Yes – in certain cases you can deduct attorney fees from a settlement, but it depends on the type of settlement and specific tax laws. Getting it wrong can mean paying tax on money you never actually received.
According to a 2022 Harris Poll study, 69% of Americans were unsure whether attorney fees from a lawsuit settlement were tax-deductible. This confusion is understandable: the rules around deducting legal fees have changed dramatically in recent years. Plaintiffs who win settlements often assume they’ll be taxed only on their net gain (after paying their lawyer), but the IRS sometimes taxes the gross amount – leading to an unpleasant surprise.
In the wake of tax reforms, many people are paying taxes on their settlements as if they kept the lawyer’s share, creating what some call a “plaintiff tax trap.” The good news is that certain settlements do allow deductions for legal fees, especially under federal law, and businesses have even more flexibility. Below, we’ll break down the rules at the federal level and then provide a full 50-state breakdown to see how each state handles attorney fee deductions. Let’s dive into how to maximize your after-tax settlement and avoid common pitfalls.
- 💡 Most personal legal fees aren’t deductible: After 2018, federal law suspended deductions for personal attorney fees – unless your case falls under specific exceptions like employment discrimination or whistleblower claims.
- ⚖️ You can deduct fees in special cases: Legal fees from unlawful discrimination, certain whistleblower, or civil rights lawsuits are deductible above-the-line (no itemizing needed), ensuring you’re taxed only on your net settlement.
- 💼 Business-related legal fees are fully deductible: If your lawsuit is related to a business or trade (for example, a contract dispute or defending your business in court), attorney fees are usually ordinary business expenses that reduce taxable income.
- 🚩 Without a deduction, you’re taxed on the lawyer’s share: Many plaintiffs pay taxes on their gross settlement (100% of the award) even though 30–40% went to their attorney. This phantom income can slash your after-tax payout if you’re not careful.
- 🗺️ State laws vary widely: Some states follow federal rules, while others still allow deductions for legal fees on state returns. Our 50-state table below reveals how your state’s tax code treats attorney fee deductions, which can further impact your total tax bill.
Why Deducting Attorney Fees Is So Complicated (Federal Law)
Deducting attorney fees from a settlement sounds straightforward – after all, your lawyer’s cut isn’t money in your pocket, so why should it be taxed? The complication arises from how tax law defines gross income. Under federal law, everything you receive in a settlement is generally taxable income (unless specifically exempted).
In a landmark Supreme Court case, Commissioner v. Banks (2005), the Court ruled that if you win a taxable lawsuit settlement, the entire award is counted as your income, even if a chunk goes directly to your attorney. The logic was simple: you can’t assign income to someone else to avoid tax. Your attorney is considered your agent, not a partner – so it’s as if you received 100% and then paid your lawyer.
The result? Plaintiffs must include the full settlement amount in gross income and then hope for a deduction for the attorney fees. Prior to 2018, those legal fees could sometimes be written off as a miscellaneous itemized deduction (after meeting a 2% of AGI threshold).
But even then, many high-award plaintiffs got hit by the Alternative Minimum Tax (AMT), which disallowed these deductions entirely. In practice, folks who thought they could deduct their lawyer’s 40% fee often found the AMT taxed them as if no deduction existed – a nasty surprise turning a big win into a tax nightmare.
Tax reform changes: The federal Tax Cuts and Jobs Act (TCJA) of 2017 made this issue even more stark. From 2018 through at least 2025, miscellaneous itemized deductions (including most legal fees) are suspended for federal tax purposes. This means if you’re an individual with a personal legal settlement, you generally cannot deduct your attorney’s fees at all on your federal return (unless you qualify for a special exception, discussed below).
Essentially, the IRS will tax you on the gross settlement, even though you only kept the net after legal fees. Many have dubbed this the “double taxation trap,” because you’re paying tax on money that went straight to your lawyer.
Example: Imagine you settled a claim for $100,000 and, under a contingency fee agreement, $40,000 (40%) goes to your attorney. You only receive $60,000. Yet, under these tax rules, you could be on the hook to pay taxes as if you got the full $100,000. If you’re in the 24% federal tax bracket, that’s $24,000 of tax – which would eat up nearly half of your actual $60k take-home.
Your after-tax settlement might drop to around $36,000, meaning you effectively lost $24k to taxes on $60k of income (an effective tax rate of 40%!). This harsh outcome is why deducting legal fees is such a critical issue.
The key question becomes: when can you deduct those attorney fees to avoid this over-taxation? The answer lies in federal exceptions carved out by Congress, as well as whether the lawsuit is connected to a business (in which case the fees might be business expenses). Below, we’ll cover the federal rules for different types of settlements and highlight when a deduction is possible. After that, we’ll examine how each state’s tax laws come into play.
When Can You Deduct Legal Fees? (Federal Exceptions & Rules)
Not all hope is lost for plaintiffs – there are important exceptions that allow you to deduct attorney fees above the line (which means they reduce your gross income, not just as an itemized deduction). An above-the-line deduction is powerful: it directly reduces your Adjusted Gross Income (AGI), which lowers your taxable income and can also benefit other tax calculations (since many credits and deductions depend on AGI).
Crucially, above-the-line deductions do not require itemizing. Even if you take the standard deduction, you can still subtract these specific legal fees before reaching your AGI. In effect, this prevents you from being taxed on the lawyer’s share.
Under federal law, you can deduct attorney fees from a settlement in the following situations (the major exceptions to the no-deduction rule):
- Unlawful discrimination or civil rights claims: If your case was an unlawful discrimination claim, you qualify for an above-the-line deduction for attorneys’ fees and court costs. This category is quite broad: it covers most employment-related claims (think sexual harassment, wrongful termination, workplace discrimination based on race/gender/age, etc.) and other civil rights lawsuits.
- In fact, Congress defined “unlawful discrimination” expansively – even some state or local law claims and common law claims related to employment or civil rights can count. Example: You sue your employer under Title VII for discrimination, or under the Americans with Disabilities Act, and win a settlement.
- Your attorney fees for pursuing that claim are deductible above-the-line, so you’ll only be taxed on the net amount you keep. This tax break was introduced in 2004 precisely to stop double-taxation of discrimination plaintiffs after a high-profile case highlighted the issue.
- Whistleblower claims against the government: If you received an award for blowing the whistle on someone’s wrongdoing (for instance, an IRS whistleblower reward for reporting tax fraud, or a False Claims Act qui tam settlement for exposing fraud on the government), your legal fees are also deductible above-the-line. Congress specifically allows deductions for fees related to whistleblower awards paid under federal law.
- Example: You provided information to the IRS that led to recovering unpaid taxes, and the IRS gave you a reward of a percentage of the amount. The fees you paid your attorney to help with that claim can be written off on page 1 of your 1040, ensuring you’re taxed only on the reward minus those fees.
- Certain claims against the U.S. government or under specific statutes: In addition to generic whistleblower cases, the tax code singles out a few other scenarios. One notable example is legal fees for private causes of action under the Medicare Secondary Payer statute – essentially lawsuits to recover Medicare costs in certain personal injury cases.
- While this is a niche area (recovering medical expenses paid by Medicare), it’s explicitly included. More broadly, any claim based on federal, state, or local law “providing for the enforcement of civil rights” or regulating any aspect of employment can qualify for the above-the-line deduction (this catch-all covers many lawsuits). The idea is to cover lawsuits where Congress believes plaintiffs shouldn’t be penalized tax-wise for seeking justice.
