Legal Expenses Explained
Legal expenses generally are the costs incurred to facilitate a legal process that could include the production of bonds, rents, securities or similar assessments. Legal expenses can also be incurred for the protection of intangible property rights, the prosecution or defense of an action on debt (for example, contracts, notes, bonds, etc.), loss in value of property, or cost of obtaining favorable accounting treatment for particular transactions. These expenses, by subject, can be broken down into several categories.
Fees to Attorneys. For income tax purposes, amounts paid to attorneys are out-of-pocket business costs that can be deducted as ordinary and necessary business expenses. These costs frequently include:
Generally, these fees are fully deductible as ordinary and necessary business expenses and there is no legal limit on the amount that can be deducted during the current year. Exceptions would include capital expenditures and acquisition costs and amounts paid to successfully acquire or obtain a loan.
Tax Advice. Legal fees incurred in the production of income that are unrelated to property acquisition are deductible. In addition to the deduction of legal fees which directly relate to specific business transactions , legal fees incurred in the ordinary and necessary conduct of a trade or business such as business liability and product liability insurance often are deductible.
Fees incurred to obtain tax advice and return preparation assistance are also deductible. Expenses here may cover fees incurred to determine the correctness of previously filed returns, fees incurred to restructure a business to minimize annual income or estate tax burdens and fees incurred to determine tax treatment and treatment of business transactions.
Court Costs. Expenses incurred to litigate or defend civil proceedings that result in a change or shift of economic benefit are generally deductible as business expenses. Costs to appear before an administrative agency (such as the Patent Trade Mark Office or the U.S. International Trade Commission) also are deductible in these circumstances.
Fees for Legislation and Regulation Guidance. The costs incurred to organize a corporation or partnership are generally allowable as a deduction if the corporate formation is a function of trade or business. The taxpayer must show that the entity actively engages in business at least one day after formation to make the costs allowable. Any direct costs incurred for the formation of a corporation are deductible, however, indirect costs must be amortized over 180 months. The exception here is that legal costs incurred in respect to pooling or consolidation of assets between related parties must be capitalized.
When are Legal Expenses Tax Deductible?
In general, legal expenses incurred in the course of carrying on a business are deductible, provided that the expense is directly related to the production of income. For example, any costs incurred in connection with the defense of an action to collect amounts owed to a business by a defaulter in payment of his/her account would be deductible. The cost of enforcing a patent may also be deductible as can the costs of tax planning and the obtaining of a nation-wide business license.
Legal expenses incurred personally or in connection with investments usually do not qualify for full deductibility.
Lawyers’ fees in connection with litigation in respect of the taxpayer’s income tax liability may be deductible if the proceeds of the taxation year are increased or verified as a result of litigation costs incurred. However, deductibility of legal expenses incurred in litigation concerning the assessment of other tax, such as corporate taxes, have not been upheld.
An important exception to the above generalities concerns legal expenses related to the acquisition of land for a future retirement residence, as opposed to a residence to be used in the course of carrying on a business. The Income Tax Act permits a deduction of legal expenses incurred in the acquisition of a residential unit, if the expenses were incurred in relation to the disposition of the new unit. It would be expected that the purchase of land for a future residence would be similarly treated. Such deductions are taken into account in calculating the capital cost of the property for purposes of calculating capital cost allowance and are not available where the acquired property has not been disposed of by the end of the year. The Supreme Court of Canada rejected the related concept of a paid-up capital adjustment in the seminal case of Greiner v. The Queen, [2009] 1 S.C.R. 125 at para. 27.
Legal Expenses Not Deductible
Certain legal expenses won’t qualify for a tax deduction. Those that benefit your business or organization generally can be deducted. But some costs directly related to non-business activities can’t be deducted, regardless of their purpose.
Examples of nondeductible legal costs include:
— For medical ailments. These would be deductible as a medical expense as long as you meet the other requirements.
— For tax-deductible fines and penalties. Fines and penalties due to violations of law or regulations are usually nondeductible as a business expense, and the same is true of legal costs incurred to contest or reduce assessed penalties.
— For illegal purposes. Legal services you buy to create or defend the right to do a specific activity that is illegal aren’t deductible.
— To collect taxable alimony or child support. Legal expenses in a divorce case to acquire alimony or child support aren’t deductible. But the legal expenses to divide property are deductible.
Claiming Legal Expenses on Taxes
If you plan to claim tax deductions for legal expenses, it’s imperative that you’re aware of the process and follow the right steps. While the main criteria for claiming legal fees are whether the expense was incurred in determining tax liability, there are other guidelines.
