A settlement award for bad tax advice is taxable, IRS attorneys say. A couple who participated in an abusive tax shelter sued the accounting firm that promoted the transaction to them for malpractice due to improper tax advice. The parties settles the lawsuit, and the couple excluded the payment they received, claiming the amount was a nontaxable return of capital. But the Service disagreed. In addition, any legal fees paid to get the damage award are taken on Schedule A as a miscellaneous itemization that’s deductible only to the extent it is over 2% of AGI.