- Cases involving physical injury that also have taxable elements: This is a bit of a gray area, because a personal physical injury settlement is generally tax-free. If you win a settlement for personal injuries (like from a car accident or medical malpractice causing bodily harm), the compensatory damages for your injuries are not taxable income at all. In those cases, you don’t need to deduct legal fees because the settlement itself isn’t taxed. However, sometimes a personal injury case includes taxable components – for example, punitive damages or interest. Punitive damages (meant to punish the wrongdoer) are always taxable, even if the underlying injury is physical.
- Likewise, if your settlement included interest (say the defendant delayed paying and had to add interest), that interest is taxable. If you have a case like this, the portion of attorney fees allocable to the taxable part of the award might be deductible as a miscellaneous itemized deduction for production of income (subject to limitations) – but since miscellaneous deductions are currently disallowed federally, in practice you can’t deduct it now. So, for physical injury cases with punitive damages, you may end up taxed on the punitive portion and stuck without a deduction for that portion of the lawyer’s fee.
- (One workaround could be to have your attorney fee agreement specify how fees apply to taxable vs. non-taxable proceeds, but even then, federal law offers no above-line exception for punitive damages awards.) In short, pure physical injury compensatory awards are tax-free (and thus no deduction needed), but any taxable chunk of a personal injury settlement is treated like a taxable non-business award – deductible only if you find a misc. deduction or exception, which as of now is very limited.
- Business-related legal fees: This one is technically not an “exception” – it’s the normal rule for businesses. If you incurred legal fees in the course of operating a trade or business, those fees are ordinary and necessary business expenses. You can deduct them fully on your business tax forms (Schedule C for sole proprietors, Form 1120 for C-corps, etc.), reducing the taxable business income. This applies whether you are suing someone or being sued.
- Example: Your small business paid $50,000 in attorney fees to sue a supplier for breach of contract, and you won a $200,000 settlement. The $200k is business income, but you also deduct the $50k legal expense – so effectively you’re only taxed on the $150k net profit from the lawsuit. Likewise, if you’re a business defendant and you pay legal fees to defend a case or pay a settlement, those legal costs are deductible.
- The major point: business vs. personal is a dividing line. Business legal fees (even related to settlements) are generally deductible against business income. Personal legal fees (e.g. a lawsuit over a personal matter) generally aren’t deductible, except for the special above-the-line categories listed earlier.
It’s important to note that the above exceptions (discrimination, whistleblower, etc.) allow a 100% above-the-line deduction for attorneys’ fees and court costs related to those specific claims. This means the deduction occurs on your Form 1040 Schedule 1 (Adjustments to Income), not on Schedule A.
The IRS even added dedicated lines for these in recent years to simplify filing. If you qualify, you would enter the attorney fees on the line for “Attorney fees and court costs for actions involving certain unlawful discrimination claims” or the line for “Attorney fees for whistleblower awards,” etc., with appropriate codes (e.g., “UDC” for unlawful discrimination claim).
What if your case involves multiple claims, some qualifying and some not? Many real-world lawsuits include a mix of claims. For example, you might sue your employer for both unlawful discrimination and a contract dispute over unpaid bonus. Or you have multiple counts, one of which qualifies. Generally, you should allocate the attorney fees to the various claims based on, say, the relative damages or effort.
The portion of the fee related to the qualifying claim can be deducted above-the-line, while the rest cannot (under current law). It can get thorny, and tax professionals often have to help with reasonable allocation. Failing to allocate means you might lose out on a deduction you’re entitled to, or conversely, try to deduct more than allowed.
Finally, be aware that these above-the-line deductions eliminate the federal tax on the lawyer’s share, but state taxes might have their own rules. Also, the current federal restriction on miscellaneous deductions is set to expire after 2025 – if that happens, starting in 2026 individuals might once again be able to deduct other legal fees as itemized deductions (subject to the old 2% rule). But unless Congress extends the ban, we could see the return of some deductions for things like investment-related legal fees or other personal legal expenses in 2026 and beyond.
Settlement Types and Tax Treatment of Attorney Fees
Different types of legal settlements have different tax consequences, both for the settlement itself and for whether you can deduct the related attorney costs. Let’s break down key categories of settlements and how the attorney fees are treated for tax purposes under federal law:
Personal Injury Settlements (Physical Injuries)
Tax status of settlement: If your settlement is for personal physical injuries or physical sickness (for example, compensation for pain and suffering after a car accident, medical malpractice, slip-and-fall injuries, etc.), the *compensatory damages are not taxable. The tax code specifically excludes damages received on account of personal physical injuries from gross income. This includes payments for your medical bills, lost wages (if part of a physical injury claim), and general pain and suffering due to actual physical harm. Essentially, the IRS lets you keep 100% of a physical injury settlement tax-free, as long as it’s not for punitive damages or interest.
Deducting attorney fees: Since the settlement itself isn’t taxed, you effectively don’t need a tax deduction for the attorney’s fees – you’re already not paying tax on the money used to pay your lawyer. However, you also cannot deduct the attorney fees from a tax-free settlement. The IRS isn’t going to give a tax break for an expense incurred to produce tax-exempt income. This is a general rule: deductions are typically only allowed for expenses related to taxable income. So, in a standard personal injury case where the entire $100,000 settlement is tax-exempt, the $33,000 you paid your lawyer is essentially a non-deductible personal expense. It came out of the award, which wasn’t taxed to begin with.
One thing to watch: as mentioned earlier, if part of your physical injury settlement is carved out as punitive damages (which are taxable) or you receive interest, you will owe tax on those portions. Unfortunately, current law does not provide an above-line deduction for the attorney fees attributable to punitive damages or interest in a personal injury case. Before 2018, you might have tried to deduct that portion as a miscellaneous deduction for the “production or collection of income,” but now that’s off the table until 2026. Essentially, with a physical injury case:
- Compensatory damages for physical injury: not taxable, no deduction for fees (and none needed).
- Punitive damages or interest: taxable as ordinary income, no special deduction for the related legal fees (you’re stuck with tax on gross for that portion, unless perhaps your state taxes allow something).
Bottom line: The majority of personal injury plaintiffs won’t be taxed on their settlements, and thus cannot deduct their legal fees. If you’re only receiving non-taxable damages, you keep your whole settlement (minus the fee) tax-free. Just don’t try to deduct the lawyer’s share – it’s not allowed when the underlying money isn’t taxed.
Emotional Distress & Other Non-Physical Personal Claims
Lawsuits for personal non-physical injuries – think of claims like defamation, intentional infliction of emotional distress (where there’s no physical injury), invasion of privacy, or even certain employment-related torts – have a different tax treatment. The IRS taxes damages for emotional distress or other non-physical harms unless they originated from a physical injury.
For example, if you sued for emotional distress from a traumatic incident that did not involve a physical injury, those damages are taxable. Damages for defamation or damage to reputation (not involving physical harm) are also taxable. In employment cases, damages for things like emotional anguish or harm to reputation are taxable as well.
Tax status of settlement: These types of settlements are generally taxable income to the recipient. Often, they might be reported on a Form 1099-MISC or 1099-NEC if not wage-related, or on a W-2 if paid as back wages (for instance, a wrongful termination that isn’t a discrimination claim might be paid as wages). Regardless of how it’s reported, the key is: if it’s not a physical injury, it’s usually taxable.
Deducting attorney fees: Now here’s where it hurts: under current federal law, most people cannot deduct the attorney fees in these taxable personal cases. Why? Because these cases often do not fall under the “unlawful discrimination” umbrella or other above-line exceptions.
