What Makes Attorney Fees Tax-Deductible
When it comes to legal fees and taxes, the IRS says that they should be treated like any other business expense for a corporation. If legal fees are incurred as part of running your business, they are considered a legitimate expense and deductible from your taxes. If you are considering filing a lawsuit, the legal fees are considered ordinary and necessary, and therefore fully deductible.
If you are suing someone, the IRS says that those legal fees aren’t deductible if you are pursuing emotional distress because economic damages stemming from emotional distress are generally not deductible.
Other deductible legal fees and expenses, according to the IRS, are those incurred for the production or collection of income; acquiring or disposing of a capital asset; managing, conserving and maintaining property produced; obtaining tax advice; tax planning; filing a tax return; and contesting a tax return challenge.
The IRS also says that in most instances, attorney fees are deductible as unreimbursed employee expenses. The fees must result from services rendered in connection with business activities from which you derive income. Examples of deductible legal fees include fees you paid to obtain taxable damage awards for injury to your reputation or other non-physical injuries you may have received due to your employment, as well as legal fees connected with sex discrimination or age discrimination cases or wrongful termination suits.
A lawyer’s fee may be deductible if you were placed in a lower tax bracket after a divorce, but only the amount of the decrease in your tax on that portion of the award constituting income .
In a divorce case, the IRS says that generally, fees paid to your attorney to obtain alimony for yourself or to obtain taxable child support are not deductible from your taxable income and child support alimony is not taxable to the recipient. Legal fees paid to obtain child custody or to enforce child visitations are not deductible from your taxable income.
However, fees paid to enforce the terms of a post-nuptial agreement or for the division of marital or non-marital property, including household furnishings, real estate, bank accounts, pensions, retirement plans and business interests are deductible from your taxable income.
And, the IRS says that in general, legal fees paid to establish, enforce or challenge paternity, from which you will receive taxable alimony or receive a share in the support of children, are deductible.
If you are in an employment situation that requires you to retain legal counsel to negotiate a non-compete that your employer has given you, the advice given by the attorney is often tax deductible. Similar situations where attorney fees for a non-compete or severance negotiation are deductible are when you are moving to a new state, but the move has no direct ties to employment and you will receive no compensation for the move or relocation.
And while you cannot deduct attorney fees incurred to defend against an audit, you may be able to deduct the legal fees you paid to your attorney for the successful defense of the IRS audit.
Common Situations When Attorney Fees Are Tax-Deductible
While not an overarching rule, there are certain specific instances where lawyer fees may be tax deductible:
Business-related cases — If your case relates to a business, the legal fees can be deductible as a necessary expense of carrying on that trade or business. This usually applies to business structures, dealer representation, disputes, breach of contract claims, warranties, product liability claims, securities fraud, complaints against regulatory bodies, etc. The costs related to defending a business from a tort claim is also generally deductible.
Employment related cases — This includes claims for wrongful termination, employment discrimination, harassment, overtime pay grievances, non-compete agreements, sexual harassment, wrongful discharge, bullying, dangerous working conditions and retaliation. Even internal disciplinary hearings can warrant the deduction.
Real estate cases — This allows for the deduction of various counsel fees in connection with the development of raw land for zoning issues, environmental issues, sales contracts, easement issues, lease agreements, title issues, etc.
Insurance cases — Legal fees incurred to establish or protect a claim against an insurance policy could potentially be deductible.
Alimony — Separating shared income and joint property through this legal mechanism allows for legal fees to be deductible.
Tort claims — Litigation and pre-litigation costs in a civil case where damages are sought for bodily injury, physical sickness, emotional distress, wrongful death, or damages to tangible property. These cases usually have a clear winner and loser, and typically do not include criminal charges.
Other — Personal injury lawyers, injured judges, disbarred attorneys, court officials and witnesses, abusive ex-spouses or parents, guardianship, euthanasia and con artists suing their victims.
The key to determining whether your particular case meets the IRS requirements is whether the expenses are ordinary and necessary. It is recommended you speak with your attorney or accountant before deducting legal fees.
