Evaluating the Tax Impact of Legal Fees
As part of the cost-benefit analysis for deciding whether to proceed with a legal matter or settle a legal matter, the potential tax treatment of legal fees should be considered.
Unfortunately, there is no one provision in the Internal Revenue Code (“IRC”) that describes the treatment of legal fees in different situations. Rather, taxpayers must consult a case law and an assortment of general IRC sections.
Whether legal fees will be fully deductible, partially deductible, capitalizable or nondeductible for tax purposes depends upon the particular facts and circumstances in which they are being incurred. Legal fees incurred in connection with the conduct of a trade or business may be deductible or capitalizable, depending on the context. Legal fees arising solely from personal or family matters are generally nondeductible.
Legal fees incurred in connection with the conduct of a trade or business may be deductible or capitalizable, depending on the context. Legal fees arising solely from personal or family matters are generally nondeductible.For example, legal fees related to the personal aspects of divorce proceedings, tort claims, contract claims or criminal matters are not deductible. However, if there is a substantial relationship to the taxpayer’s trade or business or other income producing activity such legal fees may be fully or partially deductible.
The Supreme Court ruled in United States v. Gilmore that the treatment of legal fees depends on the “origin of the claim.” This “origin of claim” test looks to the kind of transaction or event that caused the legal fees to be incurred. The test ignored the consequences of the legal matter. If the origin of claim is personal it is nondeductible even if the results of the legal matter could adversely impact a business or investment activity.
IRC Sec. 162 provides a deduction for “ordinary and necessary” business expenses, such as legal fees, that are incurred in carrying on a trade or business. In order to qualify as part of a trade or business, the legal fees must have originated in the conduct of the taxpayer’s business activity. If legal fees are directly connected with and result from a business activity carried on other than as an employee, then an individual will generally receive a deduction in calculating adjusted gross income (“AGI”), also known as an “above the line” deduction. Such deductions are fully deductible against taxable income.
If the claim relates to a trade or business carried on as an employee, then the legal fees are deductible as a miscellaneous itemized deduction “below the line”. Below the line deductions are less favorable because IRC Sec. 67 limits the deduction to the amount that exceeds two percent of AGI. Even worse, if the taxpayer is subject to the alternative minimum tax, a miscellaneous itemized deduction provides no tax benefit.
When legal fees directly relate to income producing activities that are not trade or business expenses, such as investing, IRC Sec. 212 provides again that the deduction is below the line as a miscellaneous itemized deduction, subject to the two percent of AGI limitation and complete disallowance if the taxpayer is subject to AMT. On the other hand, if the legal fees have their origin in defending or perfecting title to property or in a capital transaction, they will be capitalizable IRC Sec. 263(a) and may be amortizable or reduce gain from sale of the related asset.
Determining the treatment of legal fees is sometimes difficult since many legal matters have more than one origin. Sometimes allocations are appropriate or weighing and balancing is necessary. Often the proper treatment is not clear cut. Since legal fees can add up quickly, before proceeding with a legal matter, consult your tax advisor on the tax treatment of legal costs.