are legal fees deductible

When Legal Fees Aren’t Strictly Business

Apr 29th 2019
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Can a taxpayer deduct his or her legal fees? The answer, in short, is “it depends.” As evidenced by a new case, Ray 2019-36, 4/15/19, it makes a big difference if the expenses are related to business activities or are personal in nature.  

Generally, legal fees paid for purely personal reasons are nondeductible. For instance, if you’re suing someone for a personal injury, you can’t deduct your attorney’s fees. It’s just a cost you have to pay.

Previously, certain other legal fees were deductible as miscellaneous expenses, subject to a floor of 2 percent of adjusted gross income (AGI). This included, for example, costs associated with a divorce proceeding or legal fees for managing investment property. But the Tax Cuts and Jobs Act (TCJA) completely eliminated the deduction for miscellaneous expenses for 2018 through 2025.

Conversely, legal fees incurred for bona fide business reasons are 100 percent deductible. There’s no restriction like the 2-percent-of-AGI floor. And the TCJA didn’t touch this deduction.

In the new case, a couple living in New York City divorced in 1977 but continued to live together. They also shared bank accounts and didn’t divide their assets. Instead, they kept track of their joint expenses by way of a ledger system.

The husband was in the computer programming field. His ex-wife was a financial services professional involved in trading securities.

Over time, the couple grew further apart, with the husband moving to Florida in 1992. But their finances remained entangled. In 1993, the husband invested $350,000 with his ex-wife for a unique method in trading in commodities and options. In addition to supporting her theories, he believed the investment would turn a profit. However, in just a few short months, the ex-wife lost all his money.

So the husband got mad and sued his ex-wife—three times. The lawsuits reflected claims for alleged financial damages for not repaying loans and for fraudulently conveying property in Long Island that the couple had jointly purchased.

On his 2014 return, the husband deducted about $225,000 in legal fees stemming from his ex-wife’s alleged misdeeds. He claimed they were related to his computer programming business. But the IRS disputed this and denied the business deduction.

Now the Tax Court has agreed with the IRS that none of the legal fees were deductible as business expenses. To qualify for a deduction, the fees must be directly connected with, or proximately related to, the taxpayer's business. The Court did not find a sufficient connection here. However, a portion of the fees relating to the investments was deductible as miscellaneous expenses under the rules in effect at this time.

Moral of the story: Make sure your clients are standing on firm ground concerning deductions for legal fees. When appropriate, have them obtain a detailed breakdown of fees from the attorney.

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