What are Legal Fees?
The law and the treatment of legal fees (which is a catchall phrase for anything lawyers charge) can be complicated. There are basically two types of legal fees: transactional fees and case fees. Transactional fees are paid in situations not directly involving court litigation. Examples include fees paid when buying or selling an asset, fees paid for drafting a will or fees paid for counseling on business transactions. Case fees are those paid for pursuing a specific claim or action in court. Contract disputes and injury claims fall in that category.
Transational fees generally are not deductible. The IRS has a long-standing rule that individuals cannot deduct legal fees related to a business purchase or sale unless the business is owned by the individual if the asset purchased is a business asset. Likewise, a personal injury claim would not be deductible. In other words, the lawyer who drafted your will or helped you purchase a business cannot be written off on your taxes. But the lawyer you hired because you were injured in a car accident or your business was sued can probably be written off. These distinctions are laid out in IRS Publication 529, Miscellaneous Deductions.
In recent years, issues have arisen with regard to the deductibility of legal fees in cases where a person can argue that all of the fees should be deductible as case fees, not transactional fees. The distinction is important. When you can count all legal fees as "case fees," you will also be able to deduct many types of expenses. Legal fees tend to be among the largest out of pocket expenses owed for a case, so extending the deductibility of legal fees can have a significant impact on tax liability. When you can count all the fees as "transactional," however, you cannot used the legal fees to offset the tax liability incurred on a settlement.
In the area of criminal cases, the distinction between transactional fees and case fees is particularly important. In general , legal fees paid in criminal cases are deductible if the entire case is about something else. If the legal fee was paid in relation to the crime itself, however, then the fee is not deductible. For example, if I were charged with operating a vehicle after a DUI conviction, the legal fees associated with my defense would likely be deductible. If however, I was convicted of tax fraud, my legal fees would not be deductible because they were incurred to defend against a criminal charge.
Relevant IRS guidelines and rulings clarify the rules regarding legal fee deductibility in criminal cases. IRS Code 262 disallows any fee that is personal in nature. The IRS has ruled that all fees paid to obtain property for a taxpayer’s personal use are personal. In a series of rulings, the IRS ruled that fees paid to mitigate against criminal charges and penalties were personal in nature. A recent Ruling reinstated the position that legal fees paid to defend against criminal charges were personal, but it also grants some refunds to people who had successfully argued that legal fees were deductible in earlier years.
IRS Ruling 2008-2 recognizes that taxpayers who were successful in defense against criminal charges may have incurred legal fees that were deductible. Examples of such fees that would be deductible, according to the ruling, include fees for mailings, deposition transcripts, investigation, expert testimony, witness fees and investigator costs. Those fees, when incurred to defend against criminal charges, are deductible. While the new ruling permits the IRS to grant refunds to taxpayers previously denied the use of deductibility of legal fees, it does not make that use automatic. A successful outcome with the IRS will require adequate proof of the legal fees incurred in a criminal case, which can include case fees that are typically deductible, and a good deal of time.
General Rule on Tax Dedibility of Legal Fees
When it comes to understanding the tax deductibility of legal fees, the first question you need to ask yourself is whether the expenditure qualifies as a nondeductible personal expense under § 262 of the Internal Revenue Code ("Code"). Section 262 of the Code provides that no deduction will be allowed for personal, living or family expenses. "The cost of goods and services which are incurred for personal purposes are ‘personal’ in nature and thus not deductible, notwithstanding their general usefulness or necessity." Kingsley v. Comm’r., 37 T.C. 83 (1961), holding modified on other grounds Sierra Vista Vaginal Research v. Comm’r., 100 AFTR 2d 2007-3307 (10th Cir. 2007) ("[i]ncome tax preparation fees are reported as an itemized deduction on the tax return, and, thus are ‘personal, living or family ‘ expenses subject to disallowance under § 262.").