They are personal in nature, and so the legal fees are considered personal expenses. For instance, a defamation lawsuit against someone who smeared your reputation – the $200,000 settlement is taxable to you, and the $80,000 fee you paid your lawyer is not deductible. You’ll pay tax on the full $200k.
Before 2018, you could deduct those fees as a miscellaneous deduction (subject to the 2% rule), but as we’ve noted, that option is gone (temporarily suspended) until 2026. Even when it was available, many folks with big awards fell into AMT which disallowed it. Now, it’s simply not deductible at all for federal purposes.
This can lead to extremely harsh outcomes. The effective tax rate on your net recovery skyrockets. In some cases, plaintiffs have ended up owing more in taxes than they actually received net (imagine legal fees + taxes exceeding the settlement amount).
For example, some sexual harassment cases that didn’t qualify as unlawful discrimination (perhaps a gap in the law or if the claim was a common law tort) left plaintiffs owing taxes on amounts they never saw. This “phantom income” issue is why Congress carved out the discrimination and whistleblower exceptions. But if your case doesn’t fit one of those carve-outs, you unfortunately fall into the crack.
Is there any workaround? A few creative tax arguments have been attempted. Some taxpayers have tried to argue that, under certain state laws, the attorney had a property right in the fee (through a lien) so that portion never belonged to the plaintiff. Others have tried to structure the settlement so that the defendant pays the attorney’s fees directly in a separate check or as court-awarded fees.
However, the IRS regulations generally require the defendant to issue a Form 1099 to the plaintiff for the full amount, including any portion paid to the lawyer. And the Supreme Court’s Banks decision essentially shut down the “attorney owns the fee” argument in most cases. Unless you fall into an exception, the IRS stance is firm: you got the income and paid your lawyer, so no exclusion.
So for non-physical personal claims (like defamation, emotional distress, etc.), assume no deduction for your attorney fees on your federal return. This makes it vital to plan for the tax hit. Some plaintiffs in these cases negotiate a higher settlement to account for the taxes, or structure settlements over multiple years (to avoid jumping brackets), but that’s more about tax planning than changing deductibility.
Employment Settlements & Workplace Claims
Employment-related settlements are extremely common and have their own tax wrinkles. They can include things like wrongful termination, workplace harassment or discrimination, unpaid wages or overtime claims, breach of employment contract, and so on. From a tax perspective, many employment settlements are considered either wage income (if they’re back pay, front pay, etc.) or other income (if they compensate for emotional distress, etc.). Wages will have withholding and payroll taxes; non-wage damages will be on a 1099. Either way, most employment settlements (except physical injury on the job, which would be rare outside of workers’ comp) are taxable.
Tax status of settlement: If your settlement is for things like lost wages, it will typically be taxed like wages (subject to income and FICA taxes, reported on a W-2). If it’s for other damages (like a purely emotional distress claim or a retaliation claim), it may come on a 1099 and be taxed as miscellaneous income. Some employment settlements allocate portions to different categories (e.g., $50k wages, $50k emotional distress, $50k punitive). Generally, assume the money is taxable unless specifically stated otherwise by statute.
The big benefit: Many employment claims do qualify as “unlawful discrimination” cases, because they often involve violation of laws like Title VII, ADA, ADEA (age discrimination), etc., or even retaliation for exercising rights. Thanks to the aforementioned above-the-line deduction provision, if your case was brought under one of the laws prohibiting discrimination or retaliation, your attorney fees are deductible above-the-line. This is a lifesaver for employment plaintiffs.
For example, you settle a gender discrimination lawsuit against your employer for $300,000. Your lawyer takes $100,000. Without the special rule, you’d owe tax on $300k despite netting $200k. But since this is an unlawful discrimination claim, you can deduct the $100k legal fee on Schedule 1 of your 1040. If you’re in, say, the 24% bracket, that deduction saves you $24,000 in federal tax – meaning you are only taxed on the $200k you actually kept. Essentially, the tax code is ensuring you aren’t penalized for standing up against discrimination.
It’s important to note the range of employment claims that count: not just classic discrimination. The law references a list of statutes and a broad catch-all for any federal, state, or local law “providing for the enforcement of civil rights or regulating any aspect of the employment relationship.” This likely includes wrongful termination in violation of public policy, whistleblower retaliation claims, Fair Labor Standards Act (wage/hour) claims, and others.
Even if your employment case was a breach of contract (which on its own might not qualify), if you had any concurrent claim that touches on employment laws or rights, it might bring it under the umbrella. For instance, sometimes plaintiffs will include a claim under a state labor law or discrimination law to ensure the fee deduction – this is a strategic consideration for attorneys when formulating lawsuits.
Exception – purely contractual disputes: If your employment lawsuit was purely a contract matter (say you sued for an unpaid bonus or severance that was owed, with no allegation of violating a law), that might not fall under unlawful discrimination or similar. In that scenario, oddly, you’d be taxed on your award and unable to deduct your attorney fees under current law.
So two employees each getting $100k but under different legal theories can face different tax outcomes: one alleging, say, age discrimination (deduction allowed), another just enforcing a contract (no deduction). It feels unfair, but that’s how the line is drawn right now.
Settlements involving multiple claims: Many employment settlements have a mix – e.g., they might settle both a discrimination claim and a wage claim in one agreement. Usually, that whole case would still qualify for the above-line deduction because the claims arose out of an unlawful employment practice. The IRS doesn’t make you split hairs if it’s one integrated case under, say, both Title VII and a state law. But if you’re unsure, consult a tax expert to see if all or part of your fees qualify.
In summary, employment and civil rights plaintiffs have a significant tax advantage: their attorney fees are generally deductible above-the-line, thanks to Congress wanting to encourage enforcement of those laws. If you have an employment settlement, make sure you or your accountant takes that deduction! (And use the correct forms – the IRS now provides a specific line for it, as mentioned earlier, labeled something like “attorney fees for unlawful discrimination claims.”)
Whistleblower Awards and Qui Tam Settlements
Whistleblower cases deserve a special mention. These are cases where individuals report fraud or wrongdoing, often involving government funds or taxes, and receive a reward or settlement for their role. Common examples:
- An IRS whistleblower who reports a company’s tax evasion and gets a percentage of the recovered tax.
- A whistleblower under the False Claims Act (a qui tam relator) who sues a company on behalf of the government for, say, Medicare fraud or defense contract fraud, and gets a share of the settlement (these are also called qui tam settlements).
- Other whistleblower programs (SEC, CFTC, etc.) that reward tipsters for information leading to penalties.
Tax status of award: Whistleblower rewards are typically taxable income. The IRS whistleblower awards, for instance, are explicitly taxable (they even do withholding on large awards). Qui tam relator awards under the False Claims Act are taxable as ordinary income as well.
Deducting attorney fees: Fortunately, Congress recognized that whistleblowers often have to give a sizable cut (often 30-40%) to their attorneys, and that taxing them on the whole award would discourage people from coming forward.
So, legal fees related to whistleblower awards are also given the above-the-line deduction treatment. Specifically, fees for cases brought under certain federal whistleblower statutes (like the IRS program or FCA cases) can be deducted. In tax terms, they fall under the same Internal Revenue Code provision as the discrimination cases (just a different paragraph).
This means if you got, say, a $1 million whistleblower reward and paid $400k to your lawyer on contingency, you can deduct that $400k directly from your gross income. You’d only be taxed on the $600k remainder. Without this provision, the tax on $1M could have been crushing and made the whole effort less worthwhile.
