Can a taxpayer deduct the cost of hiring an attorney from taxable income? The answer depends greatly upon whether the lawyer was hired for a personal or business matter. The passage of the Tax Cuts and Jobs Act of 2017, whose provisions largely became effective January 1st, 2018, further affected the ability of taxpayers to deduct their legal fees on their tax returns. Here is a summary of situations where attorney's fees may or may not be tax deductible:
1. Attorney Fees for Personal Matters:
Prior to tax year 2018, a taxpayer who itemizes deductions was allowed to take miscellaneous itemized deductions for:
- Expenses related to unreimbursed employee expenses;
- Expenses to produce or collect taxable income;
- Expenses relating to managing or conserving property that produces income;
- Expenses relating to determining or collecting a tax refund; and
- Tax preparation fees.
These miscellaneous itemized deductions include attorney's fees relating to any of the above. To claim these expenses, the taxpayer must itemize tax deductions on Schedule A (the standard deduction cannot be claimed). Furthermore, miscellaneous itemized deductions were deductible only to the extent that the total exceeds 2% of the taxpayer's adjusted gross income. The following are examples of legal fees that were generally deductible:
- Legal representation in proceedings before the Internal Revenue Service or the federal courts relating to your personal tax matter;
- Tax advice obtained from an attorney during divorce representation or in obtaining estate planning services (the attorney's bill must apportion the fee for tax advice from the other services and ONLY the tax services are deductible)
- Attorney fees relating to collecting the arrearage on past-due alimony (EXCEPTION: this will not apply to divorce or separate maintenance judgments entered after December 31st, 2018, where alimony awarded in those court orders will no longer be deductible to the payer and taxable income to the payee).
- Attorney fees related to keeping your job (e.g. discrimination lawsuit or wrongful termination lawsuit)
- Attorney fees related to evicting a tenant from your rental property.
- Attorney fees charged to prepare your personal tax return.
Attorney fees were NOT deductible for the following:
- Attorney fees related to child custody or child support disputes (because child support is not taxable income to the payee or tax deductible to the payer)
- Attorney fees to defend personal civil or criminal legal actions.
- Attorney fees related to winning money in a personal injury lawsuit as a plaintiff because the recovery is not taxable income (EXCEPTION: If you are awarded putative damages, then you have received taxable income and the attorney fees must be apportioned among the taxable and nontaxable award. For example, if 60% of your award is compensatory damages and 40% of your award is putative damages, you may only deduct 60% of your attorney fees).
- Attorney fees related to disputes with a family member's estate because inheritances you obtain are not taxable income
- Attorney fees to obtain or perfect title to real estate (SEE SECTION #3)
For tax years from January 1st, 2018 to December 31st, 2025, the Tax Cuts and Jobs Act of 2017 SUSPENDS miscellaneous itemized deductions that may be claimed on Schedule A. As a result, taxpayers MAY NOT deduct legal expenses relating to personal legal matters during this period. This suspension will end in tax year 2026 or until Congress changes the law, whichever happens first.
2. Attorney Fees for Business Matters:
If you own a business, the costs of hiring an attorney to assist you in your business matters is generally deductible on Schedule C. The following are generally deductible:
- Attorney fees to organize and start up a business. Tax laws allow you to deduct up to $5,000 in start-up costs and $5,000 in organization costs initially, including legal fees. Any amount of your start-up cost beyond $5,000 not deducted in the first year is amortized in equal portions over the next 15 years.
- Attorney fees in collection actions against customers or clients.
- Attorney fees in instituting, defending or settling civil litigation regarding employee lawsuits, business disputes or copyright and patent claims (EXCEPTION: 26 U.S.C. 162(q) states that "[n]o deduction shall be allowed ... for - (1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney's fees related to such a settlement or payment.")
- Attorney fees in negotiating or drafting business contracts and representation in contract disputes or settlement.
- Attorney fees for receiving tax advice relating to your business
3. Attorney Fees To Acquire Property:
Whether personal or business, attorney fees for obtaining property or defending and perfecting its title are not immediately deductible but rather added to the "adjusted basis" of the property. For example, if your business buys real estate for $20,000, you have a "basis" of $20,000. The "adjusted basis" is the basis of the property adjusted by increases or decreases. Items that increase basis are the cost of extending utility service to the property, impact fees, zoning costs and legal fees. Items that decrease basis to the property are deductions for depreciation, certain tax credits and easements. If the property is sold later, the difference between the adjusted basis and the purchase price determines if you have a gain or loss. So, if you paid $20,000 to purchase real estate and spent $5,000 in legal fees, you have an adjusted basis of $25,000. If that property is later sold for the price of $30,000, you realize a gain of $5,000. While legal fees relating to acquiring and defending property are not immediately deductible, they may help off-set the taxable consequences of sale or disposition later.
If you have questions about whether your legal fees are deductible or not, then do not hesitate to contact the tax professionals at Kershaw, Vititoe & Jedinak PLC.