Understanding Individual Legal Fees Tax Deductibility

Legal Fees & Tax Deductions: An Introduction

Legal fees are expenses paid to lawyers for legal representation on particular cases. They come in a number of categories, including consultations, trial preparation, hearing representation and general advice. Individuals seeking legal advice or representation may wonder whether the fees paid are tax deductible or whether they can be used for anything else. In some cases, legal fees may be deductible when buying or selling a home, starting a business, inheriting property or dealing with any other property that necessitates legal assistance.
Deductible legal fees include those paid to a professional such as an attorney, accountant or appraiser. Legal fees incurred to secure taxable income may be deductible , but nondeductible fees paid to secure nontaxable income are not. When the primary purpose of legal fees falls into the realm of profit-seeking, the fees are generally deductible if paid to a professional who is unrelated to the property in question. A prime example of this would be a legal fee for a will. Legal fees incurred to obtain tax advice, however, generally are not deductible.
Specific legal fees that may be deductible include fees incurred to acquire, produce or collect taxable income. Examples of these types of fees include fees related to patent and copyright protection, tax advice, and business and investment activities. Legal fees incurred to collect alimony or business income may also be deductible.

What Legal Fees May Be Deductible?

The criteria that must be met in order for the Internal Revenue Service or other applicable tax authority to permit the tax deduction of legal fees on the return of an individual can vary somewhat from jurisdiction to jurisdiction. The following discussion is based on Internal Revenue Code Section 212, IRS Notices and court decisions that apply Federal tax law. A taxpayer should also verify the applicability of the entire Federal Internal Revenue Code to his or her particular situation, and then confirm with regard to similar provisions of the laws of the State or States in which he or she is subject to taxation. Many states do not automatically accept as deductible for state income tax purposes a legal expense that has been deducted for Federal income tax purposes, so this should also be checked. IRS Regulations section 1.212-1 sets forth the general rule, that "properly allocable items of expense attributable to the production or collection of gross income of a type described in section 212, or for the management, conservation, or maintenance of property held for the production of such income" may be treated as miscellaneous itemized deductions. The term "the type of income or gain referred to in section 212 which must be recognized under the method of accounting used by the taxpayer" is used in the regulations to describe a category of income that may be subject to tax and therefore eligible expenses may be deducted, while non-taxable income does not appear to be intended to qualify as allowable expense deduction for the taxpayer. The following categories of expenses are specifically described as deductible: An important distinction to the above is that the legal expenses typically associated with the purchase of real property ownership, are generally a nondeductible capital expenditure. However, the subsequent expenses of compliance with the laws and regulations pertinent to the ongoing use of the real property are deductible.

What Legal Fees Are Not Deductible?

If a fee is being incurred to pursue a personal claim or to proceed with a criminal case, the likelihood is that the fees are not tax-deductible. In this regard, Internal Revenue Code section 262 generally disallows a tax deduction for any expenses incurred "in carrying on a trade or business not connected with a trade or business" or for any expenses "that are personal, living, or family expenses."
For example, an Individual may pay legal fees to investigate a possible claim for a 10-year-old injury. If any taxes were payable upon a successful recovery, it is unlikely that the fees would be tax deductible.
Another individual may pay legal fees for a divorce action. Clearly, payments of such fees are not deductible, since such fees will not lead to a recovery that is subject to tax.
An Individual may pay legal fees to a bankruptcy attorney for the defense of his or her discharge. Such fees have no potential to result in a recovery and are, therefore, not deductible.
Additionally, legal fees incurred in a criminal matter generally are not tax deductible.

Specific Legal Fees that May Be Deductible

However, the Tax Court has carved out an exception to the general rule which allows an individual to deduct legal fees incurred for services rendered in connection with the collection of income. Specifically, "expenses that protect or produce taxable income are not personal in nature [and] may be deducted." Anita Zollo v. Commissioner, T.C. Memo 2010-205. In Zollo, the taxpayer was allowed to deduct fees paid to attorneys who advised her about an employment contract she entered into in connection with the sale of her corporation to protect her self-employment income from taxation as ordinary wage income. According to the Tax Court, the payments were deductible because they "were directly connected to the production of taxable income."
Similarly, in an earlier case, the Tax Court ruled that legal fees incurred by a former CEO to challenge an IRS levy against his former employer were deductible. The Tax Court pointed out that Mr. Alm had a contingent right to payment of funds from his former employer in order to recover his wages and therefore "[b]oth taxable and non-taxable funds were at risk during [his] effort to assist the company to obtain a refund of its tax payments . . . [I]t was uncertain whether the refunds would ever be received." Alm v. Commissioner, T.C. Memo 1991-389.
Thus, fees paid for advice about an employment contract or challenging other tax matters may be deductible.

