The Deductibility of Legal Expenses
In certain cases Internal Revenue Code allows for the deduction of legal fees on an individual tax return through Schedules A, C, or E and in other cases on Schedule D.
Where the legal fees are deducted on the return is determined by the source of the claim that gives rise to the legal fees at issue. Legal fees associated with the production of income, including wages, or relating to charitable contributions, are deducted on Schedule A. Fees that are connected to a taxpayer’s trade or business, rental, or royalty activity may be deducted on either Schedule C (sole proprietorship) or Schedule E. Finally, fees that are connected with capital expenditures or property are capitalized and reported on Schedule D as an increase in the property’s basis when the property is sold.
Schedule A (Production of Income)
Legal expenses are deductible on Schedule A of an individual’s income tax return when they are associated with the production or collection of income; 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. These expenses are classified as miscellaneous itemized deductions and subject to both the 2% and 3% limitations. In addition, these legal fees are also add-backs for Alternative Minimum Tax purposes.
Expenses related to estate planning may be deducted on Schedule A. However, estate planning is generally not solely concerned with tax matters. The portion of the fees that are allocable to tax planning should be separated from the portion allocable to other estate planning work and only the portion related to tax advice can be properly deducted on Schedule A.
The origin of the claim with respect to the expense determines whether or not it is related to the production of income. For example, legal fees associated with a property settlement in a divorce or separation proceeding are generally not deductible under the origin-of-the-claim rule because they arise from a personal matter even though they may affect income-producing property. However, legal fees incurred in order to collect or recover taxable income, such as alimony, are deductible.
Schedule A (Charitable Contributions)
Legal fees incurred in a transaction related to a charitable contribution, such as structuring of a gift to a charitable land trust, may be deductible as charitable contributions. However, it is a complex determination that must be studied carefully. For example, if the taxpayer directly pays the Land Trust’s legal fees associated with the transfer, the fees are deductible as a charitable contribution. However, if the taxpayer incurs personal legal fees associated with this transfer, the most likely result would be that the fees would be deductible as miscellaneous itemized deductions rather than charitable deductions on Schedule A.
Schedule C (Trade or Business Expense)
Legal expenses are deductible on Schedule C when they are:
- Ordinary;
- Necessary;
- Paid by the taxpayer during the tax year;
- Incurred as part of the taxpayer’s trade or business;
- Connected with or a proximate result from that trade or business.
Schedule E Deduction (Rental and Royalty Expenses, Unreimbursed Partnership and S-Corporation Expenses and Trade or Business expenses in Limited Circumstances)
A taxpayer who reports rental or royalty income on Schedule E, Part I, or Partnership or S corporation income on Schedule E, Part II for Partnerships or S corporations in which he or she actively participates will likewise deduct unreimbursed legal expenses incurred through these activities on Schedule E. Note, however, that in certain cases legal expenses related to property must be capitalized and added to the property’s basis, as discussed later.
If a taxpayer is a limited partner in a partnership with no involvement in the management of the partnership, any unreimbursed legal expenses incurred by the partner must be deducted on Schedule A instead of Schedule E. According to IRS the limited partners in a partnership are primarily investors, thus not involved in a trade or business. Ultimately the taxpayer’s involvement in the partnerships operations and management must be analyzed in determining if it rises to the level of participation that would allow for a deduction on Schedule E.
Schedule D Capitalization (Capital Expenditures)
Legal expenses that are incurred defending or perfecting title to capital property, in acquisition or disposition of capital property, or in developing or improving capital property are not expenses that are deductible, and must be capitalized instead. These expenses are added to basis and taken into account for tax purposes either through depreciation or by reducing capital gain (or increasing capital loss) when the property is sold. In cases where litigation involves the defense, acquisition, disposition, or improvement of capital property, the origin of the claim, not the taxpayer’s primary purpose in litigating is the prevailing test to determine whether fees can be deducted or capitalized.
Conclusion
There are many different scenarios where taxpayers may incur legal expenses. Careful consideration must be given to the facts and circumstances surrounding any scenario that involves litigation or legal advice and how to determine if and when those expenses may be deductible.
