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was to protect his ability to earn income. Accordingly, we must
consider whether the legal fees are attributable to petitioner’s
employment status and not to the tax-exempt income.
Section 1.265-1(b), Income Tax Regs., deals with the
definition of the terms “exempt” and “nonexempt” income for
purposes of section 265. Section 1.265-1(b)(1), Income Tax
Regs., in pertinent part, states that a “‘class of exempt income’
means any class of income (whether or not any amount of income of
such class is received or accrued) wholly exempt from the taxes
imposed by subtitle A of the Code.” Section 1.265-1(b)(2),
Income Tax Regs., defines “nonexempt income” as “any income which
is required to be included in gross income.” There is no
question that petitioner’s lawsuit recovery was exempt income.
Likewise, petitioner’s current and possibly his future
compensation from employment would meet the definition for
nonexempt income set forth in the regulation. In that regard, in
addition to the $140,000 recovery, petitioner’s attorney’s
efforts permitted him to continue earning employee compensation,
both during the year under consideration and for future years.4
Section 1.265-1(c), Income Tax Regs., provides for
allocation of expenses between exempt and nonexempt sources of
income, as follows:
4 For the taxable year under consideration (1996),
petitioner reported almost $69,000 in wages from employment in
the Oakdale School District.
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