Clearing Up Some Common Misconceptions
A common question which often arises is whether or not legal expenses can be deducted. The answer to this question can be both yes and no and can be complicated depending on the specifics of the legal expense.
The Internal Revenue Code (IRC), which is the body of the tax laws that are written by the United States (U.S.) Congress have been approved by the president in office at the time of the creation of the law, tells us that unless it has been expressly provided, such as itemized deductions, no deductions are permitted for personal, living or family expenses.
The IRS also indicates that in the case of an individual, deductions are permitted for all of the ordinary and necessary expenses that are paid or incurred during the taxable year:
- For the production or collection of taxable income;
- For the conservation, management, or maintenance of property that has been held for the production of income;
- Related to the determination with the collection, determination or return of tax.
Applying these IRS provisions will permit you to determine whether a legal expense that you have incurred is deductible or not, but the application can be somewhat complicated and must also take into account the Internal Revenue Service's (IRS's) interpretation of the law as the result of rulings and regulations and also court opinions on all of these matters.
The following are some commonly encountered circumstances and how legal expenses that were paid in these instances should be dealt with:
- Divorce – Legal costs, such as attorney fees and court costs, in connection with a divorce, separation, or support are nondeductible personal expenses. This non-deductibility is extended to legal fees that are incurred as a result of disputes over money claims. However, the legal and accounting fees that are paid for tax advice as a result of the divorce are deductible, provided that the amounts for those services are explicitly indicated on the legal firm's invoices.
- Taxable Alimony – This is the portion of the legal fees that can be attributed to the production of taxable alimony that can be deducted by the recipient of the alimony. The attorney's statement or invoice should indicate which portion of the fee is related to the alimony to ensure that a deduction will be permitted for the recipient of the alimony. Legal fees that are paid by the payer of the alimony can not be deducted. This is because child support payments are not taxable. Therefore, fees paid to obtain those payments can not be deducted.
- Conducting a Business – Legal fees that are incurred by a taxpayer as the result of conducting a trade or business are typically deductible if they are ordinary and necessary business expenses.
- Legal Expenses in Relation to Insurance Proceeds – Legal fees that are incurred in order to collect on a claim that is related to a taxpayer's business may be deducted. However, the legal fees that are related to personal losses can not be deducted. In instances where the loss is related to a capital asset, such as a taxpayer's personal home, the related expenses can be added to the home's tax basis and may be used to offset any taxable gain in the future.
- Collecting or Producing Taxable Income – Attorney fees, court costs, and related expenses may be deducted if they are incurred during the production and collection of taxable income. In general, there must be a close connection between the legal expense and the collection or production of the taxable income.
- Bankruptcy – Legal fees that are connected to a business bankruptcy may be deducted. If a personal bankruptcy is the result of a failure of business activity, the legal fees that are related to the bankruptcy proceedings may be partially deducted as business expenses. The courts have used a proration of the fees that is based on the ratio of the claims by the business creditor to total creditor claims.
- Management, Conservation, or Maintenance of Income-Producing Property – Legal fees that are related to the management conservation or maintenance of income-producing property are typically deductible. However, just because a taxpayer may be required to sell income-producing property in order to satisfy a potentially adverse judgment, this does not mean that the taxpayer can deduct the expenses related to defending the lawsuit using this provision.
- Related to the Title of Property – Despite the fact that the legal costs to acquire, perfect, defend or clear title to property is not currently deductible as a business or investment expense, they are capital expenditures whose cost can be recovered by using cost recover, depletion or depreciation. Incurred legal costs that are related to the title of personal property, such as a principal residence, can not be deducted but can be added onto the basis of the property.
- Damage Lawsuits – The legal fees associated with the defense and filing of damage lawsuits in a taxpayer's business or in employment are deductible. Examples include expenses that are paid for defending a lawsuit for wrongfully taking property; settling a damage lawsuit against a business, which could help to prevent negative publicity and controversy; receive a judgment for damages to rental real estate; and a teacher's action of sex discrimination against a university.
- Damages for Personal Injury or Illness – In certain instances, the damages for personal injury or illness may be excluded from income. As a result, the legal fees that are paid to secure such income can not be deducted if the damage award is not taxable. However, to the extent that the damage award can be taxed or accrue interest is paid on the settlement funds, the legal fees may be deducted. When the funds are partially taxable and partially excludable, the legal costs must be prorated in the same ratio as the income is.
- Document Preparation for Wills and Trusts – The legal costs of preparing a will is considered to be a personal expense that can not be deducted. In many cases, the legal cost of creating a living trust is similarly treated as a nondeductible, personal expense. However, if the lawyer who has prepared the trust makes a notation on the billing invoice that the fee is for tax planning or tax advice, then the tax-related portion of this fee can be deducted.
- Criminal Cases – Legal fees that are incurred to defend against criminal charges related to a taxpayer's business or trade can be deducted. This is also true in the event that the taxpayer is convicted of a crime. However, the legal defense expenses that are incurred by an individual charged with a crime are personal and typically may not be deducted.
- Tax Concerns – Legal fees that are associated with obtaining tax advice, having tax returns prepared and defending a taxpayer being audited are allowed to be treated as deductible legal expenses.
Just because some legal fees can be deducted doesn't mean that you will obtain any tax benefits from taking such deductions.
While certain legal costs can be deducted via business schedules and provide the maximum benefit, others are required to be deducted as miscellaneous itemized deductions, the total of which is subject to a 2% of AGI deduction floor.
In addition, the miscellaneous itemized deductions can not be deducted for the purposes of the alternative minimum tax (AMT).
Therefore, trying to determine which legal expenses can be deducted is quite complicated, and even if permitted, a deduction may not offer any tax benefits. As every situation is different, you are encouraged to contact us in order to determine if you can obtain any tax benefits from your legal expenses.
Have a questions about your tax deductions? Call us at (408) 990-3365 to set up a consultation regarding your accounting and tax planning needs.