Acquiring Income
In Conducting Business
Legal fees incurred by a taxpayer in the course of a trade or business are deductible, if they are ordinary and necessary expenses. In Harvey (1953) TC Memo 53376, reasonable legal fees were currently deductible by a businessman even though paid to a relative.
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Corporate Officer - Legal fees were allowed as a deduction for a corporate officer who was responsible for filing the corporation’s Federal tax return., The fees were incurred in relation to his defending an indictment for evasion of the corporation’s income tax., His defense was unsuccessful. (Rev Rul 68-662, 1968-2 CB 69)
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Bankruptcy – Legal fees connected with a business bankruptcy are deductible. If personal bankruptcy is primarily caused by the failure of a business activity, the legal fees related to the bankruptcy proceedings are partially deductible as a business expense. The courts have used a proration of the fees based on the ratio of business creditor claims to total creditor claims. (Cox v. Commissioner, Dec. 38,294(M), TC Memo 1981-552)
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Involuntary Bankruptcy - Legal expenses related to an involuntary bankruptcy proceeding brought against the taxpayer were allowed. (Suckow Borax Mines Consolidated Inc., (1953) TC Memo 53244) No deduction was allowed, however, for a taxpayer whose business went bankrupt and was later sued for fraudulent transfer of assets to a family trust. The Court held that the origin of the expenses was personal in nature., The Court rejected a lower court judgment that there would have been no bankruptcy, except for the taxpayer’s business creditors and a settlement payment would benefit those creditors., The settlement payment made by the taxpayer was, in fact, no more than his personal payment to the trustee to get dismissal of the suit against his family trust., (Collins, Ralph (1994, CA11) 74 AFTR 2d 94-5336)
In Producing or Collecting Income
Legal expenses (including attorney fees, court costs, etc.) are deductible if incurred in the production or collection of income.
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The reduction of a personal expense isn’t the same thing as the production of income.
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There must be a reasonably close connection between the legal expense and the production or collection of taxable income.
Example - Legal Expense Deductibility and Nature of Property - Tara incurred legal expenses to defend herself in an injury suit brought against her by Jim who had slipped on the sidewalk in front of a property she owned. Tara won the case. The deductibility of Tara’s expenses depends on the type of property involved in the accident. If the property was a rental, the expenses are deductible. If the property involved was Tara’s personal home, no deduction is allowed.
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Cases:
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Legal expense deduction allowed an Army retiree who contested rank and rate of retirement pay at which he retired. (Rev Rul 72-169, 1972-1 CB 43)
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Deduction allowed for a trip to Ireland with an attorney to collect winnings in Irish Sweepstakes. $1,000 attorney fee allowed., Extortion payment to attorney not allowed. (Kanelos (1943) TC
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Memo 43429) o Deduction allowed for an unemployed engineer in an action to collect unemployment compensation. The action was unsuccessful. (Mohiuddin (1996) TC Memo 1996-442)
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Legal expense deduction allowed when expenses were incurred to “consider ways” to collect fees for services the taxpayer performed., The Court evidently was not concerned with whether there was, in fact, any action to actually collect the fees., (Barnes, Thomas (1992) TC Memo 1992-720)
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Managing, Conserving, or Maintaining Income-Producing Property
Many cases in this area, covering a great variety of income-producing property types, have seen legal expenses allowed. However, just because a taxpayer may have to sell income-producing property to satisfy a possible adverse judgment doesn’t mean he/she can deduct the cost of defending the suit. Examples are:
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Racketeer - Fees paid by a labor union official to successfully defend against Racketeer Influenced and Corrupt Organizations (RICO) charges weren’t deductible as expenses incurred to conserve/maintain income-producing property, specifically the taxpayer’s certificates of deposit. The CDs weren’t acquired from racketeering or through use of proceeds from racketeering., Thus, they weren’t forfeitable under RICO., Even the possibility that the taxpayer might have to use the CDs to pay an adverse RICO judgment wasn’t enough to permit deductibility on grounds of conservation of the CDs. (Accardo v. Com., (1991, CA7) 68 AFTR 2d 91-5418)
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Breach of Promise - Legal expenses to defend a suit for breach of promise to marry were nondeductible personal expenses, even though satisfaction of an adverse judgment would require sale of income-producing securities. (Rockwell, Henry (1961) 37 TC 246)
Related To Title To Property
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Legal expenses related to acquire, perfect, defend, or clear title to property are capital expenditures and can’t be deducted currently as business or investment expenses., However, even though legal expenses may not be immediately deductible, their cost may be recovered through depreciation, depletion, or cost recovery.
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Legal expenses paid to recover property (other than investment property and amount of income that, if and when recovered, must be included as gross income) are part of the cost of the property and not deductible., Such recovery refers to times where ownership of property was lost but has been restored.
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Expenses to acquire, perfect, or defend a leasehold interest generally aren’t currently deductible.
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Legal costs related to the disposition of a property are considered a reduction in the amount realized on the sale (expense of sale).
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Fees related to blocking a condemnation are capital in nature.
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Legal fees connected with gifts are generally nondeductible., Making a gift of income-producing property is neither conserving nor managing the property.
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Legal fees for setting up an irrevocable trust were not deductible by a taxpayer who set up the trust for his children to which he transferred a reversionary interest in an existing trust., The legal fees paid to establish the trust were a nondeductible personal expense, not a business expense. (Mathews, (1973) 61 TC 12)
Opt-Out Class Action Lawsuits
IRS has ruled privately that attorney fees paid in an opt-out class action lawsuit weren't includible in class members' or class representatives' gross income, because no contractual obligation for a fee existed between them and litigating counsel. (PLR 200906010)