The Attorney Took Their Cut. Why Do You Owe Tax on It? – Houston Tax Attorneys

Imagine you sue a company over a mistake on your credit report. You win a settlement. Your lawyer takes their cut off the top, and you walk away with a small check for what feels like a big fight. Then a Form 1099 shows up, and it reports the entire settlement as your income—including the part you never touched.

This happens more often than you might think. The tax code treats the money that goes to your attorney as your income, even when the check goes straight to the law firm. You can start to see the problem here. You are taxed on money you never held.

So the question becomes whether there is any way out. Can you exclude the attorney’s share from your income, or at least deduct it? A recent case, Eiler v. Commissioner, 167 T.C. No. 3 (2026), gives us a chance to look at that question and the narrow relief the tax code actually provides.

The Facts of the Case

The taxpayers believed several credit reporting agencies had put inaccurate and derogatory information on their credit reports. They hired a law firm and sued under the Fair Credit Reporting Act. Their main goal was to clean up their reports. They also stood to recover damages and attorney’s fees.

The fee agreement was a contingency arrangement. If the taxpayers recovered nothing, they paid nothing. If they recovered, the firm took its share. They settled with the agencies over the course of a year. Each settlement was a single lump sum. None of the agreements broke the payment into categories of damages.

The defendants paid out about $65,000. Of that, roughly $4,700 reached the taxpayers. The rest—about $60,000—went to the law firms for fees and costs. The taxpayers then received Forms 1099 from the defendants showing the full amount as income. On their return, they reported only the small piece they actually received–net of attorneys fees.

The IRS audited and issued a Notice of Deficiency for about $11,000. The taxpayers took the case to the U.S. Tax Court to fight it. You can start to see the issue here. They received a small fraction of the money but got taxed on all of it.

What Counts as Income in the First Place

The concept of income is the starting point for most income tax questions. We start with the broad rule. Gross income means income from whatever source, unless the tax code says otherwise. That is a wide net. Courts read exclusions from income narrowly, so a taxpayer who wants to keep something out of income has to point to a clear rule that lets them.

Settlement money is not automatically excluded. Whether a settlement is taxable depends on the nature of the claim and what the payment was meant to replace. If the money replaces something that would have been taxable—lost wages, economic losses, and the like—it is usually taxable too.

Here the settlement agreements were silent. They did not say what the payments were for. When an agreement does not spell out that a payment is for a nontaxable reason, the IRS will often treat the whole thing as taxable. The taxpayer carries the burden of showing otherwise, and silence does not carry that burden. The IRS often makes these adjustments on audit and they catch them via the automated underreporter program.

Why the Attorney’s Share Is Still Your Income

Now to the heart of it. The general rule is that when a recovery is income, the part paid to the attorney as a contingent fee is still the client’s income. The Supreme Court settled this years ago in Commissioner v. Banks. This is not a new court case or concept.

The reasoning is the assignment of income doctrine. You cannot take a gain that is yours and assign it away in advance to avoid tax on it. A contingent fee agreement is treated as an advance assignment of part of your recovery to your lawyer. The income is earned by you first. The fact that the money flows straight to the firm does not change who earned it.

The taxpayers tried a clever angle. They argued their fee was contingent only in the sense that the lawyers got nothing if there was no recovery—not a fixed percentage of the total. The court was not persuaded. A contingent fee is a fee charged only if the case succeeds. Their arrangement fit that description. It was an unusual contingent fee, maybe, but a contingent fee all the same.

They also argued the fees were paid under the fee-shifting provisions of the credit reporting statute. These rules can make a defendant pay a winning plaintiff’s legal fees. That did not help either. They settled their cases rather than winning them. The defendants disclaimed any liability. No court determined the fees. And even if the fee-shifting rule had applied, courts have long held that a defendant’s payment of your attorney’s fees is still income to the taxpayer. A third party paying your obligation is income to the taxpayer. Why should the fees not follow that rule?

Is There a Deduction for Legal Fees?

If the fees are income, the next question is whether you can deduct them. For most personal legal fees, the answer since 2018 has been no. This was a change made as part of the Tax Cuts and Jobs Act. There is one narrow exception that matters here. The tax code allows an above-the-line deduction for attorney’s fees paid in connection with a claim of “unlawful discrimination.”

This is the good deduction. It comes off the top. So it directly offsets the fee income instead of getting buried in itemized deductions you may not be able to use. The catch is the definition. “Unlawful discrimination” is defined by a list, and one part of that list covers laws providing for the enforcement of “civil rights.”

The taxpayers argued their credit reporting claims were civil rights claims. So the whole case turned on one word. What does “civil rights” mean in this part of the tax code?

What Does “Civil Rights” Mean Here?

Congress did not define civil rights in this section. When a statute leaves a term undefined, courts look to the ordinary meaning of the term at the time the law was passed. The relevant amendment came in 2004, so the court looked at how dictionaries defined civil rights around then.

The common definitions pointed to personal liberties tied to the Constitution and landmark laws—the right to vote, due process, equal protection, and protections against discrimination based on race, religion, or sex. The taxpayers pushed a much broader definition, one where any legally enforceable claim of one person against another counts as a civil right. They leaned on an old IRS memorandum that read the phrase “human and civil rights” broadly.

The court was not convinced. An IRS internal memorandum is not binding law. And even if it were, it addressed the broader phrase “human and civil rights,” which naturally sweeps wider than civil rights alone. The ordinary meaning of a word is not the widest possible meaning it can bear. It is how the word is normally used. Credit reporting accuracy, while important, is not a civil right in that ordinary sense.

So the deduction was denied. There are cases where the line between a civil rights claim and an ordinary consumer claim is not so clean, but a garden-variety credit reporting dispute falls on the wrong side of it. The taxpayers were left taxed on the full recovery with no above-the-line deduction to soften it.

The Takeaway

The big picture is simple even when the result feels unfair. If you win or settle a lawsuit that produces taxable income, the money your lawyer keeps is still your income. That is the rule from Banks, and courts apply it whether the fee is a contingency or shifted to the defendant. The one real escape is the above-the-line deduction for fees tied to an unlawful discrimination claim, and that door only opens for a narrow set of cases. Before you settle, ask how the payment will be characterized and whether your claim fits that deduction. A little planning up front, ideally with a tax attorney, can keep you from paying tax on money that never reached your pocket.