19.17 Deducting Legal Costs

A legal expense is generally deductible if the dispute or issue arose in the course of your business or employment or involves income-producing property. Legal expenses for personal lawsuits are not deductible unless you recover taxable damages. Legal fees incurred in obtaining an award of tax-free damages, such as for physical injuries (11.7), are not deductible.

If you are self-employed, your deduction for legal fees arising from a business-related dispute is claimed on Schedule C. Legal expenses related to your job as an employee or to investment activities are claimed as miscellaneous itemized deductions subject to the 2% AGI floor, except for fees relating to employment discrimination claims, which may qualify for an above-the-line deduction (19.18). The IRS may disallow the deduction on the ground that the legal dispute does not directly arise from the business or income activity. Thus, for example, the cost of contesting the suspension of a driver’s license for drunken driving is not deductible despite a business need for the license; the suspension arose out of a personal rather than a business-related activity. A deduction may also be disallowed where the dispute involves title to property.

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image Planning Reminder
Lawyer’s Bill Should Be Itemized
Your lawyer should bill you separately or itemize fees for services connected with deductible items (collection of taxable alimony or separate maintenance payments; or preparation of tax returns, tax audits, and tax litigation) and nondeductible capital items (expenses incurred in purchase of property or dispute over title).
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Legal fees incurred in organizing a new business may be deductible (40.11).

Employment suits.

The following Examples illustrate when legal costs for job-related matters may be deductible.

EXAMPLES
1. An Army officer was allowed to deduct the cost of successfully contesting a court martial based on charges of misrepresentations in official statements and reports. He would have lost his position had he been convicted.
2. Tellier, a securities dealer, was convicted of mail fraud and securities fraud. He was allowed to deduct legal fees as business expenses related to his securities business. That he was found guilty of the criminal charge does not affect the deductibility of the expense. The deduction of legal expenses is not disallowed on public policy grounds since a defendant has a constitutional right to an attorney.
3. In an alimony action, Gilmore was successful in preventing his wife from securing stock and taking control of corporations from which he earned practically all his income. He was not allowed to deduct his legal costs. The dispute did not arise from an income-producing activity; the fact that an adverse determination of the dispute might affect his income did not make the legal expenses deductible.
4. A doctor who attempted to bribe a judge to suspend his sentence for tax evasion was convicted of the bribe attempt and lost his license to practice medicine. He could not deduct his defense costs. His practice of medicine did not give rise to his need for an attorney. The fact that the conviction affected his ability to earn income was merely a consequence of personal litigation.
5. Siket, a police officer, was not allowed to deduct expenses of successfully defending a criminal charge of assault while off duty. The origin of the claim was personal, even though a conviction might have been detrimental to his position as a police officer. The arrest did not occur within the performance of his duties; he was off duty and in a different municipality at the time of the arrest.
6. A resort company instructed its staff to stop serving drinks to intoxicated patrons and to encourage the patrons to either take a taxi home or to stay on the premises at a reduced rate. One of the company’s executives attempted to deduct legal defense fees when he was charged with criminal sexual assault, arguing that the assault allegation arose from his business duty to procure a room for three intoxicated guests. The IRS and the Tax Court denied the deduction on the grounds that the allegation arose from the executive’s second visit to the guests’ room, not from the time he placed them in the room. Even if the alleged assault had occurred during the first visit, the executive personally violated company policy by not stopping the guests from drinking when they were already drunk.

Will contests and wrongful death actions.

Legal costs of a will contest are generally not deductible because an inheritance is not taxable income. Similarly, legal fees incurred to collect a wrongful death award (which is tax-free income) are not deductible.

EXAMPLE
Parker, an heir who was left out of his grandmother’s estate, sued to recover his inheritance. In a settlement, he received his share of his grandmother’s property plus income earned on that property. The allocable portion of legal fees attributed to the income, which was taxable, was deductible; the balance of the fees was not deductible.

Title issues or disputes.

Legal costs related to the acquisition of property or to the determination of title to property, whether such property is business or personal, are nondeductible capital expenditures. They are added to the basis of the property. For example, litigation costs to fix the value of shares of dissident shareholders are not deductible because they are related to the purchase of the stock and are part of the cost of acquisition.

Legal fees incurred to acquire title to stock are also nondeductible.

Where a dispute over property does not involve title, such as in a recovery of income-producing securities loaned as collateral, the Tax Court holds that legal fees are deductible.

Personal injury actions.

Where you recover taxable damages, the legal fees (19.18) are deductible above the line (from gross income) in unlawful discrimination cases or as a miscellaneous itemized deduction subject to the 2% floor in other cases (12.2). If the damages are not taxable, legal fees are not deductible (11.7).

Legal expenses incurred in marital actions

(37.8).

Collecting Social Security.

If you hire an attorney to press a claim for disputed benefits, such as disability benefits, you may deduct the legal fees only to the extent that your benefits are taxable (34.3). For example, if 50% of your Social Security benefits are taxable, 50% of your legal fees are treated as miscellaneous expenses subject to the 2% AGI floor.

Estate tax planning fee.

All or part of an attorney’s fee for estate tax planning services may be deductible subject to the 2% AGI floor. Estate tax planning usually involves tax and non-tax matters. To the extent that the services do not cover tax advice or income-producing property, the fee is not deductible. A bill allocating a fee between deductible and nondeductible services may help support a deduction claimed for the deductible portion of the fee.

Recovery of attorneys’ fees from government.

See Chapter 47.

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