Suppose your client, Maritza, is an unmarried individual U.S. taxpayer living in New York City. She informs you that she recently entered into a settlement agreement with her investment advisor. The investment advisor has paid Maritza $150,000. The payment is attributable to investment losses caused by the investment advisor’s alleged failure to follow the asset allocation directions from Maritza. Specifically; Maritza instructed her advisor to change the investment objective for her account from “all equity” to “current income.” The advisor understood these instructions to mean reallocate her portfolio from equity to income gradually over time, rather than an immediate sell off and restructuring. Maritza claims that her intention was to do an immediate sell off and restructuring. Hence, a dispute arose with respect to the correct interpretation of her instructions and the decline in market value of the equity position over the length of time it took her advisor to gradually sell (restructure) her equity portfolio to income. Maritza says this could have been avoided had the change in asset allocation been implemented immediately the way she wanted. In the interests of both parties in settling the dispute without admission of fault by either party, the investment advisor agreed to pay Maritza $150,000.
Maritza (the payee) wants to know the following:
Is this settlement payment taxable for federal income tax purposes?
If so, what is the character of the payment? Is it a reduction of tax basis of investment assets, ordinary income, or short or long-term capital gain income?