Article: When and How to Deduct Legal Fees

March 2005

When and how to deduct legal fees

Whether personal (and even some business) legal costs are deductible depends largely on the circumstances surrounding the need for legal services

Sooner or later, you are likely to need the services of an attorney, and shortly thereafter you will incur legal fees. Being able to deduct that expense from your taxable income can help alleviate the pain, but whether a current deduction is in the cards depends on the circumstances.

In theory, the federal income tax treatment of legal expenses is fairly simple. In many situations, the charges will fall rather neatly into one of the four categories listed below, with the indicated tax outcomes. Then again, sometimes it’s not so easy.

Fees related to income, taxes or business. Legal fees paid by an individual to produce or collect income or to manage, protect or maintain income-producing assets can generally be written off as miscellaneous itemized deductions on Form 1040 Schedule A. For example, this rule covers hiring an attorney to collect spousal maintenance owed by an ex-spouse or to resolve a dispute regarding how much interest is due on an installment note receivable. That’s the good news.

The bad news is you cannot deduct legal fees connected with the production or collection of income not subject to the federal income tax or for the management, protection, or maintenance of assets producing that non-taxable income. Likewise, you cannot deduct legal expenses for the management, protection or maintenance of a personal residence.

Tax services. Individuals are entitled to deduct legal expenses for tax advice, tax calculations, return preparation, contesting tax assessments, or claiming refunds. This is true for taxes levied by any and all jurisdictions and for any and all types of taxes (income, estate, gift, property, sales, use, etc.)

Unfortunately, the deductible legal expenses described in the preceding paragraphs generate a tax benefit only if, when they are combined with your other miscellaneous itemized deductions, they exceed 2% of your adjusted gross income (AGI). And if you are subject to the alternative minimum tax (AMT), miscellaneous itemized deductions do you no good because they are completely disallowed in calculating your AMT bill.

Business purposes. Legal expenses are fully deductible – for both regular tax and AMT purposes – if they are “ordinary and necessary” in the conduct of your business. “Ordinary” in this context means something that can be expected to happen in your line of business from time to time. It need not be something that happens with great regularity.

Naturally, there are exceptions to the current deductibility rule for business legal expenses. If the costs are incurred to enter a new line of business, you may have to “capitalize” the expenses (along with other startup costs) and amortize them over 60 months. For example, the capitalization rule applies to legal due diligence work performed in connection with acquiring the assets of a target business. However, if you are merely expanding your existing business, you should be able to deduct legal due diligence expenses currently as garden-variety business expenses.

Capitalization is also required for legal charges necessary to set up a new business entity like a corporation, LLC or family limited partnership. Such “organizational” expenses can then be amortized over 60 months.

Finally, legal costs incurred in connection with arranging debt-financing for your business must be capitalized and amortized over the life of the loan to which they relate.

Fees related to personal matters. Legal fees incurred in connection with personal matters should generally be presumed to be nondeductible, subject to exceptions discussed below. For example, you can’t deduct the cost of hiring an attorney to fight a traffic ticket, defend you against a lawsuit, or represent you in a divorce proceeding. The same goes for the cost of preparing a will or establishing a trust for you or another person.

Exceptions. As we discussed earlier, tax-related fees, fees to generate or collect income, and fees to manage, protect or maintain income-producing assets generally qualify as miscellaneous itemized deductions.

While the fees paid to, for example, a divorce attorney would be a nondeductible expense, the portion of his fees that pertain to taxation, business property, etc., would probably be deductible.
In drafting your will, your attorney will likely give you estate and other tax planning advice. As in the preceding example, the tax advice portion of the bill should be deductible.

January 2005 U.S. Supreme Court rulings in Commissioner v. Banks and Commissioner v. Banaitis affect the deductibility of contingent legal fees as a percentage of a taxable settlement or jury award that you receive. Those rulings requires you to (a) declare as income the gross taxable settlement or award, and (b) include the contingent attorney fees in your miscellaneous itemized deductions.

Fees related to asset purchase or sale. Legal costs to acquire an asset are not currently deductible. Instead, they are capitalized as part of the asset’s tax basis. The same is true for legal costs to prepare ownership documents. When you later sell the asset, the taxable gain will be reduced (or your loss increased) by those capitalized fees. If the asset in question is depreciable or amortizable, the capitalized fees are depreciated or amortized along with the rest of the acquisition cost. However, if the asset is not depreciated or amortized and you end up leaving it to your heirs, the additional basis “falls through the cracks.” This is because an heir’s basis is adjusted to reflect the asset’s date-of-death fair market value. Legal fees to sell an asset are considered part of the selling expenses and should be added to the basis of the asset being sold, which reduces the gain (or increases the loss) on the sale.

Based in Mesa, Arizona, and serving closely held businesses in the East Valley, the Phoenix area and throughout Arizona, Schmidt Westergard & Company, PLLC, is an independent full-service tax, audit, accounting and business advisory firm focusing on the middle market.