Eligibility for Tax Deductibility of Attorney Fees
The general concept behind the tax deductibility of lawyer fees is straightforward: if a taxpayer incurs legal expenses in the course of carrying out their business, then the fees are generally tax deductible (subject to limitations or other provisions of law). If the legal expenses relate to acquiring or disposing of an asset or in protecting or conserving one’s wealth, they can be deducted as miscellaneous itemized deductions. In certain cases, they can be capitalized into the basis of the property being acquired or for which the deductible expense is paid.
It is worth noting that while under general tax principles, the deductible and nondeductible characterizations of business income also apply for individuals and entities. More specifically, if the income is business income, it is subject to tax; if it is capital gain, it is taxed at a lower rate; if it is a dividend, interest or royalty income it may be subject to a maximum rate of 15 percent (or 20 percent for high-income taxpayers) and receive other favorable treatment . Because the definition of what constitutes business income is not universally defined (and the applicability of different rates of tax depends on whether the assets producing those amounts are considered business assets), the characterization of deductible and nondeductible expenses are just as unclear. As a result, one should carefully analyze the character of the income when determining when fees should be deducted.
Lawyer fees are subject to other limitations for individuals. For example, if the fees are incurred during a tax year in connection with the production of taxable income or in the collection of rent, they may be deductible as an expense to the extent they exceed 2 percent of the taxpayer’s adjusted gross income (computed without the affected deductions). They may also be deductible because they "reduce" items of income, such as taxable interest or dividends that are subject to the previously mentioned favorable rates of taxation, but also subject themselves to limitations.
Legal Fees Personal vs. Business
Personal legal fees are those incurred in relation to your person as a taxpayer. Examples include services pertaining to the completion of your income tax return and other tax planning services, representation before the Internal Revenue Service (IRS), estate planning and personal injury claims.
The IRS does not allow the deduction of fees related to the management of your investments, such as fees associated with investment counsel or the purchase and sale of stock, bonds or other securities.
Business legal fees include those incurred directly in relation to the business operations. These legal fees are included in the business income, loss and expenses on the business’s information returns. The cost of incorporating a business entity, formation of a limited liability company, preparation of various contracts and litigation related to the same are some examples. It should be noted that legal fees related to the settlement of personal injury lawsuit are also considered business expenses.
Chapter 37 of the following IRS publication tends to be the first place people look: IRS Publication 535. However, many people do not understand the difference between personal legal fees and business related fees and think that they are interchangeable or that all legal fees are personal. They are not.
It is important to know that in most cases business legal fees are considered fully deductible. Personal legal fees, except for those related to income tax advice, are not.
Fees That Are Tax-Deductible When Incurred For a Business
Generally, taxpayers can deduct only those legal costs that can be considered a necessary and ordinary expense of their business. However, there is a gray area regarding which fees qualify as necessary or ordinary. For example, in 2007, a federal court limited the deduction of legal fees related to shareholder disputes because the company did not establish its "primary purpose" was its business. Thus, in order for fees to qualify as a business expense, the taxpayer must have been involved in a business at the time the cost was incurred.
Typical examples of business-related legal fees that can qualify for a deduction include: consultation costs for tax advice; defending a business against a civil claim in court; settling a civil dispute; collection of payment owed by debtors; drafting contracts; and negotiating contracts. However, other examples include costs incurred during litigation to determine whether an insurance company had to defend or indemnify a policyholder against a claim. Generally, the legal fees incurred for the defense of the policyholder would qualify for a deduction as a protection of an existing business asset, while the underlying settlement or judgment paid to the third party would not qualify. Measured against the business activity test, these activities would generally qualify as a business expense.
Attorney Fees That Aren’t Tax-Deductible for People That Aren’t Business Owners
Not all legal fees are tax deductible. Non-deductible fees include those that are paid for purely personal reasons and that are not related to your income-generating efforts. Personal divorce fees paid to dissolve a marriage are an example of non-deductible legal fees. As another example, if you are injured in a car accident, the money you pay to your lawyer for assistance with the personal injury lawsuit is not a deductible legal expense. Some personal legal fees are deductible, however. If you need legal assistance that directly relates to your business or employment, the fees paid in connection with that assistance are generally 100 percent deductible.
