Understanding the Fundamentals of Legal Fee Deductions
Legal fee deductions are generally allowed for the payment of expenses incurred in collecting, securing or obtaining taxable income. In order to claim the deduction, the legal fees must be described either in terms of specific transactions or activity that produced taxable income or financial transactions that impacted taxable income. For example, legal fees are usually deductible if related to arranging the sale of securities. However, legal fees incurred defending ownership of securities are usually not deductible.
Legal fees incurred in defending one’s right to receive a money judgment, if successful, are also generally deductible. Legal fees incurred to defend one’s right to receive property such as a lawsuit alleging denial of child support are not usually deductible.
Generally, if the services performed by an attorney are directly related to a claim that arose out of a business, trade or profession, then the legal fees incurred in defending the claim are deductible. Contingent legal fees are included in gross income in the year received and can be deducted from the taxable income. The taxable net gain is subject to self-employment tax. However, the deduction is an itemized deduction for non-business legal fees on Schedule A. A taxpayer can deduct the full amount of deductible legal fees. In addition, a taxpayer can deduct legal fees that were previously capitalized.
It should be noted that the costs associated with filing a refund suit for a frivolous claim are not deductible. A taxpayer cannot deduct bookkeeping fees to maintain a record in response to an IRS inquiry. Legal costs related to a civil violation of the Fair Labor Standards Act are deductible even if incurred to protect a personal reputation . Legal fees incurred to protect the title to a family residence are not deductible, but legal fees incurred to protect a trust for a home are deductible.
Legal fees incurred to protect Social Security benefits are deductible because the grant of Social Security benefits could be considered taxable income. Legal fees incurred in obtaining an offer in compromise offered pursuant to an IRS request are deductible, assuming the offer is upheld because it is necessary to obtain taxable income. Legal fees are not deductible for claims of filing status, earned income credit, and child tax credit. Tax preparation fees are not deductible, but the portion allocable to business income reporting is. Legal fees to reduce the taxpayer’s personal liability are not deductible. Legal fees incurred to determine tax liability are often deductible, however, if the issue is factual the fees are not deductible. Legal fees incurred for the repayment of business loans are generally not deductible. Legal fees incurred in starting a new business do not increase basis.
Special rules apply to legal fees arising in connection with the divorce or separation of a taxpayer. Legal fees incurred to produce or collect alimony are generally deductible. A complete separation of the taxpayer and spouse must exist and deductible legal fees must be incurred only to secure alimony or to enforce alimony already awarded. Legal fees incurred to secure eligibility for child support are not deductible. Legal fees incurred in connection with a divorce to obtain a settlement property award are not deductible.
Legal fees incurred in nondeductible litigation are generally not deductible. Legal fees incurred in contesting gambling related criminal prosecutions are generally not deductible.
Requirements for Legal Fees and Expenses You Can Deduct
The IRS has some very specific criteria that the taxpayer must meet in order for legal fees to be deductible. For instance, fees that are incurred in obtaining taxable and non-taxable awards or settlements may be deductible. Other examples include attorney fees that are incurred in obtaining an award in connection with the cancellation or modification of a tax-free grant, but not in obtaining the grant itself. Fees paid for the recovery of employment discrimination damages generally are also deductible as above, however, fees paid in connection with the defense of a tax return position generally are not deductible. IRS regulations include a list of areas where such legal fees are deductible. Fees paid for:
In each of these areas, the legal fees must be related to the settlement or award that the taxpayer is receiving in order to be deductible. In other words, the fee has to be necessary to acquiring the taxable award, litigation, or proceeding.
Categories of Legal Fees and Expenses That Are Typically Deductible
Legal fees that are deductible include:
• Fees related to business expenses
• Fees related to the production of taxable income
• Fees related to the determination, collection and refund of any taxes
• Any other legal fees incurred in connection with business, production of income, taxes, etc.
Examples of deductible legal fees include those related to:
• Defending a suit based on a contract with a customer
• Formulating or validating golf club membership and initiation agreements
• Researching tax issues for the IRS
• Researching and drafting lease documents
• Protecting the ownership rights to a trademark
• Drafting contracts to help protect intellectual property rights
• Procurement and protection of patents
• Inventory appraisals (with time limits on hardwood timber)
• Contract negotiations
• Tax-free exchanges
• Arranging long-term financing for real estate or for an elevator company
• Investment recovery
• Death tax
• Inheritance tax
• Gift tax
• Gift conveyance
• Property tax
• Compromise agreement for tax liabilities
• Liability for tax imposed under a document called Quitclaim with warranties
• Filing of 706 and 709 forms (Related Interest Code 4419)
• Filing an 843 for excessive tax and additional claims form under section 6402(k) of the Internal Revenue Code of 1986 claiming recovery of amounts erroneously collected
Examples of legal fees that are not deductible include those related to:
• Own divorce
• Tax planning
• Ward of court
• Sale of partnership interests
• Sale of corporate stock
Legal Fees and Expenses That Are Not Deductible
Legal fees that are not deductible include all legal expenses associated with acquiring, producing or collecting taxable income, including: The "production of income" referred to above pertains to investments. It includes legal fees paid to collect dividends and interest. Fees incurred in connection with the classification or reclassification of a department, function or subdivision of a business as a separate "trade or business in order to obtain a deduction of losses attributable to that trade or business against income from that or other trades or businesses is also not deductible.