One nuance: The IRS form for above-the-line deductions explicitly lists a line for fees on an “award from the IRS for information you provided” – that’s the IRS whistleblower program. For other whistleblower cases like False Claims Act (which might be considered a case against the federal government, since you’re suing on behalf of the government), the deduction still applies, but you might have to use the generic “Other adjustments” line if no specific line is provided. Either way, you do get the deduction as long as it’s one of the covered actions.
Bottom line: Whistleblowers should not be taxed on their attorney’s portion. If you’ve courageously come forward to stop fraud, the tax code has your back regarding legal fees. Always claim your above-the-line deduction for those fees – it can save you potentially hundreds of thousands in taxes on a big case.
Business and Commercial Settlements
When it comes to businesses, the landscape changes because of the fundamental difference in how business expenses are treated. Businesses can deduct all ordinary and necessary expenses incurred in the course of operating – and legal fees are no exception. Whether you’re a sole proprietor, a partnership, an S-corp, or a large C-corp, if the lawsuit is related to your profit-making activities, the attorney fees will typically be a deductible expense.
Examples of business-related legal fees:
- A company sues a vendor or competitor and wins a settlement/judgment.
- A company is sued for something and has to pay defense legal fees and perhaps a settlement.
- A landlord incurs legal fees to collect overdue rent or evict a tenant, resulting in a settlement.
- A self-employed individual pays legal fees to collect a contract payment from a client.
In all these cases, the legal fees have a business purpose – they are spent in the process of earning or protecting business income. Such expenses go on the business’s tax return (Schedule C, E, F, or corporate return) just like any other expense (rent, supplies, etc.).
Tax status of settlement: If a business receives a settlement, that settlement is usually taxable business income (unless it’s for property damage and can be treated as return of capital, etc.). If a business pays a settlement, that payout might be deductible too (e.g., settling a lawsuit for a business-related matter is often deductible for the payor as a business expense, unless it’s a fine/penalty or something against public policy).
There are some exceptions, like certain government fines or the notorious rule that a company can’t deduct a sexual harassment settlement if it’s subject to an NDA (a special provision in tax law), but generally settlements of business disputes are deductible for the payer.
Deducting attorney fees: For the business receiving income, the attorney fee it paid can offset the income. For example, your LLC wins a $500,000 lawsuit settlement from a breached contract. You pay your attorneys $200,000. You would report $500k as gross income, but also report $200k as a deductible expense – so only $300k net is taxable profit. Essentially, the tax system ends up taxing you on what you actually gained economically (which makes sense).
If you’re a sole proprietor, this happens on Schedule C: you’d include the full settlement in gross receipts and list the legal fees under legal/professional services expense. For partnerships or corporations, similar inclusion and deduction on their income statement.
What if you’re an individual but the lawsuit was related to income-producing property or investments? There used to be a category for expenses to produce income (Section 212 expenses) – for instance, legal fees to collect taxable investment income.
Those were miscellaneous itemized deductions (subject to 2% floor) before 2018. Currently, they’re suspended, so a personal investor can’t deduct legal fees either (until maybe 2026). But if you are truly treating it as part of a business or trade (for example, you’re a full-time landlord and you have a legal dispute regarding your rental property), then those fees can go on your Schedule E as an expense against rental income.
Key takeaway: If you have a business dispute or commercial litigation, you generally don’t fall into the plaintiff tax trap that individuals do. Businesses get to deduct their legal costs, so the tax is only on the net recovery. Likewise, if a business pays out money and legal fees in a settlement, those reduce taxable income.
Always ensure that you classify and document legal fees properly as business expenses in your records. The IRS can disallow a deduction if they think an expense was personal rather than business, so maintaining that it was indeed in the context of business is important.
One more angle: What about entrepreneurs or independent contractors suing for payment? This can straddle personal and business. Suppose you did freelance work and weren’t paid, so you sued the client and got a settlement. If you had reported that expected income as business income, the legal fees to collect it should be deductible on Schedule C. If you hadn’t reported it yet (because you never got it initially), you just include the settlement now as income and the fee as an expense.
Either way, it’s part of your self-employed earnings. Compare that to an employee suing for unpaid wages – that employee would report a W-2 wage and possibly get above-line deduction if it’s under employment law (as discussed in employment cases). Different mechanisms, similar effect.
Class Action Settlements
Class action lawsuits can involve thousands of plaintiffs and often result in a common fund from which attorneys’ fees are paid. If you are a member of a class action (not the lead plaintiff or attorney), you might receive a notice saying, for example, “You are entitled to $2,000 as your share of the settlement, and attorneys’ fees of 30% have been approved by the court.” Typically, the settlement fund pays the lawyers separately, and class members get their net amount.
Tax status of settlement: This depends on the nature of the class action. Common class actions include consumer protection cases (like product defects, data breaches, etc.), securities fraud cases, antitrust cases, etc. If the settlement is essentially a refund or compensation for economic loss, it’s usually taxable (unless it relates to something like a personal physical injury for each member, which is less common in a class context).
Securities class action settlements are generally taxable as capital gains or lost profit recovery. Consumer lawsuit settlements (like a product that didn’t work) might be a reduction in purchase price (which could be non-taxable if it’s like a reimbursement). It varies.
For most people receiving a class action payout, the amount is relatively small, and often it just arrives as a check or maybe accompanied by a 1099 if over $600. Many might not even get a tax form if the payout is below the threshold.
Deducting attorney fees: As a class member, you generally cannot deduct anything related to that settlement. The attorney fees in a class action are typically handled within the fund. For instance, if there’s a $10 million settlement, the court might award $3 million to the attorneys and $7 million gets distributed to class members. The class members are effectively receiving their portion net of fees.
For tax purposes, the IRS could say each member received their share of the $7M, and the $3M was not their income at all (it went to attorneys by court order). This is one scenario where individual members aren’t taxed on the gross fund, only on what they actually pocket – which is good. In practice, a class member will just report the amount they received (if it’s taxable) and that’s that. They don’t list an attorney fee expense, because they technically didn’t pay the attorneys out-of-pocket; the class counsel was paid by the fund (or by the defendant as part of the settlement).
For lead plaintiffs or class representatives, sometimes they get an extra award for their service, which is taxable. But again, they typically wouldn’t deduct the attorney fee either.
Important: If you ever find yourself in a situation where you individually had to pay legal fees to claim your class action money (rare, usually class counsel does the work), you might wonder about deducting that. Usually it doesn’t happen – you just sign a claim form and receive your share.
So, in summary, class action members generally don’t deduct legal fees – the fees are handled before distribution. You just pay tax on whatever portion of the settlement you actually receive that is taxable. The concept of the plaintiff double-tax trap is more relevant to individual lawsuits or being a lead plaintiff outside of the class mechanism.
One thing to mention: class action settlements often involve cy pres (money going to charities) or other distributions. None of that is deductible by class members either. Only perhaps if you got a separate 1099 for interest on the settlement (if the fund earned interest before payout, sometimes they allocate interest to you – that is taxable interest income, and there’s no deduction for any related fees, but the interest amount per person is usually minuscule).
