Generally, for years other than 2018-2025, nonbusiness legal expenses are deducted on Schedule A as Tier 2 miscellaneous itemized deductions if paid in relation to the production of taxable income.

If related to the taxpayer’s: (1) self-employed business, deduct expenses on Schedule C (or Schedule F if farm activity); (2) real estate rental, deduct on Schedule E.

If the expenses must be added to basis, sale of the related property would be reported on Form 8949 (Schedule D) or Form 4797.

When a taxpayer wins a taxable damage award, the following questions come up: is the whole award taxable to the taxpayer even though part of it is paid to an attorney? YES, unless the award is related to unlawful discrimination or a whistleblower award. Does the part paid to the attorney come off the top of the judgment and the taxpayer pays tax on only the net? NO. For years 2018-2025, due to the suspension of Tier 2 deductions, none of the attorney fees that would otherwise be reported as miscellaneous itemized deductions will be deductible. For other years, the issue plays an important part in the tax treatment:

A taxpayer may deduct attorney fees and court costs paid in connection with any actions involving a claim of “unlawful discrimination,” which includes a number of specific federal statutes (see Code Sec. 62(e)) and any federal, state, or local law regulating any aspect of the employment relationship or prohibiting the discharge of an employee as an adjustment to income (above-the-line). (Code Sec. 62(a)(20)). The amount of the deduction can be no more than the amount of the award includible in gross income. Note: Because the provision allows an above-the-line deduction as opposed to an itemized deduction, the deduction effectively is allowed for AMT purposes as well.

Attorney’s fees and court costs paid in connection with a whistleblower award paid for providing information about tax law violations are deductible above-the-line. (Code Sec 62(a)(21)) However, the deduction is limited to the amount includible in gross income as a result of the reward. For 2018 and later years, this above-the-line deduction is also available to whistleblowers receiving awards under the SEC and Commodity Future Trading Commission whistleblower programs, as well as the State false claims acts.