Documenting Legal Fees and Expenses To Deduct on Your Tax Return
To take a deduction for legal fees, the taxpayer has to be able to show that the services were related to the income being reported or were incurred in order to produce and collect taxable income. To deduct legal fees, the taxpayer must keep adequate records of the actual service performed, the date of the service, who performed it, the time involved by the person performing the service, and the amount charged.
It’s helpful to have an attorney write out a list of services performed and what the legal fees were for each as you go along . In evaluating whether you want to deduct and/or whether you can deduct the legal fees and/or costs on your return, it is helpful to have support for the amount of the fees and costs. Payment authorizations, copies of retainer agreements, copies of checks, credit card orders, and invoices should all be kept for your tax records and provided to your tax preparer. If you are realistically attempting to document legal fee activities and seek to assert thata deduction may be available, such records should be kept for at least five years.
How To Deduct Legal Fees and Expenses on Your Tax Return
Claiming legal fee deductions on your tax return requires more than a mere mention of "legal fees" on Schedule A. You must provide details in Section B of Form 1040, and report the total on line 21 of Schedule A. You generally can’t use Form 2106-EZ if you’re claiming legal fees on Schedule A.
Specific information is needed for filing, including the amount you claim as a deduction, a description of the underlying case, the date it was settled, and any amounts related to personal expenses (non-deductible). In addition, you need to provide the name and address of your attorney, their Social Security number or employer identification number, and the amounts paid to that attorney. A copy of Form 8275 or 8275-R for "Disclosure Statement" is needed if the claim is over $100,000.
If you’re granted an award by a federal court, you aren’t able to deduct legal fees except on Form 1040 Line 29 and you must attach a copy of Form 8886-A, "Disclosure Statement." And you have to be in compliance with all IRS requests for information regarding the case.
Changes to Tax Law Impacting the Deductibility of Legal Fees and Expenses
In 2017, Congress passed sweeping tax legislation that included provisions which may impact the ability of individuals and businesses to deduct legal fees for tax purposes. The new law generally suspends miscellaneous itemized deductions, which are deductions that an individual or business can take for ordinary and necessary expenses not accounted for in other parts of the tax code. Prior to 2018, these allowable deductions included the cost of legal fees incurred by an individual or business. While the impact varies depending on the nature of the case and the structure of the transactions involved, the new definition of the adjusted gross income took away the ability of certain taxpayers to claim legal fees as a miscellaneous itemized deduction on their tax returns or apply the payment against gross income to minimize overall taxable income for the year. The new rules generally only allow taxpayers to take a deduction on those fees paid to enforce a right or to obtain a refund for a wrong made against them.
A few states have also enacted similar tax law changes that may affect the deductibility of legal fees. California law currently does not provide for a cost of living adjustment like the Internal Revenue Code. However, beginning on January 1, 2019, the mandatory California Income Tax will be automatically increased annually on a yearly basis by the percentage increase of the "California Consumer Price Index" (CPI for all urban consumers) from the previous year. New York law includes a similar provision whereby annual mandatory adjustments can be made for inflation to the exclusion amount. Beginning in 2017, the New York law also allows for partial ratable recapture of the deduction beginning when the taxpayer’s New York adjusted gross income exceeds $315,000 (for married filing jointly taxpayers). However, with the recently passed tax legislation, the exclusion amount for the deduction no longer has to be applied to legal fee payments made for maintaining or defending a second residence, so it may increase the deduction available at the municipal levels.
Generally, these changes may significantly reduce the amount of deductions available to taxpayers when claiming the deduction for legal fees. For individuals who qualify as "higher-income taxpayers" at the state level, due to their relatively high income or residence state, taking these deductions generally helps to minimize their tax liability. However, the recent tax changes will further limit these deductions. The new tax laws and adjustments may also affect estate planning tools including the Gift Splitting Provision and Installment Sales by Individuals, which are dependent upon the use of the exclusion amount. Accounting for the changes to the deduction for legal fees paid as itemized deductions may require a person to rethink their options and determine if there are other more favorable methods to minimize their taxable income for the year. The advice of a seasoned accounting and tax attorney, such as Bressler, Amery & Ross, P.C., is therefore essential.
Working With a Tax Specialist
Engaging a tax professional can save taxpayers valuable time and effort when attempting to deduct legal fees on their tax returns. But even though we put our heads together and came up with step-by-step instructions, applying the law to facts is always a slippery slope. It is important to remember that an internet search will yield infinite results . It is always best to develop an individual plan of action by consulting with a tax professional. Tax laws are constantly changing and complex situations require an expert. The right professional can help you navigate the many nuances of the tax code and avoid stiff penalties for improperly taking a deduction.