If the expenditure meets one of the exceptions to the general rule that prohibits deductions for "personal, living or family" expenses, then the individual must next consider whether the legal fees are a "business expense" as defined in Treas. Reg. § 1.162-1(a), which provides that "business expenses" are "ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered . . ." (emphasis added). Based on this definition, common "business expenses" that are deductible include wages, benefits paid to employees, automobile expenses, travel costs, insurance premiums, professional fees, and repair costs.
"Where capital structures or reorganization fees are attributable to a trade or business, however, they are deductible under § 162(a) if they are payment for services actually rendered in the current tax year." Zapata Companies v. United States, 428 F.Supp 1210 (3rd Cir. 1977) citing, e.g., Universal Packing & Tanking Co. v. Commissioner, 55 T.C. 1, 3 (1970), aff’d per curiam, 455 F.2d 934 (6th Cir. 1972).
However, a legal fee is not as "ordinary" and "necessary" as defined above where those expenditures are made for the purpose of obtaining or settling a divorce and, thus, are "personal" as argued in IRS Letter Ruling 200350030 (August 15, 2003). In this ruling, the IRS held that the legal fees incurred for the settlement of the divorce were not necessary, but were only desirable.
Lawyer’s Fees in Criminal Matters
When it comes to criminal cases, legal fees are much more straightforward. Most attorneys handling these matters work based on flat fees and take pay that amount upfront. If you are charged with a crime, your attorney will work for you no matter what the case involves because they get their full fee regardless of outcome. As such, the only real question about these legal fees is whether they are tax deductible. The IRS has released several statements on the topic and does not consider these flat fees as tax deductible. They do mention that certain fees can be declared as a business expense if you are taking the fees for an activity that is considered a trade or business. However, the IRS is very specific about the allowances and how they have to be reported. As such, unless there are salient facts that you can find in the tax code, the legal fees for a criminal case will be viewed as personal expense and you will not be able to deduct them from your tax return.
Are Lawyers’ Fees in Criminal Cases Deductible?
In the past, the IRS has ruled that legal fees incurred in connection with criminal proceedings are not tax deductible. For example, in IRS Notice 2004-35, the IRS shared its position that legal fees in connection with a criminal defense are not deductible whether paid to lawyers or accountants. However, more recent developments may suggest that such positions are being abandoned in light of taxpayer challenges.
A 2015 Illinois Tax Tribunal decision published as an "Advisory Opinion" of the Office of the General Counsel for the Illinois Department of Revenue, which although not binding, provides insight as to how the agency believes the law should be applied, explains how "legal services connected with criminal matters are not automatically nondeductible in all cases…whether representing a client in court or finding an accountant to break down evidence for use in court."
Rather, the Department of Revenue explained that "legal fees incurred during criminal proceedings which have a business origin and are incurred with the dominant purpose of producing income or making or keeping property in good standing are not exempt from taxation as personal expenses" when they are incurred in pursuit of a business related to the production of income. The Advisory Opinion went further to clarify that "it does not matter if the success of the underlying business cannot be directly attributed to the provision of the legal defense."
The Advisory Opinion also cited the 1931 United States Supreme Court case of United States v. Gilmore, 372 U.S. 39, 40 (1953), stating "no charge so out of line with usual business practices, cost-wise, and so unrelated to the attainment of specific income, can be treated as ordinary and necessary under the statute," in further support for its conclusions. Although this citation again appears to suggest that legal fees in connection with a criminal defense are not deductible, the Illinois Department of Revenue’s position is that "Gilmore is inconsistent with more current rulings related to deductibility of legal fees in tax situations," and that "Gilmore stands for the proposition that legal fees must be ‘ordinary and necessary’ related to the production of income, not that every witness fee in a criminal trial is not deductible."
