Hello and thank you for your question.
This usually comes up when a corporation is liquidated and corporate debts exist after liquidation where creditors are able to go after shareholders in receipt of assets upon liquidation that should have been used to pay corporate debts. The shareholder has a capital loss. See Arrowsmith v. Commissioner, 344 U.S. 6, 73 S.Ct. 71 (1952):
" In 1944, a judgment was rendered against the corporation and against one of the taxpayers individually. Each of the two taxpayers paid half of this judgment and deducted 100% of the amount so paid as an ordinary business loss in his income tax return for 1944.
Held: Under §§ 23(g) and 115(c) of the Internal Revenue Code, these losses should have been treated as "capital losses," since they were paid because of liability imposed on the taxpayers as transferees of liquidation distribution assets."
You may wish to also refer to §1341 for the mechanics of this:
(a) General rule
an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
the amount of such deduction exceeds $3,000,
then the tax imposed by this chapter for the taxable year shall be the lesser of the following:
the tax for the taxable year computed with such deduction; or
(5) an amount equal to—(A)
the tax for the taxable year computed without such deduction, minus
the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).
The attorney's fees are deductible under §212:
In the case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year—
... for the management, conservation, or maintenance of property held for the production of income.
This was a good question.