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I think that James and Kathryn Eiler v Comm 167 TC 3 deserves its own post rather than just being another one of the July developments I am reporting on in bulk. After all, we don’t get that many regular opinions. If you are involved in litigation as a plaintiff or are a plaintiff’s attorney it is worthy of study.
Losing Big By Winning A Lawsuit
If you are taxed on the proceeds from a lawsuit, it seems like you should be able to deduct the legal fees involved at least to the extent of your income. Only that is not the way it generally works. There are a couple of exceptions with AGI deductions for discrimination suits (IRC 62(a)(20) and whistleblower suits (IRC 62(a)(21)).
James and Kathryn Eiler were suing credit reporting agencies. They had a sort of workaround with the attorneys. The attorneys would get paid the gross amount of the settlement and they would get the net after costs and fees. The three defendants paid out $64,750 of which $4,700 went to the Eilers. The attorneys sent the Eilers a 1099-MISC for $4,900. In a footnote Judge Guider notes that nobody figured out the $200 difference, but it didn’t matter. They also got 1099s from the companies they sued totaling $64,750. They used the $4,900 in filing their returns. The IRS preferred the $64,750 making for a notice of deficiency of $11,423.
The workaround didn’t work:
“s a general rule, when a litigant’s recovery constitutes income, the litigant’s income includes the portion of the recovery paid to the attorney as a contingent fee.” Commissioner v. Banks, 543 U.S. 426, 430 (2005). The Supreme Court reached this holding by applying the anticipatory assignment of income doctrine—a taxpayer “cannot exclude an economic gain from gross income by assigning the gain in advance to another party.” Id. at 433. The Court agreed that “a contingent-fee agreement should be viewed as an anticipatory assignment to the attorney of a portion of the client’s income from any litigation recovery.” Id. at 434.
The Eilers argue that the contingent fees were contingent in the limited sense that the attorneys would receive nothing if the Eilers recovered nothing, not in the sense that the attorneys would receive a fixed percentage of the total recovery. Indeed, the service agreements were silent as to how the attorney’s fees would be calculated. The Eilers contend that the fee structure was therefore not a typical contingent fee arrangement and that the attorney’s fees portion of their recovery should be considered fees paid under a fee shifting provision.
But the mere fact that the arrangement was not a typical one does not mean there was no contingent fee arrangement.”
There was also an argument that the fees should have the same treatment as if it were a discrimination case, but that also failed.
“We hold that petitioners’ FCRA actions did not involve claims of unlawful discrimination as defined in section 62(e)(18)(i) because those claims did not involve provisions of federal law providing for the enforcement of civil rights. “
I am tempted here to bring up one of my “bad idea” thought experiments. What if the Eiler’s had refused to cough up their id numbers to the defendants. Then, at least in principle, there would have been withholding and they might have, more or less, came out even. Of course the lawyers would not have been too happy about that.
Ed Zollars and Notebook LM gave a deep analysis of the opinion on Current Federal Tax Developments, They rightly note that litigators should be paying attention to this opinion. Lew Taishoff in Uncivil Rights adds one of his signature humorous notes.
“I award JW’s and Kate’s trusty attorneys a Taishoff “Good Try, Second Class” for citing Section 62(a)(20), the deductibility of legal fees in civil rights cases, which I myself tried once.”
The National Association of Consumer Advocates wrote to Congress about the case back in 2025 promoting a legislative solution to the problem.
For great value in continuing professional education check out the Boston Tax Institute.
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