Attorney fees can quickly add up, leading many individuals to question where and how they should deduct them on taxes. Since 2004, the IRS has made it easier for taxpayers to claim these expenses as tax deductions; nonetheless, it still presents unique difficulties.
Origin is key when deciding if legal fees should be classified as personal or business expenses. Here are some examples to help guide you:
Business expenses
Legal fees vary in their tax treatment based on numerous factors and can often differ significantly. While some legal fees qualify for favorable treatment as above-the-line deductions or adjustments to basis or selling price in property transactions, others qualify as miscellaneous itemized deductions limited by Sec 67’s 2%-of-AGI limit for regular or alternative minimum taxes purposes and still others may fall into less favorable categories like personal nondeductible expenses or employment-related expenses subject to that limitation.
Legal fees directly related to a business or rental property can usually be deducted on Schedule C, F, or E of Form 1040. For instance, landlords hiring attorneys to fight off problem tenants are eligible to claim these legal expenses as deductions on Schedule C or E, while lawyers handling whistleblower and civil rights cases involving significant money can claim similar deductions on Schedule A line 24h as miscellaneous itemized deductions.
Personal expenses
Legal fees can be difficult for individuals to classify according to tax code requirements, since legal expenses tend to fall either into nondeductible personal expenses or itemized deductions subject to the 2%-of-adjusted-gross-income cap. In certain instances however, legal fees may still be considered deductible expenses.
Individuals must use the origin-of-the-claim test to classify their legal fees properly. When considering why and whether these expenses relate to trade or business activities, this test can help individuals decide if their legal expenses should be deducted as expenses or capitalized as investments.
One who owns rental property may be eligible to deduct attorney fees related to maintaining their investment properties as above-the-line deductions, including legal costs associated with maintenance, eviction proceedings and contractual disputes. Furthermore, the IRS allows people to deduct legal costs associated with certain whistleblower and civil rights claims as above-the-line deductions.
Settlements or awards
Attorney fees incurred while settling or awarding legal claims or actions may be deductible; however, tax laws regarding these deductions have changed frequently over time and must be carefully observed.
Example: in a contingent fee case where legal fees are payable over several years, plaintiffs can deduct only those charges made during the year of recovery. Some plaintiffs have claimed this limitation unfairly prevents them from taking full advantage of their legal fees.
Similar to settlements and awards, certain awards or settlements may be taxable as income. For instance, when awarded money as damages caused by destructive tenants in their rental property, such payments should also include amounts allocated as legal expenses deductions (according to Secs. 163) and Secs 164. The rules for reporting this payment are laid out in Sec 164.
Taxes
Legal fees are an often necessary expense, yet their tax treatment can vary significantly depending on the source and nature of any associated income claims. Deduction options could include miscellaneous itemized deductions, above-the-line deductions or adjusted cost basis adjustments in property transactions.
Attorney fees associated with business matters are typically deductible as ordinary and necessary business expenses, while fees rendered to clients for services related to tax collection, refund, or determination can often be written off as tax-related expenses. Furthermore, personal legal fees incurred due to unlawful discrimination claims, civil rights cases or whistleblower lawsuits may qualify as deductions above-the-line deductions.
Congress created an above-the-line deduction in 2004, shortly before the Banks decision, for plaintiffs in employment and certain civil rights lawsuits who pay contingent fees; this effectively ensures they pay taxes on net recoveries rather than gross recoveries. Unfortunately, however, its mechanics remain complicated, leaving many taxpayers and accountants with difficulty claiming this deduction. For 2021 returns, however, the IRS made this process simpler by adding a line item for attorneys’ fees on Schedule 1.