Leah Witcher Jackson (Baylor) has published Won the Legal Battle, But at What Tax Cost to Your Client:  Tax Consequences of Contingency Fee Arrangements Leading Up to and After Commissioner v. Banks.  57 Baylor L. Rev. 47 (2004).  Here is the Conclusion:

Civil rights claimants no longer have to worry about paying income tax on the contingency fee portion of the award. Relief from taxation is now in place for clients with the types of claims listed in § 62(a)(19). As for other types of cases, the issue remains in question. Several approaches presented to the courts of appeal and the Supreme Court are viable choices. Ultimately, the answer should be based upon an approach that will accomplish the most equitable, effective and efficient result. The approach taken in the circuit cases should not depend on whether the recovered damages involve nontaxable awards, such as physical personal injury awards, or taxable awards, such as punitive, employment and other awards. The outcome should not differ for contingency, hourly or flat fee arrangements.

The best possible answer is recognizing that the costs of litigation, including the attorney’s fees, are a direct cost of disposition of the claim. As a transactional cost, the fees should be a direct offset against the amount realized from the claim. This approach provides equity in assuring that all types of litigation and claims have similar treatment. All clients and lawyers will pay tax only the portion of the taxable award realized and received. This approach also provides an effective and efficient manner for addressing the issue with no amendments required and no additional reporting requirements for the parties.