One of the most complicated tax issues is the question of whether or not legal expenses are tax deductible. The tax laws established within the Internal Revenue Code are quite specific regarding itemized deductions, and state clearly that personal, family and living expenses are not deductible. However, the tax laws, which are written by Congress and approved by the president in office at the time, also indicate that certain individual deductions can be taken if they meet specific criteria. Those criteria include expenses that are incurred for the following reasons:
- For the purpose of maintaining, managing or conserving a property that is owned to produce income
- For the purpose of producing or collecting taxable income
- For the purpose of determining, collecting or refunding taxes
Though at first glance these provisions may seem fairly straightforward, in reality they are not. The taxpayer not only needs to be aware of other rulings that have been established to address specific issues, but also they need to understand that even if deductions are permitted, they may not be of any actual tax benefit. Where deductions taken for legal fees on business schedules, others may be subject to itemization, and as a result may be subject to the AGI deduction limitation of 2 percent. The alternative minimum tax may also eliminate the usefulness or ability to take deductions.
Following are several categories of common legal expenses, and information regarding when and whether they can be deducted:
Bankruptcy – When a business files for bankruptcy, or a personal bankruptcy is largely caused by a business failure, then the legal fees incurred during the process of filing for bankruptcy are partially deductible as a business expense. The portion of the fees that are deductible are calculated using a proration based on the percentage of business creditor claims to total claims.
Conduct of a Business – When a business incurs legal fees as part of the ordinary and necessary operations, they are generally deductible.
Criminal Cases – When an individual taxpayer incurs legal defense fees for a crime conducted personally, those expenses are not deductible. However, when legal fees are incurred to defend against charges related to their business or trade, they are deductible, even if the taxpayer is found guilty.
Damages for Personal Injury or Sickness – When a person files a lawsuit for sickness or injury and they are awarded damages, those damages are sometimes considered to be taxable and sometimes not. If they damages are taxable then the person who received the award is able to deduct the legal expenses incurred in winning that award. If however the damages are not subject to tax then the legal expenses cannot be written off. Where some of the damages award is taxable and some is not, the same ratio applied to the award is applied to the legal expenses’ deductibility.
Damage Suits – If a business or employee is sued for damages, then legal fees incurred in defending against the suit can be deducted. This is true whether the suit is settled out of court or resolved in court.
Divorce – Attorneys fees and court costs for divorce, separation, issues of support and custody can not be deducted – neither can legal fees involving disputes over monetary claims. Fees for legal and accounting services to provide tax advice in connection with the divorce may be deducted as long as they are properly documented identified as such on the providers’ bills.
Managing, Conserving or Maintaining Income-Producing Property – In most instances, if a taxpayer owns an income-producing property and they require legal services to help them manage, conserve or maintain the property, the fees for those services can be deducted. However, if the property needs to be sold in order to satisfy a judgment against them, they cannot deduct any legal fees incurred in defending against the lawsuit.
Producing or Collecting Taxable Income – If a taxpayer incurs court costs, legal fees or other related expenses in the course of either producing or collecting taxable income, those expenses can be deducted. However, it may be necessary to provide a clear link between the expenses and the named income.
Relating to Insurance Proceeds – The deductibility of legal fees expended to collect on an insurance claim are deductible for business claims but not for personal losses. For losses associated with a personal home or other capital asset, expenses for legal fees may be added on to the asset’s tax basis for consideration when assessing taxable gains.
Relating to Title of Property – When legal expenses are incurred by a business in the course of defending a title to a property, clearing the title, acquiring it or perfecting it, those expenses cannot be deducted against the business’ taxes. They can, however, be recovered as part of writing off depreciation, depletion or cost recovery of a capital expenditure. Likewise, legal expenses regarding titles incurred by individuals purchasing or defending personal property cannot be defended, but can be included as part of the property’s cost basis in order to offset capital gains.
Tax Issues – When a business or individual incurs legal fees that represent tax advice, defending against an audit or the preparation of a tax return, those legal expenses are deductible.
Taxable Alimony – The recipient of alimony is permitted to deduct legal fees spent on producing taxable alimony, but in order to do so the invoice or statement from the attorney must clearly identify the portion of their fee that represents those specific services. The party that is responsible for paying the alimony is not permitted to deduct legal fees associated with the alimony, and legal expenses relating to child support can not be deducted because those payments are not taxable.
Will and Trust Document Preparation – For the most part, the preparation of legal documents such as living trusts and wills is considered to be a personal expense, and is therefore not a deductible expense. However, any portion of the legal services dedicated to providing tax planning advice, then that portion of the service can be deducted as long as it is clearly delineated on the attorney’s statement or invoice.
Properly identifying which legal expenses can be deducted and which cannot be deducted is a complex issue.
For assistance in determining whether you can deduct legal fees, or whether doing so would be of any benefit to you call us at (301) 637-6453 for a consultation.