The Department of Revenue’s position was further supported by a more recent 2013 Illinois Supreme Court decision in Trcontainer Corp. v. Hynes, 989 N.E.2d 127, 132 (2013), in which it held that while the standard for determining whether an ordinary and necessary expense is deductible is whether the, at the time the expense was incurred, there was a reasonable expectation of eventual realization of income from the activity, the Illinois Supreme Court "has viewed [Gilmore] as more narrowly applicable to legal expenses incurred in conjunction with domestic relations disputes."
In view of the above referenced developments, taxpayers may be challenged on their attempts to deduct legal expenses for a criminal proceeding attached to a business producing income unless they can prove that the expenses were incurred to protect/recover income from the business (and not a personal asset). There is no black and white rule, as each case must be evaluated under its specific facts. For example, the IRS has suggested that legal fees incurred in defending a conviction of embezzlement income earned in a business is not deductible.
Instances and Special Situations
Exceptions may apply to the deduction of legal fees for criminal defense depending on certain circumstances.
One such exception is if a defendant is attempting to recoup money that was obtained illegally, or if the individual can demonstrate a sufficient connection to a business. In (the tax court case of) Stanley v. Commissioner, 87 T.C. 416 (1986), the taxpayer was being investigated for allegedly conspiring to manufacture and distribute illegal alcohol for sale in violation of the Internal Revenue Laws and the state of New Jersey laws and ordinances. He was also charged with conspiracy to invest some of the proceeds from the unlawful sale of the alcohol in the stock of an automobile dealership, which was owned by the defendant and other non-family members.
The Tax Court allowed a limited deduction with respect to the expenses for criminal defense of the civil charges the taxpayer incurred in connection with unlawful proceeds from the sale of alcohol. The court found that the expenses were incurred with respect to an activity that was connected to or necessary for the operation of the taxpayers’ trade or business within the meaning of I.R.C. § 212(1).
In Strasser v. Commissioner , a California tax court allowed expenses incurred for legal fees and other expenses connected with a criminal investigation for mail fraud arising from the alleged theft of money from restaurants. The taxpayer was attempting to recover stolen funds. The court cited § 212(1) of the Internal Revenue Code and found that the expenses met the trade-or-business connection to an income producing activity permitted under the Code.
Any deductions must still meet the requirements of the IRS audit guide: If a criminal charge is filed, the legal fee should be deductible as a business expense provided the requirements for deducting business expenses are met. If the legal fees are not for professional services but are instead for services performed in acquiring criminal proceeds, the above requirements are not met.
Proof of Payment of Legal Fees
If you are successful in proving that your legal fees are tax deductible, the next step is properly documenting them. The IRS requires evidence of amounts you paid to a lawyer (or any vendor for that matter), so collecting written records is of course the number one priority. This means obtaining invoices before you pay, in addition to properly documenting payment itself. In this case, as with all other legal fees, it might make sense to have them clearly itemized into two categories, one for amounts you wish to deduct for current tax purposes, and one for amounts you plan to defer until next tax year. Make sure you are clear with your tax professional on how you want these fees allocated. Depending on the nature of your case, you may find that proper documentation requires more specific descriptions of services than you usually receive on an invoice. Consult with your tax professional about the information you need to provide to prove the fees qualify for a tax deduction in advance so you can provide it to your lawyer to include on future invoices. If your lawyer is reluctant, remind them that providing their tax number and a detailed invoice is legally required for any third party payments to qualify for a tax deduction.
Talk to a Tax Advisor
Tax law for non-attorneys can be exceedingly complicated. This is why experts in the tax arena are so important, and this is no exception when it comes to claiming legal fees as deductions. As a potential taxpayer, you need to consult with a qualified tax professional at this stage. Your attorney can advise you on whether your fees are deductible and your tax professional can then help determine the qualifications for deductibility . But this needs to happen before you submit your return for filing. A tax professional can help you determine if you are eligible for a deduction, and they can prepare the correct tax forms and records you need to file as well. This is the most reasonable course of action in helping someone decide what makes the most sense for their unique situation.