Often the question comes up are legal fees deductible? The answer to that question can be both yes and no. It’s complicated and depends on the nature of the legal expense. This two part blog will discuss:
- Legal Fees Associated With Personal, Living, or Family Issues
- Legal Fees Associated With Business and the Production of Taxable Income
- Examples of Legal Fees and Their Deductibility
- The Tax Benefit of Legal Fee Deductions
- What does the Internal Revenue Code say About Legal Fees?
The Internal Revenue Code (IRC) is the body of tax laws written by the United States (U.S.) Congress and approved by the president in office at the time the law is created. The IRC tells us that except as otherwise expressly provided, such as itemized deductions, no deduction shall be allowed for personal, living, or family expenses. The IRC also says that, in the case of an individual, deductions are allowed for all of the ordinary and necessary expenses paid or incurred during the taxable year:
- For the production or collection of taxable income;
- For the management, conservation, or maintenance of property held for the production of income; or
- In connection with the determination, collection, or refund of any tax.
IRC Provisions for Legal Fees
Applying those IRC provisions will allow you to determine whether a legal expense you have incurred is deductible or not. The application can sometimes be complicated. It must take into account the Internal Revenue Service’s (IRS’s) interpretation of the law through rulings and regulations as well as the courts’ opinions on all of the above. Here are some situations that may involve legal expenses to be paid and how they should be handled:
Divorce – Legal costs, such as attorney fees and court costs, connected with divorce, separation, or support are non-deductible personal expenses. Non-deductible extends to legal fees incurred in disputes over money claims. However, legal and accounting fees paid for tax advice in connection with the divorce are deductible. This is provided the amounts for those services are clearly marked on the legal firm’s billings.
Taxable Alimony – The part of legal fees that qualify as producing taxable alimony is deductible by the person who receives the alimony. The attorney’s statement or invoice should stipulate what part of the fee relates to alimony. This ensures a deduction for the alimony recipient. Legal fees paid by the payer of the alimony are not deductible. Because child support payments are not taxable, fees paid to get those payments are not deductible.
Damages for Personal Injury or Sickness – In some cases, damages for personal injury or sickness can be excluded from income. Thus, the legal fees paid to secure such income are not deductible if the damage award is not taxable. However, to the extent that the damage award is taxable or accrued interest is paid on the settlement funds, the legal fees are deductible. Where the funds are partially taxable and partially excludable, the legal expenses have to be prorated in the same ratio as the income is.
Relating to Insurance Proceeds – Legal fees to collect on a claim related to a taxpayer’s business are currently deductible. Legal fees related to a personal loss are not deductible. However, where a loss is associated with a capital asset, such as a taxpayer’s personal home, the related expenses can be added to the home’s tax basis. This means that they can be used to offset any taxable gain in the future.
Producing or Collecting Taxable Income – Attorney fees, court costs, and similar expenses are deductible if incurred during the production or collection of taxable income. A reasonably close connection must exist between the legal expense and the production or collection of the taxable income.
Will and Trust Document Preparation – The cost of legal fees for preparing a will is considered a personal expense that is not deductible. In most cases, the legal cost of creating a living trust is similarly treated as a personal, nondeductible expense. However, if the attorney who prepares the trust on the billing statement the amount of the fee that is for tax planning or tax advice, the tax-related portion of the fee is deductible.
In our next blog, Part 2, we will talk about more business-related issues with debt. In the meanwhile, if you have any questions, you can call Alex Franch, BS EA at 781-849-7200.