You Can Owe Tax on Money You Never Received
Most people assume they only pay income tax on money that actually lands in their bank account. Unfortunately, the tax law doesn't always work that way. You may owe federal income tax on income you never physically receive. These rules often surprise taxpayers and can create unexpected tax bills if they are not anticipated.
A Recent Tax Court Reminder
On July 14, 2026, the U.S. Tax Court issued its decision in Eiler v. Commissioner (167 T.C. No. 3). The taxpayers received a lawsuit settlement, but most of the settlement proceeds were paid directly to their attorneys under a contingent fee agreement.
The taxpayers argued that they should only be taxed on the amount they actually kept. The Tax Court disagreed. Relying on Commissioner v. Banks, the court held that when a lawsuit recovery is taxable, the taxpayer generally must include the entire recovery in income, including the portion paid directly to the attorney. Because the claims in this case did not qualify for a special deduction available for certain civil rights and employment cases, the attorney fees did not reduce taxable income.
The result was that the taxpayers owed tax on money they never personally received.
Other Situations Where This Can Happen
- Cancellation of Debt: When a lender forgives debt, the forgiven amount is generally taxable.
- Debt Settlements: Settling a loan or credit card for less than the balance may produce taxable cancellation-of-debt income and a Form 1099-C.
- Partnership and LLC Income: Owners are taxed on their share of business profits even if the business keeps the cash instead of distributing it.
- S Corporation Income: Shareholders generally pay tax on their share of corporate income whether or not cash distributions are made.
- Imputed Interest: The tax law sometimes treats interest as having been paid on below-market loans even when no interest actually changes hands.
- Foreclosures and Repossessions: Losing property can result in taxable gain, cancellation-of-debt income, or both depending on the facts.
Why These Rules Exist
The tax law often focuses on economic benefit rather than cash actually received. If your financial position improves because a debt disappears, a business earns income on your behalf, or another party satisfies an obligation you owe, the IRS may treat that benefit as taxable income.
Planning Can Prevent Costly Surprises
Many of these situations involve exceptions and planning opportunities. Understanding the tax consequences before signing a settlement, restructuring debt, or completing a transaction can help avoid unexpected tax bills.
How Can We Help?
Unexpected taxable income often catches taxpayers off guard because the transaction does not feel like income. If you are settling a lawsuit, negotiating debt, selling a business, or facing another complex financial transaction, Gurel CPA can help you understand the tax consequences before you make a costly decision.
The article is meant for informational purposes only. Please contact me directly to discuss how this applies to your individual tax situation.