To tie all these scenarios together, here’s a quick reference table of real-life scenarios and whether the attorney fees are deductible:
| Scenario | Tax Deduction Outcome |
|---|---|
| Personal injury settlement (physical injuries only) – e.g. $100k for pain and suffering, 1/3 to attorney | No deduction needed or allowed. The $100k is tax-free, and you can’t deduct the $33k fee from a tax-exempt award. You keep the remainder tax-free. |
| Workplace discrimination lawsuit – e.g. $300k settlement for harassment, $100k to attorney | Yes, deductible. The $300k is taxable, but because this is an unlawful discrimination claim, you can take a $100k above-the-line deduction for the legal fees. You’re taxed only on the $200k net. |
| Workplace contract dispute – e.g. $300k settlement for breach of contract (no discrimination), $100k to attorney | No deduction under current law. The $300k is taxable (likely as wages or other income) and, since it’s not a discrimination or whistleblower case, you cannot deduct the $100k fee. Tax will be calculated on the full $300k. |
| Business lawsuit (Company is plaintiff) – e.g. $500k settlement in a contract case, $200k legal fees paid | Yes, deductible (business expense). The company includes $500k in income but deducts $200k in legal costs as a business expense. It pays tax only on the $300k profit from the case. |
| Class action member payout – e.g. $2,000 received from a consumer class settlement (after attorneys’ fees taken out of fund) | No personal deduction (not needed). You’re taxed (if at all) only on the $2,000 you got. The legal fees were handled within the settlement fund, so you don’t report or deduct them on your return. |
As you can see, the deductibility hinges on the nature of the claim. Individual, non-business plaintiffs must fit into a special category to deduct their fees; otherwise, they face taxation on the gross award. Business plaintiffs or defendants nearly always deduct their legal fees through business expenses. And class action members effectively get the benefit of not being taxed on attorneys’ fees by the way settlements are structured.
Now that we’ve covered federal law and various scenarios, let’s look at how the situation might change when state taxes enter the picture. State income tax rules don’t always mirror the federal rules, so it’s possible you might catch a break (or face a restriction) at the state level that’s different from federal.
50-State Breakdown: How States Treat Attorney Fee Deductions
Tax treatment of attorney fees from a settlement can also depend on where you live or pay state taxes. States have their own income tax laws, which may or may not conform to federal rules. Some states piggyback entirely on the federal definition of taxable income, meaning if something isn’t deductible federally, it’s not deductible on the state return either. Other states “decouple” from certain federal changes – for example, a few states still allow miscellaneous itemized deductions (including legal fees) even though the federal tax code no longer does (at least until 2026). There are also states with no income tax at all, where this question is moot for state taxes.
Below is a state-by-state breakdown of how each state treats the deduction of attorney fees from a legal settlement. This assumes the context of a personal legal settlement (not a business expense, since business expenses are generally deductible in all states that tax business income similarly to federal). We focus on whether a state allows any deduction or adjustment for attorney fees if the federal law does not. Keep in mind that if your attorney fees were deductible on your federal return above-the-line (for a discrimination case, etc.), that will automatically flow through to many state tax calculations via a lower federal AGI. The notes below highlight differences and key points for each state:
| State | State Tax Treatment of Legal Fee Deductions |
|---|---|
| Alabama | Allows deduction: Alabama permits itemized deductions similar to pre-2018 federal rules. Unreimbursed legal expenses (e.g. attorney fees to produce taxable income) can be deducted on the Alabama return if you itemize. |
| Alaska | N/A – No state income tax. Alaska does not tax personal income, so there’s no state tax concern or deduction needed for legal fees. |
| Arizona | Conforms to federal (no deduction). Arizona uses federal AGI as a starting point and hasn’t decoupled miscellaneous deductions. Personal attorney fees not deductible on the state return unless deductible federally. |
| Arkansas | Allows deduction: Arkansas decoupled from the federal suspension of misc. deductions. You can itemize and deduct qualifying legal fees on your Arkansas state return (subject to the 2% rule, etc., as under old federal law). |
| California | Partially allows: California did not adopt the federal elimination of miscellaneous deductions, so itemized deductions for legal fees are still allowed at the state level. Additionally, CA follows the federal above-the-line deduction for unlawful discrimination claims (so those fees are deductible in CA too). However, California did not adopt the federal above-line for certain whistleblower fees – meaning whistleblower attorney fees can still be deducted, but only as itemized deductions in CA. Net effect: many legal fees that aren’t deductible on federal can be deducted on a California Schedule CA (itemized deductions), reducing state taxable income. |
| Colorado | Conforms to federal (no deduction). Colorado starts with federal taxable income; it follows federal rules on itemized deductions. Personal legal fees are not deductible on the CO return unless they were part of federal deductions. |
| Connecticut | Conforms to federal (no deduction). CT uses federal AGI with some adjustments. There’s no specific state provision to deduct personal legal fees if not deducted federally. |
| Delaware | Conforms to federal (no deduction). Delaware itemized deductions align with federal rules. No state-only deduction for attorney fees from a personal settlement. |
| Florida | N/A – No state income tax. Florida has no personal income tax, so no state taxation or deductions for legal settlements. |
| Georgia | Conforms to federal (no deduction). Georgia generally follows federal itemized deduction rules. No deduction for personal legal fees at the state level unless federal allowed it. |
| Hawaii | Allows deduction: Hawaii did not conform to the TCJA changes eliminating misc. deductions. You can still claim miscellaneous itemized deductions (including legal fees to produce income) on a Hawaii return if you itemize. So, personal attorney fees might be deductible for Hawaii taxpayers, subject to the old 2% AGI threshold. |
| Idaho | Conforms to federal (no deduction). Idaho uses federal taxable income as a base; it conforms to the federal suspension of misc. deductions. No state-specific deduction for those attorney fees. |
| Illinois | No deduction (no itemized system). Illinois doesn’t allow a broad range of itemized deductions at the state level (it mostly uses federal AGI and gives a standard exemption). There is no provision to deduct personal legal fees on IL returns. |
| Indiana | Conforms to federal (no deduction). Indiana starts with federal AGI and has no add-back for misc. deductions. No state-level deduction for attorney fees. |
| Iowa | Conforms to federal (no deduction). Iowa largely mirrors federal itemized deductions (with some adjustments for things like federal taxes paid). Attorney fees not deductible in Iowa unless allowed federally. |
| Kansas | Conforms to federal (no deduction). Kansas uses federal itemized deductions (with certain state-specific tweaks like for taxes paid). No allowance for personal legal fees if not in federal deductions. |
| Kentucky | Conforms to federal (no deduction). Kentucky adopted many TCJA changes; it doesn’t allow misc. itemized deductions on the state return. So no deduction for attorney fees from personal cases. |
| Louisiana | Conforms to federal (no deduction). Louisiana’s itemized deductions piggyback off federal. Personal attorney fees not deductible unless part of fed return. |
| Maine | Conforms to federal (no deduction). Maine generally follows federal definitions for itemized deductions (with a cap). No separate deduction for legal fees on state taxes. |
| Maryland | Allows deduction: Maryland decoupled from the federal TCJA on misc. deductions. Taxpayers can still claim unreimbursed employee expenses and similar deductions on Maryland returns. Thus, qualifying legal fees (e.g., related to taxable awards) can potentially be deducted if you itemize in MD. |