Form 1040
All tax deductions are reported to the Internal Revenue Service (IRS) on Form 1040—individual income tax return. Your legal fees will be itemized in Schedule A (Form 1040), Itemized Deductions. You can …
– claim most legal fees as a tax-deductible expense, provided they fall under specific categories and requirements
– include contingent fees (or percentages of settlements), which means lawyers waive their hourly fees and are paid contingent on the success of the case, among other requirements
Kinds of legal fees that can’t be deducted
There are some legal fees that are never tax-deductible, such as:
- the creation of a will
- personal injury lawsuits
- business activities other than earning a salary
- divorce proceedings
- activities of a trade or business for hobby purposes
- personal claims for damages under tort law
- negotiation of an alimony agreement
- domestic relations matters other than obtaining taxable alimony
Schedule C
The IRS allows you to deduct legal fees related to earning income. You’ll file Schedule C of Form 1040, Profit or Loss from Business, if you’re a sole proprietor, single-member LLC, or single-edged entity and report your business income. You may deduct legal expenses that are:
Note: For sole proprietors, a meal or entertainment deduction is subject to a 50 percent limit, which is the case with many expenses.
Schedule C-EZ
You’ll be better off filing Schedule C-EZ (Form 1040), Office Expenses, if you’re a sole proprietor and meet all of the following requirements:
- Your business reports the income you earn on Schedule C, and you don’t deduct any business expenses other than your single vehicle expense ,
- Your business net income (line 31 of Schedule C) is less than $5,000,
- You claim a standard deduction (line 40 of Form 1040), and
- You don’t claim depreciation expenses using Form 4562, Depreciation and Amortization.
As a sole proprietorship, you may deduct your legal expenses as travel expenses in Schedule C-EZ and Schedule C.
Schedule E
An attorney fee you pay related to property or rental real estate is reported on Schedule E (Form 1040), Supplemental Income and Loss. Claims for rental real estate and royalties are filed in Part 1 of Schedule E. Legal expenses that qualify as deductible business expenses include:
Additional legal fee deductions
According to Section 62(a)(2) of the Internal Revenue Code, you may deduct additional legal fees from your gross income, whether you’re a sole proprietor or an employee. If you’re a sole proprietor, report the additional legal fees on Schedule C (Form 1040), Profit or Loss from Business. If you’re an employee, report them on Form 2106 (Employee Business Expenses). If you’re self-employed, the fees are deducted against total income instead of being an individually-deducted business expense.
If you’re defending against a non-delinquency tax-related lawsuit (one in which you’re not seen as liable or liable for a tax), you can’t deduct privilege-related fees and federal tax examination-related fees.
Note: You can’t deduct privilege-related fees, including:
You can deduct legal fees related to administrative proceedings that result in a judgment, award, or settlement that directly entitles you to a refund of overpaid federal taxes or restoration of seized property. Examples of these officials include Federal Tax Court, U.S. Court of Federal Claims, and the U.S. Bankruptcy Court.
Additional return
You’ll need to file additional form(s) with your return, such as Schedule C or Schedule E, when you want to deduct legal fees related to:
Legal Expenses for Businesses & Individuals
For businesses, a wide variety of legal expenses may be deductible as business expenses, including: Businesses report and deduct legal expenses on their income tax return in the year they are incurred under Section 162 for ordinary and necessary business expenses. Business expenses will generally include those incurred to protect the business’s assets or to produce income unless they are specifically capitalized. As a result, legal fees incurred by a business, such as those for defense of a contract, are usually deductible. However, fees incurred in order to acquire new business entities or materials for expansion are not deductible. Individuals may deduct legal fees paid in connection with managing income-producing activities (e.g., interest payments, business deductions, or sales of income properties) under Section 212 of the tax code, subject to the two percent adjusted gross income limit.
Recent Changes in Tax Laws Impacting Legal Spending
In recent years, changes in tax laws have also impacted the deductibility of legal expenses. The Tax Cuts and Jobs Act passed in 2017 drastically changed the United States tax code, effectively repealing the deduction for unreimbursed business expenses for employees. As a result, employees can no longer deduct legal fees stemming from workplace issues such as wrongful termination or discrimination so long as the lawsuit is not for personal physical injuries or sickness .
Other areas that continue to change in the law include:
Non-employees who are self-employed or acting as independent contractors, may continue to deduct legal fees on their personal tax returns on Schedules C or E.
It is important to note that while these taxpayers may be able to deduct legal expenses, they may need to attach a Form 8275 or 8275-R if the IRS anticipates a reduced reportable transaction due to a tax benefit.
Law is an area of rapid change; therefore taxpayers may want to consult with a tax professional to discuss their specific situation and determine applicable legal deductions available for them.