Are you embroiled in a civil lawsuit? The short story is that full amount of a personal legal settlement is generally taxable as ordinary income at rates currently topping out at 37%. However, you may be able to avoid tax due to certain special exceptions in the tax law.
The outcome in a new case, Eiler, 167 TC No. 3, 7/14/26, indicates that the bar is set high for recipients of legal settlements. As a result, in this instance the taxpayers owe income tax on money they never actually put in their pockets.
One of the interesting aspects of the new case is that an argument raised by the taxpayers represents an issue of “first impression” for the courts.
Facts of the new case: In 2017, a married couple entered into service agreements to pursue substantially similar legal actions against several major credit reporting agencies based on the Federal Credit Reporting Act (FCRA). The couple alleged that these entities had reported inaccurate, incomplete, and/or incorrect and derogatory information on their credit reports.
The service agreements provided that the couple would receive 100% of any statutory damages as awarded by court or jury and 50% of any actual and punitive damages after subtracting costs and expenses. The attorneys would receive 50% of any actual and punitive damages after subtracting costs and expenses and 100% of attorney’s fees determined by court order or negotiated to be paid by the defendant through settlement. In the absence of any recovery, the couple would not be responsible for any legal fees, costs or expenses.
Ultimately, the disputes were settled in 2019 for a lump sum of $64,750. Of that amount, the couple directly received $4,700 and the remainder was split among three law firms. The couple reported only the $4,700 they actually received on their personal tax return and the IRS issued a notice of deficiency.
The couple made two arguments to the Tax Court.
- 1. The couple asserted that the portion of the payment representing attorney’s fees and legal costs should be excluded from their taxable income by special rules for fee-shifting under the FCRA. Because the fees didn’t follow a typical contingent fee structure, the couple said they should be tax-exempt.
- 2. Alternatively, the couple claimed they should be entitled to an above-the-line deduction for claims involving “unlawful discrimination” under the FCRA relating to protection of civil rights. The alternative argument presented an issue of first impression.
But the Tax Court took a narrow view of the exceptions based on FCRA claims. First, it ruled that the FCRA’s fee-shifting provisions were inapplicable. Second, it said that the actions didn’t involve claims of unlawful discrimination. Accordingly, the full $64,750 amount is treated as taxable income and no deductions are allowed for attorney’s fees.
Footnote to the case: The appropriate tax treatment of legal expenses may differ depending on the nature of the expenses. Counsel your clients to stay on the right side of the tax law.
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Tags: court, Income Taxes, IRS, settlement, tax court, Taxes