| Massachusetts | No deduction (limited itemized). Massachusetts does not follow the federal itemized deduction system broadly; it has its own limited deductions (e.g., for rent, certain taxes, etc.). There’s no deduction for personal legal fees in MA. (MA taxes most settlements as income if applicable, but won’t let you deduct the lawyer’s cut.) |
| Michigan | No deduction (no state itemized). Michigan uses federal AGI and provides a flat deduction or credit system; it doesn’t allow detailed itemized deductions. Legal fees from personal cases can’t be deducted on MI return. |
| Minnesota | Allows deduction: Minnesota is known to have decoupled from some TCJA provisions and allowed certain itemized deductions. Minnesota taxpayers can still deduct miscellaneous itemized expenses (like unreimbursed legal fees) on their state return if they itemize. Thus, a legal fee that wasn’t deductible federally could be deducted in MN, following pre-2018 rules. |
| Mississippi | Conforms to federal (no deduction). Mississippi’s tax code is tied to federal taxable income to an extent. There’s no separate deduction for attorney fees from personal lawsuits. |
| Missouri | Conforms to federal (no deduction). Missouri allows the same itemized deductions as federal (with a few differences like state tax add-back). No special deduction for legal fees not claimed federally. |
| Montana | Conforms to federal (no deduction). Montana generally follows federal itemized deduction rules; no state-only break for personal legal fees. |
| Nebraska | Conforms to federal (no deduction). Nebraska uses federal itemized figures; no deduction for attorney fees if not in the federal itemized total. |
| Nevada | N/A – No state income tax. Nevada has no income tax, so no state-level tax or deduction issues. |
| New Hampshire | No broad income tax (N/A). New Hampshire taxes only interest and dividends (not wage or settlement income). Lawsuit settlements aren’t subject to NH tax, and there’s no deduction issue to consider. |
| New Jersey | No deduction (no fed conformity and limited deductions). New Jersey doesn’t use federal itemized deductions at all; it has its own set of allowed deductions (like medical, property tax up to a limit, etc.). NJ does not provide a deduction for legal fees from personal lawsuits. In NJ, most personal income (including settlements, if taxable) would be reported without any adjustment for attorney costs. |
| New Mexico | Conforms to federal (no deduction). New Mexico follows federal itemized deduction rules for the most part. No state-specific deduction for those legal fees. |
| New York | Allows deduction: New York decoupled from many federal itemized deduction limitations after TCJA. NY residents can choose to itemize on their state return even if they took the standard deduction federally, and importantly, NY still allows miscellaneous itemized deductions that the IRS disallowed. This means if you had to pay attorney fees for a taxable settlement, you can deduct them on your New York income tax return (subject to the old 2% of AGI floor). New York essentially “adds back” deductions like these that were lost at the federal level. This can significantly reduce your NY taxable income from a settlement. |
| North Carolina | Conforms to federal (no deduction). North Carolina initially conformed to federal itemized changes; it does not permit misc. deductions on the state return. So no deduction for legal fees unless federal had it. |
| North Dakota | Conforms to federal (no deduction). North Dakota uses federal itemized calculation; no state-only deduction for attorney fees. |
| Ohio | No deduction (no itemized concept). Ohio doesn’t allow itemizing state deductions; it has a modified income calculation with credits. There’s no provision to deduct personal legal fees on an Ohio return. |
| Oklahoma | Conforms to federal (no deduction). Oklahoma follows federal itemized rules closely. Attorney fees from personal cases aren’t deductible at state level unless they were on federal Schedule A (which they can’t be currently). |
| Oregon | Conforms to federal (no deduction). Oregon uses federal taxable income as a starting point, with some state adjustments. It conforms to the elimination of misc. deductions, so no deduction for legal fees unless they qualified federally. |
| Pennsylvania | Allows limited deduction: Pennsylvania’s tax system is very different – it doesn’t have standard itemized deductions, but it does allow certain unreimbursed employee business expenses as deductions against wage income (subject to strict criteria and percentage limits). If your legal fees were related to employment (for example, suing for back wages or wrongful termination), PA may allow a deduction for those fees as part of that category. However, purely personal legal fees (like for a personal injury or defamation case) generally aren’t deductible because PA only taxes certain classes of income. The key is whether the legal fee is an expense of producing taxable income in a category PA recognizes. In short, there’s some relief in PA for work-related legal fees, but no broad deduction for all settlements. |
| Rhode Island | Conforms to federal (no deduction). Rhode Island’s itemized deductions follow federal (with a phase-down for high incomes). No special deduction for legal expenses if not in federal rules. |
| South Carolina | Conforms to federal (no deduction). SC uses federal taxable income as base and respects the elimination of misc. deductions. No state-level deduction for attorney fees from personal cases. |
| South Dakota | N/A – No state income tax. South Dakota has no personal income tax, so no state tax on settlements or related deductions. |
| Tennessee | N/A – No state income tax. Tennessee phased out its tax on interest/dividends and does not tax general income. No state tax issues for lawsuit awards or fees. |
| Texas | N/A – No state income tax. Texas has no personal income tax, so nothing to deduct at the state level. |
| Utah | Conforms to federal (no deduction). Utah offers a credit in lieu of itemized deductions, largely following federal definitions for what counts. Legal fees from personal settlements wouldn’t factor in since they aren’t on the federal side. |
| Vermont | Conforms to federal (no deduction). Vermont uses federal itemized amounts with some limits for high earners. No deduction for attorney fees unless in federal itemized. |
| Virginia | Conforms to federal (no deduction). Virginia generally follows federal itemized rules. (Virginia does allow a very limited deduction for certain specific things, but personal legal fees aren’t included.) So no deduction at state level if none federally. |
| Washington | N/A – No state income tax. Washington state has no personal income tax, so no concerns about deductions on a state return. |
| West Virginia | Conforms to federal (no deduction). West Virginia uses federal taxable income and itemized figures. No separate deduction for attorney fees from personal cases. |
| Wisconsin | Conforms to federal (no deduction). Wisconsin mostly conforms to federal itemized deduction policies; it does not allow miscellaneous deductions that the federal doesn’t. (Wisconsin has an itemized deduction credit for certain items, but legal fees aren’t included.) |
| Wyoming | N/A – No state income tax. Wyoming has no personal income tax, so state deductions are not applicable. |
Note: The term “conforms to federal” above means the state hasn’t created a special rule to allow miscellaneous itemized deductions that the federal government disallowed. If your attorney fees were deducted above-the-line on your federal return (due to discrimination or whistleblower cases), that lower federal AGI usually flows into your state AGI and benefits you there as well automatically. The state breakdown is most relevant for cases where, federally, you couldn’t deduct the fees – a handful of states (like those noted: Alabama, Arkansas, Hawaii, Maryland, Minnesota, New York, etc.) still give you a chance to deduct some or all of those fees on the state return, potentially lowering your state tax burden on the settlement.
Always double-check your own state’s current tax instructions or consult a tax professional, because state laws can change. For example, some states could update their laws after 2025 if the federal rules shift again. The above table provides a general guide as of now.
