What Legal Fees Are Deductible on Your US Income Tax Return?
IJ Zemelman Jun-15-2015
There are times in which legal fees are a necessary evil. When you are able to deduct your legal fees, they become less of an ‘evil’. It’s important to understand, though, which legal fees are deductible and which are not. Before we get into the different rules for legal fees which are deductible, let’s first outline those which are not: Personal legal fees. Personal legal fees (i.e.: fees used to pay a divorce attorney or fees used to hire an attorney to dispute a lawsuit that was brought against you) are non-deductible. These are considered personal expenses by the IRS, so that means you will not be able to claim them on your list of itemized deductions.
If you own a corporation, an LLC, a partnership, or even if you are a sole proprietor, legal fees associated with helping the reputation of your business will be considered a business investment and will – therefore – be fully deductible. The term ‘fully deductible’ means that there are no limitations or AMT (Alternative Minimum Tax) associated with your deduction. In order to claim your investment legal fees, you must legitimately be conducting business.
If you are not regularly filing as a proprietor, the legal fees associated with your business may be viewed by the IRS as miscellaneous itemized deductions. If this is the case, it will result in limitations being placed on your deductions. Legal fees which are equal to up to two per cent of your AGI (Adjusted Gross Income) are non-deductible. At higher income, deductions are completely phased out. Once you compute the AMT (which is a separate tax with a rate of 28 per cent), there is no deduction whatsoever. To avoid these limitations, you should file your US income tax as a proprietor and file Schedule C (assuming you are actually in business).
There is a different set of rules for attorneys with a contingency fee. If, for example, you are awarded $1M from a lawsuit that was handled for you by a contingency attorney who receives 30% of your lawsuit earnings, you may be under the assumption that you will only be required to pay taxes on the $700K you received. This is a false notion; you will be responsible for taxes on the entire $1M balance. If the settlement was for a personal injury case, you don’t have to worry, because compensation for personal injury cases are always tax-free – as long as the entire balance is for personal physical injury or physical sickness recovery. If there were punitive damages or interest, those items will be taxable.
If you have hired a contingency attorney to help with an employment suit, you will only be taxed on the amount you receive after attorney fees have already been taken out. The majority of employment lawsuits result in recoveries which are viewed by the IRS as income. Therefore, they do not qualify for the same exclusion as physical injury or sickness. A settlement will either be in the form of wages which are subject to withholding at the time they are paid out or non-wage income which will be reported on Form 1099.
Here are some other important tax laws on attorney fees:
- Capitalizing Attorney Fees: There are a variety of business and investment legal expenses which must be ‘capitalized’. If you are planning to sell your business and you accumulate $40K worth of legal fees, you are required to add this amount to your basis.
- Tax Advice: You may deduct legal fees spent on tax advice. This includes income taxes, estate taxes, gift taxes, property taxes, excise taxes, and sales and use taxes. Your fees may be incurred as a result of tax planning for your personal US expat tax return or getting advice on claiming your itemized deductions.
- Be Aware of Combined Cases: If you are awarded a settlement which includes both taxable and tax-free damages, you will be required to parcel your attorney fees. Assume, for example, that you are in a severe auto accident and you receive $500K for personal injury and $500K for punitive damages. Assume, also that your attorney receives 30 per cent of your award. Because your punitive damages are taxable, half of your attorney’s fees are income.
I.J. Zemelman, EA is the founder of Taxes for Expats