Win in court without losing to the IRS

Let's say you negotiate a $1 million settlement on a sexual discrimination suit that involves some physical injuries. In the 35% tax bracket, that leaves you with $650,000 after-tax.

But if you structured the settlement for $250,000 for the discrimination, and $500,000 for the physical bruising, you would net, after tax, $662,500 -- a gain of $12,500 more for you. And thanks to your magnanimity, the defendant would save $250,000.

Paying the lawyers

The taxation of legal awards and settlements becomes even more complicated when you add in the legal fees.

Lawyers in personal-injury cases usually work on a contingency basis. So your lawyer gets paid only if you win, and his fee is a percentage of your award or settlement.

The courts used to be mixed on how to handle the fees. Some courts hold that the fees create a right of ownership -- or attorney's lien -- for the lawyers. Since the lawyer owns that portion of the award, it's not your asset and therefore shouldn't considered taxable income.

However, most courts, including the U.S. Tax Court, held contingency fees to be a creditor's right, a right to be paid by you, as the attorney's client. In such cases, the entire award is included in your gross income, and is taxable.

Here's how important this distinction was:

Let's say you receive a taxable award of $1 million and have to give your lawyers 40%, or $400,000.

If your case is in a state where the fees create that lien we talked about, you were facing getting taxed only on $600,000. However, in the second case, you faced tax on the whole $1 million.

But how about a deduction for the $400,000 paid to your attorney?

Yes, you get the deduction, but only as a miscellaneous itemized deduction. So first you have to itemize, which you might not have had to do in the original instance. More importantly, your miscellaneous itemized deductions must be reduced by 2% of your adjusted gross income. So, if you had no additional income (a very conservative assumption), you lose, at a minimum, at least 2% of $1 million, or $20,000 in deductions.

The Supreme Court recently resolved the dispute. The court ruled that the legal fees are allowed only as a miscellaneous itemized deduction.

But Congress modified the rule slightly in the American Jobs Creation Act of 2004. Under this law, legal fees from claims based on unlawful discrimination and certain other federal claims (including, but not limited to, whistle-blower actions), are now above-the-line deductions. You don't even have to itemize to take those!

Updated July 7, 2009

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