Pros and Cons of Deducting Attorney Fees
If you have the opportunity to deduct attorney fees (or are evaluating the impact of not being able to), it’s helpful to weigh the pros and cons. Deductions for legal fees can be beneficial, but the rules are complex and sometimes limiting. Here’s a quick comparison:
| Pros of Being Able to Deduct Legal Fees | Cons/Challenges (When Deductions Aren’t Allowed or Are Limited) |
|---|---|
| Lowers your taxable income: You only pay tax on the portion of the settlement you actually keep, which can save you a substantial amount of money. | Tax on money you never saw: Without a deduction, you might be taxed on the gross settlement, effectively paying tax on your lawyer’s share – this can dramatically reduce your net gain. |
| Prevents “double taxation” effect: Avoids the unfair scenario of being taxed twice on the same dollars (once to you and effectively once to your attorney). | Complex rules & limitations: Determining eligibility for above-the-line deductions can be confusing. Only specific cases qualify, and others are left out, leading to complexity and potential errors if misapplied. |
| Encourages rightful claims: Knowing legal fees are deductible in certain cases (like civil rights claims) encourages individuals to pursue justice without fear of an outsized tax bill. | Alternate Minimum Tax issues: Even when deductions were allowed as itemized deductions, the AMT often disallowed them. Taxpayers with large legal fees could get pushed into AMT and lose the benefit, a problem if the deduction isn’t above-the-line. |
| Business as usual for companies: Businesses can freely deduct legal expenses, which is a pro for entrepreneurs and companies – it treats litigation costs as a normal cost of doing business. | Perceived inequity: Some plaintiffs (like discrimination victims) get a deduction, while others (like defamation victims) don’t. If you fall in the latter category, it feels inequitable – but there’s no recourse unless laws change. |
| Higher after-tax settlement: Overall, the ability to deduct means you keep more of your settlement after taxes. It can be the difference between a settlement being financially worthwhile or not. | No relief at state level (in many cases): Even if federal law allows or will allow a deduction, some states won’t, which means you could still pay state tax on the full amount. Similarly, if federal doesn’t allow it, only a few states give relief – so you might face high state taxes on the gross award. |
As you can see, the advantages of being able to deduct attorney fees are significant – it’s fundamentally about fairness and economic sense. The downsides listed are essentially what happens when you cannot deduct them. Unfortunately, many individuals currently fall into that con column due to the tax law changes.
Next, let’s cover some common mistakes people make in this realm, so you can avoid them, and then clarify a few key terms that we’ve been using.
Common Mistakes to Avoid with Settlement and Legal Fee Deductions
Even savvy taxpayers can trip up on the nuanced rules for deducting attorney fees. Here are some frequent mistakes and misunderstandings – take note so you don’t make the same errors:
1. Assuming “all legal fees are deductible.” It’s a common misconception that you can write off any lawyer expense because it’s related to income. In reality, most personal-case legal fees (post-2018) are not deductible on your federal return. Don’t assume – always verify if your case type qualifies for a deduction. Many taxpayers have tried to deduct things like divorce legal fees or personal lawsuit costs, only to have the IRS disallow it. Remember: unless it’s specifically allowed (or it’s a business expense), it’s likely not deductible.
2. Failing to claim the above-the-line deduction when eligible. On the flip side, those who do qualify sometimes miss out simply by filing incorrectly. For example, a person who won a workplace discrimination settlement might not realize they can deduct the attorney fees above-the-line. Perhaps their tax preparer isn’t familiar with the relatively new forms and codes. This mistake could cost tens of thousands in overpaid tax. Always inform your CPA or tax software if your case was an unlawful discrimination or whistleblower case so the deduction is taken. The IRS forms now have specific lines for these – use them.
3. Misreporting the settlement and fees. Another mistake is not reporting the income properly. Say you got a $100k settlement with $40k to the attorney. Some people think, “I’ll just report $60k as income since that’s what I got.” That’s incorrect in the eyes of the IRS (unless it’s a tax-free settlement to begin with). You generally must report the full $100k as income and then separately deduct the $40k if allowed. Reporting only the net amount without a proper deduction can look like underreporting income. Always report lawsuit proceeds as instructed on 1099s/W-2s and then take the deduction on the proper line – don’t net them out on the income line.
4. Ignoring state tax implications. People tend to focus on the federal outcome and forget the state. You might assume if something isn’t deductible federally, there’s nothing to do – but as we saw, a state like New York or California might still give you a deduction. Conversely, if you deducted fees above-the-line federally, check if your state requires an add-back (some states might not conform to that above-line deduction). Each state is different. A mistake here could mean overpaying state tax or getting a state tax notice. For instance, early on some state tax departments got confused by the write-in attorney fee deductions and sent automated bills – taxpayers had to respond explaining the deduction. Be proactive: on your state return, use any legal fee deduction opportunities available, and be prepared to substantiate it if the state questions it.
5. Not allocating fees in mixed cases. If your settlement involved multiple claims, some deductible and some not, you should allocate your attorney fees between those claims. A mistake is to either not deduct anything (and lose a benefit) or deduct it all (and over-claim a deduction). For example, you had a lawsuit with a $50k discrimination claim and $50k defamation claim, and you paid $30k in legal fees. Perhaps only half the fee is attributable to the discrimination part. You should only deduct that half ($15k) above-the-line. Failing to allocate means you might shortchange yourself or get in trouble for taking too much. Work with your attorney and tax advisor to reasonably allocate fees in the settlement agreement or in your records.
6. Assuming future law changes will automatically help you. Some people know that miscellaneous deductions are set to return in 2026 and assume they can amend returns or somehow get relief later. This is risky. First, Congress might extend the disallowance or change the rules before then. Second, even if the deduction category returns, it will be for future cases – it won’t retroactively fix 2018–2025 tax years where no deduction was allowed. Plan with the law that exists, not what might be. If you have a settlement in 2025, for example, you can’t assume “oh next year I can deduct it”; as the law stands, 2025 is still a no-deduction year for misc. items.
7. Not seeking professional advice for large settlements. This is more of a general tip: big legal awards can trigger big tax issues. It’s easy to make mistakes if you DIY. Getting a tax professional’s guidance can save you from costly errors like misclassification of income, missed deductions, or even penalties. Sometimes legal settlement taxation gets complicated (especially if it involves interest, multiple payees, etc.). A pro can ensure you navigate federal and state rules properly. It’s better to spend a little on advice than to mess up a six-figure tax situation.
Avoiding these mistakes will ensure you maximize any tax benefits you’re entitled to and stay compliant with the law. Now, to round out our expert guide, let’s clarify some key terms and concepts that have come up, so you fully understand the lingo used in this context.
Key Terms and Concepts Explained
Adjusted Gross Income (AGI): This is your gross income minus certain adjustments (above-the-line deductions). It’s a crucial number on your tax return that determines tax brackets and eligibility for many deductions/credits. When we say a deduction is “above-the-line,” it means it reduces your AGI. Deducting attorney fees above-the-line (for, say, a discrimination case) lowers your AGI, which can reduce phase-outs of other benefits and generally lower overall taxes. A below-the-line deduction (itemized) does not affect AGI.
Above-the-Line Deduction: A deduction that you can take on your tax return even if you do not itemize; it comes before the line that designates AGI. Above-the-line deductions include things like IRA contributions, student loan interest, and – relevant here – certain attorney fees for discrimination or whistleblower cases. These are the best kind of deductions because they are available to all qualifying taxpayers and reduce AGI.
Miscellaneous Itemized Deduction: Before 2018, this was a category of itemized deductions subject to a 2% of AGI floor. It included unreimbursed employee expenses, tax prep fees, and importantly, legal fees paid to produce or collect taxable income (or related to doing or keeping your job). From 2018 through 2025, miscellaneous itemized deductions are suspended (not allowed) at the federal level. If this category returns in 2026, attorney fees that don’t qualify above-the-line might be deductible again but subject to limitations and AMT issues. Some states still allow these now.
Contingency Fee (Contingent Fee): A payment arrangement where the attorney’s fee is a percentage of the amount recovered in the case (and is only paid if you win or settle favorably). Commonly 33-40%. In contingent fee cases, the client typically doesn’t pay upfront hourly fees – the lawyer takes their cut from the settlement or judgment. For tax purposes, as we’ve discussed, a contingency fee doesn’t change the fact that the client is treated as receiving the gross amount. The term contingent just means the fee is “contingent” on success and comes out of the award.