Examples of Legal Fees That Are Eligible For Deduction
There are some specific situations where personal legal fees may be deductible. A notable example is where legal fees are incurred to produce taxable income, such as a fee for a tax attorney in a tax audit, court proceeding, or collection proceeding. Similarly, legal fees paid to collect taxable alimony, or wage garnishments , may be deductible.
You may deduct legal fees that are connected to a divorce where a lump sum payment from one spouse to another has been allowed to be included as taxable income to the receiving spouse. If all or part of a divorce settlement agreement provides that the taxpayer obtaining tax-free alimony is not to be charged with federal taxes on the amount received, the amount paid is tax deductible.
If you are establishing a name change in a court proceeding, you can deduct the legal services because the fee is incurred to produce taxable income. However, you cannot deduct legal fees related to a name or gender change if you do not expect to receive taxable income as a result.
How to Claim Legal Fees on Tax Returns
If you’ve incurred legal fees that you think may be tax deductible, read on. You may be able to claim a deduction for some fees in your current-year tax return, but only if they meet certain criteria. You must claim deductible legal fees as an itemized deduction on Schedule A of the Form 1040 you file. These fees are generally claimed in the year you paid them.
Some legal fees are deductible, but the IRS doesn’t allow a blanket deduction for all fees you’ve incurred in connection with a lawsuit or other legal proceeding. Some types of deductible fees include amounts you paid: (1) for certain attorneys’ fees and court costs in discrimination (e.g., Employment and housing discrimination) actions, (2) to qualify for and obtain taxable damages, and (3) to obtain taxable awards in excess of damages, such as punitive damages.
Undeductible fees include those incurred for: In addition, fees you pay that aren’t for a qualified purpose or don’t produce a deductible recovery are also nondeductible. An example might be legal fees you pay to collect on a debt or damages awarded to have a contract enforced. As indicated above, fees you pay for nondeductible damages (e.g., personal injury damages) — such as the contingent fee paid to your attorney — aren’t deductible.
Common Mistakes Surrounding Legal Fee Deductions
Taxpayers often make basic mistakes when deducting legal fees. Here are the typical errors you should try to avoid:
Mistake #1 — Not keeping thorough documentation.
The taxpayer must keep well-organized records showing the amount of each legal fee and the type of legal service or activity provided.
Mistake #2 — Not identifying nondeductible legal fees.
It’s important that you separate deductible legal fees from other nondeductible fees, such as those related to tax planning, personal matters (other than divorce or legal separation) and nondeductible production of income.
Mistake #3 — Overlooking qualified legal fees paid for another person.
Couples may deduct legal fees paid in connection with a divorce or legal separation if the spouse receiving the deduction was entitled under state law to the benefit from the deductibility. Taxpayers also should be aware that the deductible spouse can’t deduct legal fees paid for the non-deductible spouse.
Mistake #4 — Failing to comply with the 2 percent AGI floor.
Legal fees are subject to the 2 percent floor for miscellaneous itemized deductions. This means that only the portion of qualified legal fees paid during the year exceeding 2 percent of the taxpayer’s adjusted gross income (AGI) is deductible in the current year. The remainder is carried forward to the next tax year.
Specific Uses of a Professional to Provide Tax Advice
Before making any major tax decisions regarding your lawyer fees, it is a really good idea to consult a professional tax adviser or accountant that can help to determine the best course of action for your taxes, and to ensure that you get the most out of any deduction you are entitled to. A tax professional or accountant has the expertise and understanding to help guide you through potential pitfalls, while a lot of what can easily become ambiguous information when it comes to other resources. For example, solicitors, etc., may be in the best position to advise you regarding the legal nature of your payments, however, they may not have the same level of knowledge when it comes to taxes and how to deal with a deduction .
There may be some variations across the country, and a tax professional may be able to help you navigate any additional steps you need to take based on where you are located, as well as any additional deductions you may be entitled to. Lawyers may charge different fees for different types of work, and this can lead to some grey areas when it comes to receipt keeping and tax deduction. A professional can help you to ensure that you have everything you need in order to ensure that you take advantage of any savings you may be entitled to through deductible lawyer fees.
In short, a professional can help you wade through the muddy waters of what is and isn’t deductible, or let you know if there is anything else you may have missed.