Allocating Legal Expenses
Sometimes legal expenses are incurred for multiple purposes-- e.g., both to perfect or defend title and to gain the right to income. In that case, an allocable portion of the expenses relating to income is deductible and the remainder is nondeductible. Where a taxpayer pays attorney fees in a suit to quiet title to land and also to collect rent, the part of the fees allocable to services related to collecting rents would be deductible. (Reg §1.212-1(k))
Suit Terms Usually Control
In deciding whether a legal expense is nondeductible because it relates to title, the nature of the relief asked for in the suit is the controlling factor in determining deductibility. The relief granted does not control. Case in point is Kelly (1955) 23 TC 682. This was a suit to gain title to property. The fact that the judgment awarded only income items did not make all of the legal expenses deductible.
Partially Taxable Income
Legal fees incurred to collect partially taxable income are deductible to the extent allocable to amounts included in gross income. Examples include social security income (conceivably partly taxable), payments which include both interest (taxable) and principal (reduction of amount realized), damage awards (could be only partially taxable), etc.
Example – Deduction of Legal Fees Connected with Partially Taxable Income (Social Security) - Single taxpayer, Bob, earned income of $31,000, had a short-term capital loss of $2,000, and received $7,000 in social security disability during the year. $3,500 of the social security was taxable. Bob paid legal fees of $1,000 in connection with his right to receive the social security benefits. $500 (one-half) of the legal expense would be a miscellaneous Tier 2 itemized deduction. Reason: His deduction is allowed in the same proportion as his social security is taxable. Since one-half of his social security income was taxable, one-half of his legal expense is deductible. If this situation occurred in years 2018 – 2025, Bob would have no legal fees deduction because of the TCJA-imposed suspension of Tier 2 deductions.
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Other Methods of Allocating Legal Fees
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Based on time spent on each issue of the case - A taxpayer sued to prevent two business associates from terminating his employment and buying his stock at an unreasonably low price. He was allowed to allocate and deduct a larger amount of legal expenses to the employment claim since it involved more work. This was true even though he received $3,168,375 on the stock and only $200,000 for the breach of employment contract., About 29% of the legal fees were determined to be part of stock basis; the remainder were related to the employment and currently deductible. The deductible portion of the legal fees was over $200,000. ,(McKeague v. U.S. (1986, Cl Ct) 59 AFTR 2d 87-347)
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Based on the value of property - In Nickel, (1989) TC Memo 1989-458, the court found that part of a legal fee was deductible even though no income was recovered., The allocation took into account all income recovered at the end of the action., It was based on the total value of stock where the taxpayer’s case involved trying to recover stock value and option price., The value of certain bank stock on which the options had expired was weighed less heavily in the allocation ratio than the value of the bank stock.
Damage Suits
Legal fees for defending and filing damage suits in a taxpayer’s business or in employment are deductible. Those that would be a Schedule A itemized deduction will not be deductible in years 20182025. Examples are:
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Defending suit for wrongfully taking property.
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Corporation’s defense of its position before the National Labor Relations Board related to liability for compensatory damages to employees.
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Settlement of damage suit in business that could help avoid adverse publicity and controversy.
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Getting a judgment for damages to rental real estate.
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Teacher’s action of sex discrimination against a university.
Damages For Personal Injury or Sickness
To the extent a taxpayer can’t exclude from income a portion of an otherwise tax-free personal damage award--e.g., due to payment of interest accruing on the settlement funds-- the legal costs are deductible (in years when miscellaneous deductions aren’t suspended).
Relating to Insurance Proceeds
Legal fees to collect on a claim related to a taxpayer’s business are deductible. In one case, a taxpayer’s building was partially damaged by a fire; his legal expense in gaining recovery was an ordinary and necessary business expense. However, legal fees related to fire destruction of a taxpayer’s personal home weren’t deductible--they were capital expenses.
Criminal Cases
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Legal fees incurred to defend against criminal charges related to a taxpayer’s trade or business are deductible. (LR 7734004 and several other cases) This is true even if the taxpayer is convicted of the crime. (Com. v. Terrlier, (1966, S. Ct) 17 AFTR 2d 633)
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Legal expenses of defending an individual charged with a crime are personal and ordinarily can’t be deductible by an employer who paid them., However, the Tax Court held that a corporation could deduct the legal fees it incurred to successfully defend its vice president against a criminal charge (Union Investment Co., (1954) 21 TC 659). The IRS acquiesced to the Union case.
Corporate Business
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Stockholder matters: If a stockholder brings a suit that benefits a corporation and its stockholders, the corporation (though a nominal defendant) can deduct legal expenses related to the matters (to the extent the expenses would be otherwise deductible).
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Valuing of stock: Generally, legal expense related to appraisals and value of stock is capital in nature and not currently deductible.
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Pre-incorporation expenses: Ordinarily corporations can’t deduct legal fees related to preincorporation matters., Such fees could, perhaps, qualify as start-up expenses.
Fiduciaries and Estates
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When deductible: Legal expense deduction in this area has been allowed for a trust beneficiary who claimed rights to taxable trust income, for recovery of trust property embezzled by the trustee, and for advice in handling estate corpus (even though income from it was payable to another beneficiary).
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Right to trust or estate property: Generally, if legal expenses are incurred to protect an heir’s right to property, the expenses aren’t deductible. The expenses must be capitalized. Likewise, protecting rights to trust property are normally not deductible.
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Wills: Legal expense deductions have been denied for probating a will, contesting a will, and will contests.
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Administration of estate, trust: Reasonable legal costs of administering an estate or trust are deductible on the fiduciary return, unless the costs are related to tax-exempt income. However, the same expense cannot be deducted on both the estate tax return (Form 706) and the fiduciary income tax return (Form 1041).
Divorce, Separations, Etc.
Legal costs connected with divorce, separation or support are non-deductible personal expenses. Nondeducibility extends to legal fees incurred in disputes over money claims.
Taxable Alimony
For years other than 2018-2025, the part of legal fees attributable to producing taxable alimony is deductible by the recipient of the alimony. Attorney should stipulate what part of the fee relates to alimony to ensure deduction for alimony recipient. See chapter 1.04 for changes to alimony taxability/deductibility created by the TCJA.
Sexual Harassment Claims
The TCJA added a provision that prevents any deduction for any settlement or payment related to sexual harassment or sexual abuse if the settlement or payment is subject to a nondisclosure agreement, or attorney’s fees related to such settlement or payment, paid or incurred after December 22, 2017. (IRC Sec 162(q)) The prohibition of deducting attorney’s fees does not apply to the recipients of settlements or payments related to sexual harassment or sexual abuse, whose settlement or payment is subject to a nondisclosure agreement. (IRS web site, Sec 162(q) FAQ 2019ARD 043-3) However, this distinction may be a moot point in years 2018 – 2025 because of the suspension of Tier 2 miscellaneous deductions.
Personal Matters
No deduction allowed when the case involved the following:
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Defending drunk driving charge;
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Invasion of privacy suit;
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Resisting deportation;
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Preparing a will;
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Release from mental hospital;
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Prosecuting malpractice suits.