Taxation of Settlements and Judgments:  Tax Court Rejects Broad Reading of Attorneys’ Fees Deduction

Key Points

• Plaintiffs generally must include gross settlement proceeds in income, including amounts paid to attorneys under a contingency fee arrangement.
• The TCJA eliminated miscellaneous itemized deductions, increasing the likelihood that plaintiffs will owe tax without a matching deduction for attorneys’ fees.
• In Eiler, the Tax Court held that Fair Credit Reporting Act (FCRA) claims involving credit reporting inaccuracies were not “civil rights” claims for purposes of the Section 62(e) deduction.
• The decision highlights the need to consider tax consequences early when negotiating litigation settlements involving fee-shifting or contingency fee arrangements.

Introduction

Federal income tax rules for settlements and judgments can produce harsh and unexpected results. For example, under Commissioner v. Banks, 543 U.S. 426 (2005), the Supreme Court held that plaintiffs generally must pay tax not only on damages they recover, but also on attorneys’ fees recovered on their behalf and ultimately paid to their attorneys under a contingency fee arrangement.  Although plaintiffs could sometimes take a deduction for these fees, the TCJA restricted the ability to deduct these fees after 2017.  That creates a bad tax result:  the entire award is taxable, attorneys’ fees are paid out of the award, and the plaintiff is left paying income taxes on the award without a corresponding deduction.  

Since the TCJA, plaintiffs and their tax advisors have advanced creative arguments to avoid these adverse tax consequences.  More recently, one of those arguments was addressed in the Tax Court’s decision in  Eiler v. Commissioner, 167 T.C. No. 3 (July 14, 2026), in which the plaintiffs (husband and wife) claimed deductions for their attorneys’ fees under Section 62(a)(20) for “unlawful discrimination” claims. 

Facts

The FCRA permits plaintiffs to sue consumer credit reporting agencies to remove inaccurate information from credit reports. In addition to statutory, actual, and punitive damages, plaintiffs may recover attorneys’ fees under the FCRA’s fee-shifting provision.

In Eiler, the plaintiffs hired a law firm to remove information from their credit reports. Under their contingency fee agreements, they would keep all statutory damages and half of any actual or punitive damages. Their attorneys would receive the remaining amounts, including any attorneys’ fee awards.

The Eilers sued the credit reporting agencies and later settled their claims. The settlement agreements provided lump-sum payments and did not allocate the amounts among categories of damages. In total, the Eilers received $64,750, paid $60,050 to their attorneys under the contingency fee agreements, and retained net payments of $4,700.

The credit reporting agencies filed Forms 1099-MISC reporting $64,750 of income to the Eilers. On their joint federal income tax return, however, the Eilers reported only the $4,700 they retained as taxable income.

The Eilers’ Argument for an Attorneys’ Fees Deduction

Prior to the TCJA, plaintiffs could generally deduct their attorneys’ fees as miscellaneous itemized deductions (subject to some limitations).  The TCJA eliminated miscellaneous itemized deductions, resulting in many plaintiffs losing their ability to claim attorneys’ fees.  However, certain plaintiffs may continue to deduct their attorneys’ fees above the line if they meet the requirements of Section 62(a)(20).  Specifically, that provision permits an above-the-line deduction for attorneys’ fees incurred “in connection with any action involving a claim of unlawful discrimination (as defined in [Section 62(e)].” 

Section 62(e) defines “unlawful discrimination” as a variety of different claims, including the Civil Rights Act of 1991, the National Labor Relations Act, the Fair Labor Standards Act, and the Americans with Disabilities Act of 1990.  Section 62(e)(18) also provides a catch-all defining unlawful discrimination as “[a]ny provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law—(i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship[.]”  The statute does not define the term “civil rights.” 

Under these statutory provisions, the Eilers contended that their FCRA claims qualified as civil rights and were therefore deductible.  However, the Tax Court disagreed, relying on dictionary definitions that defined civil rights more narrowly to include, among other things, concepts such as equal protection, due process, and voting rights, i.e., not fairness or accuracy in credit reporting. 

The economic result to the Eilers is unfortunate.  Under their contingency fee arrangement, they pocked $4,700.  The Tax Court decision indicated that the Eilers will have to pay income taxes of $11,423.  In other words, the Eilers are in a worse economic position as a result of the litigation. 

Conclusion

Eiler underscores the continuing importance of carefully analyzing the tax treatment of litigation recoveries before settlement. The decision confirms that plaintiffs may be taxed on gross settlement proceeds, including amounts paid directly to attorneys, unless a specific deduction applies. It also shows that courts may read the Section 62(e) “civil rights” exception narrowly, leaving many attorneys’ fees recoveries outside the above-the-line deduction. Plaintiffs and counsel should therefore address tax consequences early, particularly where attorneys’ fees may substantially exceed the plaintiff’s net recovery.

If you have any questions about this blog post or another tax-related topic, please feel free to contact me at 214-749-2434 or mroberts@meadowscollier.com.