and Schedule C from the IRS website.
Enter the settlement amount in the line corresponding to the underlying expense. If you paid the settlement as result of unpaid wages, enter the settlement amount in the "Wages" line in the "Expenses" section on Schedule C.
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