How To Deduct Attorney Fees On Your Taxes
Unfortunately, the above-listed fees are not tax-deductible. The IRS has a strict list of "deductions" that can be claimed. That list does not include contingency fees for litigation or settlement negotiations with an adjuster. However, the costs of attempting to collect the settlement from the insurance company MAY be deductible. Per IRS Publications 535 and 535-A, you can deduct the costs to collect taxable income or to make a refund or correction, including reasonable amounts paid to an attorney or accountant to do your tax work. A contingency fee to file a lawsuit to attempt to collect a taxable debt could be deductible because the fee was paid to collect taxable income. An amount paid to an attorney in excess of the amount includable in gross income in full satisfaction of a taxable debt would reduce the amount includable in gross income.
If you are paying an attorney for legal services directly related to making and collecting a claim with an insurance company for a loss to your property (and you are itemizing on your 1040 under Schedule A), this attorney fee is deductible on IRS Schedule A as an itemized deduction. This means that the attorney fee is deductible on Schedule A of your tax return and you calculate the total amount of Schedule A deductions on Schedule A.
In addition to attorney fees, you can deduct amounts paid for recovering or protecting a right to property or for conservation, management or land assembly expenses for property held for investment. You can also deduct fees included in the Real Property Tax assessment and court costs.
If the attorney fee is less than $600 and you are taking it as an unreimbursed employee business expense deduction, the attorney does not have to issue you a 1099-MISC.
Recent Tax Law Changes Impacting Attorney Fees
Depending upon your circumstances and the reason you are seeking a concerted effort at tax reduction, there have been some changes in the tax code that undo many of the tax benefits that could be gained by hiring a very good accountant as part of your legal representation.
The Tax Cuts and Jobs Act (TCJA) has limited many of the deductions individuals had previously claimed for tax purposes . This legislation, which applies to the tax year 2018, has made deducting legal fees more difficult. Fees related to employment claims, civil rights claims, and whistleblower claims can no longer be deducted. Fees related to the production of income, tax advice, and tax advice related to litigation may still be deductable. However, the new law caps the deductions for fees related to tax preparation and for the services of an enrolled agent.
Common Errors When Deducting Attorney Fees
Each succeeding tax year brings new forms, new practices and new software updates. But some things stay the same year after year, like the mistakes people make when filing their taxes with hopes of claiming lawyer fees as a tax deduction. Here are a few mistakes you can avoid if you know what they are up front:
Don’t overlook legal fees due to legal aid. Not everyone has a ton of money they can afford to spend on legal counsel. Some people no doubt think they don’t have a case at all and therefore decide that going to legal aid is the best option for them. Unfortunately, they overlook legal aid fees and find out later in the tax season that they could have claimed those fees. Any expenses paid to a legal aid center or clinic are eligible for taxation.
Not itemizing deductions correctly for the current tax year. There’s no broken-in procedure for a new tax year. If you are itemizing your deductions every year, you end up looking at every single line on your taxes to see if you’re doing it right. But for return filers, you know how pesky and confusing it can be when you’re going through a form line-by-line. If you aren’t doing this correctly, you may not be fully compensated for those deductions.
Not understanding when to actually deduct fees. Legal fees can be deducted in a few different ways. You could deduct them in the tax year that you paid for services, which is generally the route most people take. However, some people may deduct these fees in the tax year in which these fees are applicable to a case. So depending on your case, there’s no one-size-fits-all option. Figure out which option is best for you.
Consulting a Tax Professional
Consulting a tax professional to confirm if your lawyer fees are tax deductible may be the best course of action to take. Lawyers would be able to make that determination for you, as it is your personal financial circumstance that is at play here. There is the added bonus of having a tax professional who specializes in financial law, guiding you through the paperwork and how to remain transparent about your lawyer fees.
There are several things that a tax professional can do for you, one being that they know how to determine what qualifies as legal services on your return. They will also know about the limits on those legal services when it comes to deducting them. Your lawyer gives you invoices , so it would seem easy enough to claim those for your personal tax deduction. However, the only fees that are allowable for a tax deduction are those that were paid directly to your lawyer, not the firm that he or she works for. Your professional will know that.
In addition, a professional can guide you in remaining compliant when it comes to any tax lawyer fees that you have claimed. Any over-reported fees could trigger an audit, which would be something that any tax payer wants to avoid. The professional can help you determine if you are indeed eligible for the deduction, and then guide you in moving forward in remaining compliant.
Your best bet, when it comes to claiming your lawyer fees as a tax deduction, is to consult a tax professional.