Legal Fees Can Be Tax-Deductible Under Certain Circumstances
Generally, legal fees that you incur with respect to a trade or business or for the production or collection of income are deductible. The legal fees need not be paid to retain counsel, and taxpayers sometimes have a financial obligation for services performed long before the current year. Nevertheless, so long as the original transaction occurred within the applicable period, legal fees are generally still deductible.
Deductible legal fees include those incurred to:
• Acquire income-producing property;
• Defend or establish title to property;
• Defend or establish a protected interest in income-producing property;
• Defend against governmental action with respect to income-producing property
Ordinarily, legal fees paid to defend your property interest following an event that generates ordinary income are deductible as ordinary and necessary business expenses . For example, legal fees incurred to audit your business and defend claims by the Internal Revenue Service are typically deductible. Also, legal fees incurred to successfully challenge an excise tax are ordinarily deductible.
Non-deductible legal fees include fees incurred to defend, create, or obtain funding for a specific hedge fund. Legal fees incurred to order to establish a new real estate venture are not deductible. Legal fees incurred to defend against potential punitive damages are not deductible. Fees incurred for personal legal matters, such as a divorce, typically do not qualify for a tax deduction. Legal fees incurred to obtain or increase specific pension/retirement benefits generally are not deductible. Likewise, legal fees incurred to represent collection agencies, debtors, and creditors are not deductible.
How Attorney Fees Can be Deductible
In order for the IRS to allow a deduction to be claimed on your taxes for legal fees, there are certain criteria that have to be met. First, the legal fees must be considered ordinary and necessary for conducting your business. Within these requirements, there tends to be some confusion regarding ordinary and necessary, since these concepts are highly fact-driven. A necessity for one type of business (i.e. leasing an office) may not be a necessity for another type of business (i.e. working out of your home). An ordinary expense would be one that is common and customary for your industry, while a necessary expense may not be common or frequent but are appropriate in the specific circumstances for you to continue conducting business. As there is no bright-line test for necessary, it is up to the IRS to make a determination if a specific legal expense would be considered necessary. A good rule of thumb to follow is: if you can easily come to a consensus with your colleagues that the expense is necessary for the operation of your business, then it likely will be considered necessary by the IRS.
In addition to ordinary and necessary, for legal fees to be deductible, the claim must have originated in the business (or trade or practice). For example, legal fees related to a lawsuit brought against the business (i.e. defaulted loan) would be deductible. Whereas, legal fees incurred merely as a result of an individual being a shareholder or director of a company would not be deductible.
Legal Fees and Business Matters
The taxing statutes allow a deduction to be claimed where fees have been paid or payable to barristers or solicitors in the course of a business, where they are "defending and maintaining or setting up or defending, including determining, an interest in or right over property". This includes any cases where the outcome is likely to lead to a gain or loss and where the legal fees are "wholly and necessarily" incurred. As noted above, the statutory regime has changed, and therefore there may now be additional costs, including VAT, that can be recovered. However, one can expect that HMRC will still seek to argue that fees which arose when the individual was actually defending or maintaining such an interest would, if related, with the litigation giving rise to where it could be claimed from public funds, be disallowable. It would also be argued that costs incurred defending such a claim (an ownership situation, for example) should be denied where that defence fails.
For example, the costs of defending a land property from claims by trespassers, unlawful occupiers (or squatters) or police seizures are generally deductible, as would advice with regard to dealing with such matters. However, claims defending ownership to property (except contracts for service) are generally not prima facie allowable. Costs incurred for the enforcement of judgments (where the principal purpose was to protect or recover such an interest, subject to VAT considerations and incurring circumstances) are allowable.
Legal Fees Relating to Personal Matters
There are still certain specific personal matters in which legal fees may be tax deductible. One of these areas concerns legal fees connected with the generation of taxable income. If you incurred these types of legal expenses, you should include the amount in Miscellaneous Itemized Deduction on Schedule A. For example, if you were involved in the sale of a business or stock, you can deduct that legal fee as a Miscellaneous Itemized Deduction. If you received legal advice regarding tax planning concerns, you may also deduct the amount paid to the attorneys.
Legal Fees That Can’t be Deducted
There are some types of legal fees which you cannot deduct. These can include fees incurred to: An individual taxpayer may not deduct legal fees related to divorce cases, such as obtaining a decree of separation or dissolution of marriage (divorce) or securing a support order or an award of alimony to a former spouse . An individual taxpayer may not deduct legal fees related to fines or penalties (including interest and expenses related to changes in the law). An individual taxpayer may not deduct legal fees related to miscellaneous items subject to the adjusted gross income limitation equal to the sum of some of the more common deductions listed on the Schedule A Form, such as: An exception to this rule is legal fees incurred for tax advice or tax collection matters.
How to Claim Legal Fees as Itemized Deductions
The procedure for reporting and deducting this expense on the legal fee paid on your tax returns is straight-forward. If you have no other attorney fees, you need only to report the amounts paid on the Schedule A to the IRS Form 1040, under the following categories:
"Other Unreimbursed Employee Expenses" Unreimbursed employee expenses (aka non-deductible). This category of expenses is subject to the 2% of adjusted gross income floor. In other words, you cannot offset these expenses unless the total amount of your Schedule A itemized deductions exceeds the total of certain items added together and after those expenses fall below 2% of your adjusted gross income. Although this deduction is still found on IRS Form 2106-EZ, people with complicated deductions should avoid this form, especially if they have moved during a calendar year.
"Miscellaneous Deduction" These deduction falls into the miscellaneous deductions category, subject to a 2% floor. Unlike unreimbursed employee expenses, miscellaneous deductions are allowed only to a person who derives a substantial portion of his or her income from the performance of services as an employee. To determine whether or not the performance of services was a "substantial portion", you should analyze the following factors:
"Unreimbursed employee expenses" can include attorney’s fees paid by an employee on his or her own behalf; for example in a case of wrongful termination or discrimination claims. The above examples are not exhaustive and other kinds of cases can be included in this category of deductions. As a consequence, there may be instances where you would qualify as an employee entitled to deduct legal fees as unreimbursed employee expenses even if your employer does not directly control your hours and the manner in which you do your work.
Keep in mind that although the 2% floor only applies to unreimbursed employee expenses, the deduction for attorneys’ fees paid in connection with a trade or business is subject to a separate dollar limit ($20,000), as described immediately above.
Make sure to keep copies of all statements and invoice submitted by your attorney or retained by your employer. In addition, you should keep copies of your legal bills reflecting the payment authorizations you provided to your employer for payment of the legal fees. If possible, information copies of your payment authorization should be sent to you as well, to further document that the amount of your legal fees were properly deducted.
Seeking Professional Assistance
Consulting with a tax professional to correctly assess and report any legal fees is an important step that helps ensure compliance with the law, and may also lead to deductions that otherwise would not be available. While many taxpayers have different levels of comfort when handling their own taxes , hiring a detail-oriented professional with extensive knowledge of tax law generally results in the safely maximized and correctly classified deduction of legal fees.