Effect of the Tax Cuts and Jobs Act on Legal Fee Deductions

The Tax Cuts and Jobs Act made significant changes to the manner in which individual taxpayers may treat the legal fees as deductions. The changes especially impact the deductibility of fees paid for the acquisition of income, as well as the deductibility of legal fees paid in connection with tax return preparation and estate tax matters. Following are several important points one should know regarding the deductibility of legal fees for individuals under the Tax Cuts and Jobs Act:

Section 212 Expenses. Prior to the enactment of the Tax Cuts and Jobs Act, individuals could deduct certain legal fees as miscellaneous itemized deductions on Schedule A of IRS Form 1040 under "Expenses Paid to Acquire or Produce Income." This deduction was generally available for any legal fees that (1) were incurred for the production of income, (2) were not related to a "trade or business" and (3) were not incurred in connection with a production of real or passive property. After the enactment of the Tax Cuts and Jobs Act, Section 212 expenses paid or incurred in 2018 through 2025 are no longer deductible. Section 212 expenses incurred after 2025 are lickely also nondeductible, unless the taxpayer can fit them into one of the limited exceptions to the general rule.
Fees Relating to the Determination, Collection, or Refund of Any Tax. Similarly, before the Tax Cuts and Jobs Act, individuals were able to deduct expenses paid "for the production or collection of income" which were not deducted elsewhere in the individual’s return. These "Section 212 deductions" included, among other things, legal fees paid to contest an IRS penalty or for professional help in preparing an individual’s tax return . Section 212 expenses incurred in 2017 are still deductible as miscellaneous itemized deductions. However, Section 224 of the Tax Cuts and Jobs Act eliminated the deductibility of such fees.
Affordable Care Act "Cadillac Tax." Individuals were also able to deduct legal fees connected to the Affordable Care Act ("ACA"). The ACA imposed an excise tax on high-cost employer-sponsored health coverage, commonly referred to as "Cadillac Plans." In general, an applicable large employer (generally, companies with 50 or more full-time equivalent employees) must pay a $10,200 annual excise tax for employees (including former employees) covered by a Cadillac Plan. The excise tax is $27,500 for retired and former employees. An individual could deduct legal or consulting fees incurred in connection with the administration and compliance with the excise tax. As with other Section 212 expenses, these deductions for years occurring 2018-2025 are no longer permissible.
Uncertain Deductions. It is uncertain whether Section 212 deductions paid after 2025 are still permissible, or if Section 275(a)(6) will stay in effect indefinitely. Section 275(a)(6) indicates that "no deduction shall be allowed for expenses for or in connection with the determination, collection or refund of any tax." Although 274(a)(6) does not explicitly refer to Section 212 expenses, together with the intended purpose of the repeal of Section 212 as outlined by the House Committee on Ways and Means, there is a good argument to say that the expenses were no longer deductible moving forward.

How to Claim a Legal Fee Deduction

The process for claiming such a deduction involves:
A. Determining the various heads of tax against which the deduction is claimed
B. Completing a tax return or notification of liability disclosing details of the head(s) of tax against which the deduction would be made
C. Preparing and retaining associated documentation
D. Ensuring submission of the return or notification of liability is timely
(A) Heads of Tax
Such a deduction would be claimed against tax liabilities arising from one of the following events:
(i) an assessment of income tax relating to the immediate prior year
(ii) payment of amounts pursuant to a notice of assessment, amended assessment or amended notice of assessment relating to the immediate prior year
(iii) payment of an amount pursuant to a private ruling relating to current year income tax (to the extent the ruling was paid for a year in which a claim for legal fees could be claimed)
(iv) payment of an amount pursuant to an amended private ruling that was applied for in the current year and received prior to 30 June in a prior year (to the extent the ruling was paid for a year in which a claim for legal fees could be claimed)
(v) payment of an amount pursuant to a determination covering current year income tax (to the extent the determination covers a year in which a claim for legal fees could be claimed)
(vi) payment of an amount pursuant to an amended determination covering current year income tax (to the extent the determination covers a year in which a claim for legal fees could be claimed)
(B) Tax Returns
Taxpayers must complete the prescribed form or document (such as a notification of liability) disclosing details of the head(s) of tax against which the deduction would be claimed.
If the legal fees relate to an innocuous event such as a cancellation of an ABN, making or amending an BAS or applying for a private ruling etc., the deduction would be claimed in the next income tax return or notification of liability that is submitted.
(C) Supporting Documents
Supporting documents may include:

Invoices for payment of the legal fees received from the Entity.
Internal records evidencing authorisation of payment of the legal fees and the purpose of the payment.
Documentation establishing there was a nexus between the deduction of the legal fees and taxation.

(D) Timing of lodgement
Care needs to be taken regarding timely lodgement of the above mentioned return or notification of liability. If lodged outside of the time period, late lodgement penalties may be imposed and the tax offsets that are relevant to the legal fees may be lost.

Seek Expert Help from a Tax Professional

In order to determine the extent to which legal fees in any given tax year qualify for deduction, and to inform the scope of other related taxation obligations, individuals are best advised to consult with a tax professional as early as possible into their accounting period. A qualified professional will be able to counsel you on the nuances of tax law and the best course of action to take with respect to declared issues or concerns.

Conclusion

In conclusion, determining whether legal fees are tax deductible is a fact-specific issue that can be explored with the help of your legal counsel. At a minimum, you should understand the types of legal fees that may reduce your income tax liability, including 1) legal fees incurred in the course of a lawsuit , 2) legal fees incurred to collect alimony or child support and 3) certain expenses incurred in creating and protecting intellectual property rights. Moreover, you should keep in mind that if you paid legal fees on behalf of any of your employees, directors or officers, those individuals may also be able to deduct the amount of their share of such payments from their personal income tax returns.