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Should I take a deduction for damages?

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Should I take a deduction for damages?

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A contingent fee arrangement is one where the client pays a fee only if her claim is successful. The attorney will receive a share of the judgment or settlement amount. With contingent fees, the question arises whether the taxpayer should include the entire amount of damages in income and then take a deduction for the portion paid to the attorney, or should the taxpayer exclude the portion of the recovery paid to the attorney and claim no deduction.

The Supreme Court resolved this issue in Commissioner v. Banks, 543 U.S. 426 (2005). In that case, the Court relied on traditional assignment of income rules in reaching its decision. Because the taxpayer retained “ultimate dominion and control over the underlying claim,” the Court held that he should have the entire recovery included in his income. Therefore, the Court announced, “We hold that, as 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.” Accordingly, the taxpayer must include the item in his income and then take a corresponding deduction for the attorney fees.