Tax Deductions on Legal Fees
To put it very simply, a tax deduction is a figure that you subtract from your Adjusted Gross Income (AGI) when you file your taxes, which reduces the amount of income on which you will be taxed. Basically, legal expenses are only tax deductible in certain cases and for a limited amount of expenses. Legal fees related to debt discharge might be deductible on your tax return, depending on the circumstances. In their publication for taxpayers, the IRS clearly states that "Fees paid to attorneys are deductible only if they are directly related to a taxable award or settlement . " For example, if your lawyer helped you obtain compensation for personal physical injuries, you don’t necessarily get to deduct the attorney’s fees on your tax return. That said, if your attorney successfully disputed a government source of income that was subject to tax, then you may be able to deduct the fees associated with that legal process. While taxable awards are considered to be fully deductible, some awards are non-taxable; therefore, no legal fees can be deducted from these non-taxable awards.
Different Types of Legal Fees that Qualify for Tax Deductions
The IRS allows taxpayers to deduct certain legal fees as a business expense. To figure out exactly which types of fees are eligible, you need to consider the legal work that was performed as well as the business purpose those efforts are directly related to. Essentially, deductions are allowed for legal fees that pertain to your "trade, business or income-producing activity."
It’s also important to understand that if a transaction is closed that is taxable and has a tax purpose then legal fees associated with that transaction may be deductible. If you are being sued and must defend yourself against a breach of contract or securities or copyright claim, those costs meet the above criteria and are generally tax-deductible as ordinary business expenses.
For example, if you are being sued for patent infringement, some legal fees related to defending the suit may be eligible as a deduction against any income that the patent generates for you, your company or your shareholders. So even though there is a tax purpose associated with this type of litigation those legal fees are still tax-deductible.
For yourself personally, any legal fees relating to a divorce or child custody proceeding cannot be deducted. Legal fees incurred to obtain a new name may be eligible as a deduction, but the costs of filing a lawsuit to change your name isn’t. Legal fees associated with a civil suit, or a court proceeding such as filing a lawsuit to obtain a restraining order, aren’t deductible.
It’s critical to consider the direct relationship between the legal fee and the taxable income generation. Even if there is a tangential relationship, it may not be deductible. For example, if you are involved in cleaning up pollutants left by your ex-spouse and you have no income associated with that, the costs of the cleanup may not be deductible against your income if it is coming solely from a different source.
Legal Fees That Are Not Tax Deductible
Certain types of legal fees are not deductible. These include personal legal expenses, such as those incurred in connection with a divorce or related to the preparation of a will. The IRS also bars deductions for fees incurred to protect income-producing property. If you are involved in a controversy with the IRS and pay for a professional to represent you before the IRS, those fees also are not deductible. In addition, maintaining a suit or filing an appeal or reformation of a will is personal and therefore not deductible.
How to Claim a Legal Fee Tax Deduction
Taxpayers may be able to deduct some or all of the legal fees they’ve incurred depending on a number of factors, including the type of tax return filed and the purpose of the legal services involved. Most deductions apply these days only for issue-based litigation of tax matters, not for routine tax return preparation or tax advice. And under the Tax Cuts and Jobs Act for 2018 through 2025, many legal fees have been rendered nondeductible in connection with nonbusiness activities (except for harassment suits and sexual abuse claims).
To take a deduction, you must itemize your deductions by filing Schedule A with your Form 1040. However, even if the IRS won’t let you deduct the full amount of legal fees you’ve paid, your payments may not all be disallowed. In some cases , the deduction for the legal fees you do take may be subject to an adjusted gross income limitation (AGI limitation), which is an 80% limitation after adding back specific itemized deductions: unreimbursed medical expenses above 7.5% of AGI, state and local taxes above $10,000, property taxes above $10,000, certain personal casualty and theft losses, investment interest above net investment income, unreimbursed mortgage interest, and gambling losses.
If you take a deduction, you’ll need to provide sufficient documentation to substantiate the deduction, including the amount paid and the recipient of the payment. To be deductible, legal fees paid for the production or collection of taxable income must be ordinary and necessary, directly related to a business or income production and not capital in nature.
Mistakes to Avoid with Legal Fee Deductions
Taxpayers often make errors in their pursuit of deducting legal fees. Here are a few common mistakes, and some guidance about avoiding them.
- Not Being Specific Enough. One of the most common errors due to a lack of specifications. For example, simply saying you are trying to reduce a large tax bill is not specific enough. You need to be clear about the area of the law in which you are seeking assistance.
- Not Including Necessary Documents. When you call to set up an initial consultation with an attorney, it is likely that he or she will ask you to bring a number of documents to the meeting so that a comprehensive evaluation can be made. It is important to furnish these documents prior to the meeting, not during, after or before, and not all of them at once if a substantial group of them have to be provided. For example, if you want to have an attorney negotiate a fine imposed by the IRS, you should provide proposed documents when you are thinking about hiring the attorney, not after the fact. It isn’t fair for a lawyer to charge you for time spent searching high and low for the documents required.
- Trying to Deduct Too Much. It may seem that you can write off a substantial amount of legal fees, but remember: only the portion used to obtain a specific tax benefit can be deducted. So, for example, if you want to fight a tax penalty imposed on your income taxes because they were too high, only that portion – not the part to lower the tax bill – can be written off.
- Not Seeking Out Professionals. Once you know you have a valid reason to hire an attorney, seek out several professionals with experience in the relevant field. You will also want to make sure the attorney gives you a comprehensive rundown on his or her credentials and history. Be sure to get a fee quote as well so that you are not taken by surprise.
- Not Keeping Good Records. Make sure that you document everything you do with legal professionals. All appointments, calls, payments and pieces of correspondence should be tracked just as thoroughly as your tax documents and money.
These are just a few of the most common mistakes that can occur when you are trying to write off legal fees.
When to Consult a Tax Professional
When in doubt, hiring a tax professional is always a favorable option. A tax professional can bring expertise and knowledge to a complex situation that the average individual or small business does not have. If you find yourself unsure of how to proceed with your legal fee deductions, hiring a tax professional may be your best option.
In addition to giving you a sense of assurance that your legal deductions are being handled properly within the bounds of the law, an experienced tax professional can also act as an intermediary between you and the IRS upon request.
A tax professional will work with you to determine if your legal fees are deductible and, if so, to what extent . The tax professional can also help you prepare the proper forms and explain on the forms why you are deducting legal fees, should you be questioned by the IRS. Legal fees are a common target for IRS audit. Because the IRS is more likely to audit a tax return containing legal fee deductions, one advantage to hiring a tax professional is that they can anticipate these kinds of requests and provide guidance on how best to respond.
Likewise, if you are facing a lawsuit or some other litigation involving more than just legal fees, hiring a tax professional is in your best interest. If litigation includes legal fees, as well as other costs, it could be burdensome to break down costs in a compliant way without the assistance of a tax professional.