Commissioner v. Banks: A pivotal 2005 U.S. Supreme Court case that settled the question of gross income in contingent fee arrangements. The Court held that a plaintiff’s gross income includes the portion of the award that goes to their attorney. This case slammed the door on earlier lower-court decisions that allowed exclusion of the attorney’s share. After Banks, the only recourse for taxpayers was to deduct the fees (which, as we saw, Congress accommodated for some types of cases).
Double Taxation / “Phantom Income”: In this context, it refers to the situation where a plaintiff is taxed on income that they never actually received (because it went to pay legal fees). It’s not double taxation in the traditional sense of two different entities taxed on the same income, but for the plaintiff it feels like being taxed twice – once via paying the lawyer and again via the IRS on that same portion. Sometimes called “phantom income” because the taxpayer is paying tax on income that was only on paper, not in their wallet.
Unlawful Discrimination Claim: This term, for tax purposes, encompasses claims under a wide array of laws that prohibit discrimination, such as the Civil Rights Act (Title VII), Age Discrimination in Employment Act, Americans with Disabilities Act, whistleblower protection laws, and many more – including any local or state law (or even common law) that deals with discrimination or retaliation in employment or civil rights. It’s defined in Section 62(e) of the tax code to include a long list of specific statutes and a catch-all. If your lawsuit falls under this umbrella, your attorney fees qualify for the above-the-line deduction (we often shorthand this as “the case qualifies for the special deduction”).
Whistleblower (Qui Tam) Case: A whistleblower case can refer to various situations where someone reports wrongdoing. “Qui tam” is a type of whistleblower lawsuit under the False Claims Act where the whistleblower (relator) sues on behalf of the government for fraud. Whistleblower awards could also come from IRS or SEC programs. The key tax point: Congress gives favorable tax treatment (above-line deduction of legal fees) to most of these kinds of cases because they want to encourage whistleblowers to come forward without fear of tax ruin.
Fee-Shifting and Statutory Attorney Fees: Some laws allow or require the losing side to pay the winning side’s attorney fees (called fee-shifting provisions). For example, many civil rights laws say if the plaintiff wins, the court may award reasonable attorney fees to be paid by the defendant. If you’re a plaintiff awarded attorney fees by the court, that amount paid by the defendant still usually counts as income to you (and then a paid expense to your lawyer).
The above-the-line deduction still applies if it’s an unlawful discrimination case, neutralizing the tax. If it’s not a qualifying case, you might have a tax problem or need to rely on itemized deductions. It’s counter-intuitive: even when the defendant cuts a check directly to your lawyer per court order, the IRS can treat it as if they paid you and you paid the lawyer (because it was on your behalf). So fee-shifting doesn’t automatically solve the tax issue for the plaintiff, except that often those cases are the types that qualify for the deduction anyway.
Alternative Minimum Tax (AMT): A parallel tax system meant to ensure high-earners pay a minimum tax. Under AMT rules, miscellaneous itemized deductions (and some other deductions like state taxes) are not allowed. Before 2018, a lot of plaintiffs who deducted legal fees found themselves paying AMT, thereby losing the deduction benefit. For example, someone with a large settlement and big legal fee deduction could easily trigger AMT, which would add back the legal fees and tax them anyway.
The above-the-line deduction is not affected by AMT – that’s why Congress made it above-the-line, to bypass AMT. After 2018, AMT is less of an issue for legal fees because you can’t deduct them at all in most cases (so regular tax is already high). But if miscellaneous deductions return, AMT could once again be a concern if it’s still around.
After-Tax Settlement Amount: This simply refers to what you actually keep from your settlement after all taxes (and fees) are paid. It’s your net net – the money in your pocket once the dust settles. We often encourage people to think in after-tax terms: a $100,000 settlement might only be $60,000 after legal fees, and then maybe $40,000 after taxes, resulting in a $40k after-tax settlement amount.
When negotiating settlements, especially in taxable cases, savvy plaintiffs consider the after-tax, after-fee outcome. If a defendant offers $X, what does that mean for me at the end of the day? In some scenarios, plaintiffs negotiate characterization of payments (e.g., some as non-taxable or some as wages) to optimize tax results, but the ability to deduct fees (or not) plays a big role in that arithmetic.
Understanding these terms will help you navigate the conversation with attorneys and tax advisors. Now, to conclude, let’s address a few frequently asked questions on this topic that come up in forums and discussions, to clear any remaining doubts.
FAQs about Deducting Attorney Fees from Settlements
Q: Can I deduct attorney fees from a personal injury settlement?
A: No. Settlements for physical injuries are tax-free, so you can’t deduct the legal fees (and you don’t need to, since the money you paid the lawyer wasn’t taxed in the first place).
Q: I won a $50,000 defamation lawsuit. Can I write off my lawyer’s 40% contingency fee?
A: No. Unfortunately, for personal non-physical injury cases like defamation, the IRS doesn’t allow a deduction for your attorney’s contingency fee under current law. You’ll pay tax on the full $50k.
Q: Do I need to itemize my taxes to deduct attorney fees?
A: No, not if it’s a qualifying case. Legal fees for unlawful discrimination or whistleblower cases are an above-the-line deduction – you can take them without itemizing. For other personal cases, there’s no deduction available (and miscellaneous itemized deductions are suspended anyway).
Q: Are attorney fees for an employment lawsuit taxable or deductible?
A: Yes, you can usually deduct them if your case was under a law against workplace discrimination or harassment. Your settlement is taxable, but attorney fees in such cases are an above-the-line deduction, so you’re taxed only on the net amount you keep.
Q: I’m a business owner – can I deduct legal fees from a settlement my business paid out?
A: Yes. If the legal matter was related to your business operations, legal fees and even the settlement payout itself are generally deductible business expenses. They will reduce your business’s taxable income.
Q: What if my lawyer’s fees were paid by the defendant as part of the settlement?
A: No, it doesn’t change your tax situation. The IRS usually treats that as if the money was given to you and then you paid your lawyer. Unless your case qualifies for an above-line deduction, you still effectively have no deduction and must pay tax on the full amount.
Q: Do any states allow deduction of attorney fees if the IRS doesn’t?
A: Yes, a few states do. States like Alabama, California, New York, and others still let you deduct certain legal fees on your state income tax return even though the fees aren’t deductible on your federal return.
Q: Will the tax law after 2025 let me deduct my legal fees again?
A: Yes, possibly. Unless new legislation says otherwise, miscellaneous itemized deductions (including personal legal fees) are set to come back in 2026. This means you might again deduct attorney fees for taxable cases as an itemized deduction (subject to restrictions) in the future.
Q: If I get a taxable settlement, will I definitely get a 1099 for the gross amount?
A: Yes, in most cases. Defendants are required to issue a Form 1099 for the full settlement amount (except for physical injury damages). So expect a 1099 for the gross and be prepared to handle the tax implications on that amount.
Q: Can I ask the defendant to characterize the settlement to help with taxes (like pay more to my lawyer or label damages differently)?
A: Yes, you can try, and sometimes settlements are structured in tax-efficient ways. However, labeling more as attorney fees usually won’t avoid taxation due to the Banks rule. Allocating amounts to non-taxable categories (like physical injury) can help if legitimate, but it must reflect the actual claim situation.