Attorney Fees
The deductibility of attorney fees on federal tax returns can significantly impact a taxpayer’s financial liability. Understanding the rules and criteria for deducting legal expenses is crucial for individuals and businesses to optimize their tax obligations. This discussion explores the various contexts in which attorney fees may be deductible, the specific requirements imposed by the IRS, notable exceptions, and recent changes in tax law affecting these deductions.
Historical Background
Historically, the Internal Revenue Code (IRC) allowed for various deductions of attorney fees under multiple sections. These deductions were designed to relieve taxpayers of the financial burden associated with necessary legal expenditures incurred for business purposes, tax advice, and certain personal matters. The Tax Cuts and Jobs Act (TCJA) of 2017, however, brought substantial changes, particularly impacting the deductibility of miscellaneous itemized deductions, including many attorney fees.
GENERAL RULES for DEDUCTING ATTORNEY FEES
Business-Related Legal Expenses
Legal fees directly related to the operation of a business or trade are generally deductible as ordinary and necessary business expenses under Section 162 of the IRC. Examples include:
• Fees for drafting contracts or agreements related to business operations.
• Legal expenses incurred in defending against lawsuits arising from business activities.
• Costs of legal advice and services related to business taxes.
For business owners, these deductions can be claimed on Schedule C (for sole proprietors), Form 1065 (for partnerships), or Form 1120 (for corporations).
Employment-Related Legal Expenses
Attorney fees related to maintaining or securing employment can also be deductible. Examples include:
• Fees incurred in the defense of employment contracts.
• Legal expenses related to claims of wrongful termination or discrimination.
• Costs associated with disputes over wages or severance pay.
However, due to the TCJA, these deductions, previously categorized as miscellaneous itemized deductions subject to the 2% of adjusted gross income (AGI) floor, were eliminated for tax years 2018 through 2025.
Personal Legal Expenses
Personal legal expenses are generally not deductible. This includes fees for:
• Divorce and custody disputes.
• Personal injury claims.
• Estate planning and the creation of wills.
However, there are notable exceptions under certain circumstances.
Specific Situations Where Attorney Fees May Be Deductible
Tax Advice and Tax Planning
Attorney fees incurred for tax advice related to tax return preparation, tax planning, or any proceeding before the IRS are deductible. These fees are considered directly related to determining, collecting, or refunding any tax and can be deducted on Schedule A as a miscellaneous itemized deduction.
Investment-Related Legal Expenses
Legal fees associated with producing or collecting taxable income, or managing, conserving, or maintaining property held for the production of income, are deductible. This includes fees paid for advice on investments and the management of rental properties.
Whistleblower Cases
Under the Whistleblower Act, legal fees incurred by individuals who bring forth information about tax evasion or fraud that leads to the recovery of taxes are deductible. The deduction applies to the amount of the award received by the whistleblower.
Civil Rights and Employment Discrimination Cases
Legal fees related to claims of unlawful discrimination, certain whistleblower actions, and other civil rights issues are deductible above the line (i.e., they reduce AGI directly), under the Civil Rights Tax Relief Act of 2004. These deductions are reported on Form 1040, Line 36, with the designation “UDC” for unlawful discrimination claims.
Alimony and Child Support
Attorney fees related to the collection of taxable alimony can be deductible. However, this deduction does not apply to legal fees for securing child support or other non-taxable payments.
Impact of the Tax Cuts and Jobs Act (TCJA)
The TCJA significantly affected the deductibility of attorney fees by eliminating most miscellaneous itemized deductions. As a result, many legal expenses that were previously deductible as miscellaneous itemized deductions under Section 212 are no longer deductible for tax years 2018 through 2025. This change primarily impacts individual taxpayers who incur legal fees for activities such as defending against employment-related claims or managing investment income.
Documentation and Reporting Requirements
To claim a deduction for attorney fees, taxpayers must:
• Maintain detailed records and receipts of the legal expenses.
• Ensure the fees are clearly related to deductible activities. The invoice should specific the charges allocable to specific services to support the deduction. If the invoice is too general, the IRS will not allow the deduction.
• Use the appropriate tax forms (e.g., Schedule C for business expenses, Schedule A for itemized deductions).
• Proper documentation and adherence to IRS guidelines are crucial to substantiate the deduction and avoid potential disputes with the IRS.
Recent Developments and Future Considerations
Recent tax legislation and court rulings continue to shape the landscape of deductible legal expenses. Taxpayers should stay informed about changes in tax law and seek professional advice to navigate complex situations. Future legislative changes may restore or further limit the deductibility of certain attorney fees, impacting planning strategies for both individuals and businesses.
Conclusion
The deductibility of attorney fees under IRS regulations involves a complex set of rules and exceptions. While business-related legal expenses and certain specific personal legal expenses remain deductible, recent changes brought by the TCJA have limited the scope of these deductions. Understanding the criteria and keeping thorough records are essential for taxpayers seeking to optimize their tax positions. As tax laws evolve, ongoing vigilance and professional guidance will be critical in effectively managing and deducting attorney fees.