Generally, proceeds from a lawsuit have to be included in your taxable income unless they relate to a physical injury.

If you live in the Chicagoland area the amount of income that you will be taxed on will probably be much higher than the amount you actually received. You will have to include as your income the contingent fees your attorney receives.  In the 7th circuit court of Appeals decision in Kenesth V. Comm., No. 00-3705 the court held that the entire award (including the contingent attorney fees that went directly to the attorney) was taxable to the plaintiff. The award proceeds including the attorney fees were both income to the taxpayer and also a cost of generating the income.

However, there may not be any tax benefit from the deduction of these same legal fees. The reasons for this anomaly are:

• The deduction for the attorney fees will be treated as a 'miscellaneous itemized deduction.'  This treatment always results in a smaller deduction because the actual deduction for 'miscellaneous deductions' is the sum of all miscellaneous deductions reduced by 2% of your total income.
• Due to the impact of the alternative minimum tax (AMT), there may not be any tax benefit from the deduction.
• The miscellaneous itemized deduction cannot be deducted for the Illinois income tax.

In the Knows V. Comm., supra decision, the Court held that under Wisconsin law (which governed the case), the plaintiff/taxpayer was always the owner of the lawsuit proceeds; the lawyers merely had a lien against the proceeds of any settlement or judgment. If Illinois law follows Wisconsin law (and we were told by one attorney that Illinois law does), you will be facing a larger tax bill. If you are involved in a lawsuit and expecting a settlement or judgment, you may want to discuss the effects of the Kenesth, supra decision with your lawyer. Possibly, your lawyer can structure the contingent fee arrangement as a joint venture or partnership, to avoid the negative effects of this decision.

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