Tax Deductions for Legal Work Explained
Most people have heard of tax deductions before. However, many don’t actually understand their basic concept or how they function. A tax deduction is simply an amount that you can subtract from your total taxable income. As a result of the deduction, you need to pay less in taxes because you’ve essentially reduced the amount of money you’re taxed on. Deductions can be very useful because they reduce your overall tax bill .
Deductions usually apply to the following expenses: Before we talk about whether you can deduct attorney fees and legal fees on your taxes, let’s clarify that not all legal fees are deductible. Some people think that all legal fees are deductible, and as a result, they try to deduct everything they can from their tax returns. When it comes to legal expenses, there are both deductible and non-deductible expenses. Some people just deduct everything incorrectly, and their tax returns get reviewed by the IRS. They can be fined if the IRS doesn’t agree with the deductions.
When Legal Work Is Tax Deductible
The Internal Revenue Service permits the deduction of certain fees paid for legal services under specific circumstances. Fees paid to lawyers in connection with the acquisition, abandonment, or disposal of property or goods not connected to a taxpayer’s trade or business are not deductible (with limited exceptions). However, in limited circumstances, fees paid to lawyers can be deductible to the extent they are incurred in connection with an individual’s trade or business.
A taxpayer is permitted to deduct legal fees necessary to carry on a trade or business, as well as legal fees incurred in a profit-seeking activity that is not a trade or business. For example: Legal fees associated with the formation of an operating company may be deductible if the operating company is not a corporation or an association taxable as a corporation. In most instances, however, items such as the issuance of stock and other financing costs, and legal fees paid in connection with corporate finance transactions are not deductible. Legal fees paid to a lawyer to collect taxable income received by a taxpayer are deductible. However, a taxpayer cannot deduct legal fees paid to a lawyer to collect non-taxable income. For example, a fee paid to a lawyer to collect interest is deductible, but the cost of legal fees to collect life insurance proceeds, which are received income tax-free by virtue of I.R.C. §101(a) is not deductible. Of note is the fact that a taxpayer cannot deduct the legal fees paid to recover capital gains. See Rev. Rul. 75-429, 1975-2 C.B. 8; Rev. Rul. 82-150, 1982-2 C.B. 27. Legal fees related to the establishment of a tax-free incentive plan from the employer’s perspective are also not deductible. Rev. Rul. 58-55, 1958-1 C.B. 26.
Non-Deductible Legal Work
There are many categories of legal fees generally not deductible on your tax return. For example, legal fees paid related to personal or family matters are not deductible. This includes a divorce. A divorce is a personal matter and not a necessary step in determining your business or professional income. Likewise, if you paid legal fees for criminal defense, that is considered a personal expense to keep you out of jail. The law does not consider that a necessary step in determining business income or expenses, so that legal fee is not deductible.
Reporting Legal Work on the Tax Return
When filing your income tax return, deductible legal fees can go under "Other Miscellaneous Deduction" (line 28), in the schedule "Job Expenses and Certain Miscellaneous Deductions." Do not include attorney’s fees paid in connection with a divorce or separation, nor represent an irreducible amount of income, nor are covered by a contingent fee arrangement. Average attorneys fees from year to year will be reported, without any deduction for years in which fees are nondeductible.
Tax forms or schedules relevant to these determination include:
• Schedule A for reporting legal fees where a settlement award is permitted as a miscellaneous deduction if it qualifies as a qualified discrimination claim settlement award. In these cases , the fee amount claimed as a deduction must be prorated between your actual expenses paid to the attorney and your contingent fee.
• Schedule C for reporting legal fees when filing as a self-employed person. Only the actual amount paid to the attorney is deductible, including any retainer fee paid.
Certain attorneys fees directly associated with a business venture are deductible as a business expense under IRC Section 162. Legal fees that directly contribute to the generation of income are also deductible under Section 212. Therefore, attorneys fees have the effect of being a miscellaneous itemized deduction for corporations, while individuals may deduct this type of expense as a direct reduction in gross income. Business-related expenses should be included in the gross income of the individual taxpayer, where the basic deduction is entered on line 23 of the 1040 federal form. The IRS FAQ page also provides general information about legal fees directly related to a business expense.
How the New Tax Laws Could Change This
In recent years, there have been developments and possible changes that could affect the deductibility of legal fees. The Tax Cuts and Jobs Act, passed in December 2017, suspended miscellaneous deductions, including unreimbursed employee expenses (other than certain educator expenses). This provision also impacts the deduction of legal fees. Legal fees paid or incurred in connection with employment, advice on tax issues, estate planning, safe deposit box rental, the formation and operation of an S corporation, and the extension of credit are no longer deductible. Some legal fees are still deductible as miscellaneous itemized deductions, including legal fees related to the production or collection of taxable income, legal fees in connection with tax advice, personal injury or wrongful death, and certain whistleblower claims.
In addition, a number of changes have previously been proposed and may be revisited again in the future. For instance, payers of alimony may no longer deduct alimony payments made after Dec. 31, 2018. Additionally, further limitations on legal costs are possible and have been proposed, such as limiting the deductibility of legal costs to the extent that they are not contingent.
Should You Work With a Professional?
The best way to determine the exact tax benefit applicable to your case is to consult with an experienced tax and legal fees attorney. The attorney will have an in-depth understanding of the complex tax laws and will be able to provide insight as to how your case specifically impacts your current tax situation. Trust us, it’s worth the hour consultation to find out if you can benefit from legal fee deductibility.
If you have already hired an attorney to assist you with your case , don’t hesitate to ask them about deductibility. As long as you are upfront and honest with your attorney about your reasons for asking, it is doubtful they will look at you sideways when you ask about deductibility.
The most important advice to remember, is to plan ahead! Don’t wait until December to begin considering the tax implications of the case you just started. Get informed and get to work!
