Treatment of Legal Fees Incurred by Individuals
Depending on the claim that generated them, individuals’ legal fees may be characterized in many ways, including fully deductible, or deductible only as a miscellaneous itemized deduction, or even totally nondeductible.
from The Tax Adviser
Expenses are not tax deductible unless a specific provision in the Code allows their deduction. When an expense is connected with taxable income, taxpayers are highly motivated to find ways to deduct the expense. This is particularly true of legal fees because the income they are associated with might never have materialized without legal assistance, and the legal fees may be substantial.
Possible favorable treatments for deducting legal fees include either above-the-line deductions or adjustments to basis or selling price in a property transaction. However, legal fees incurred by individuals may also fall into less favorable categories: Personal, nondeductible expenses or miscellaneous itemized deductions limited by the Two percent-of-adjusted-gross-income (AGI) limit for regular tax and not allowed for alternative minimum tax (AMT) purposes.
The existence of less favorable deduction categories has led taxpayers to claim that their legal fees fall into the favorable categories or to describe the fees in such a way that they directly reduce the related income, thereby making deduction rules unimportant. Due to taxpayer efforts to get favorable tax treatment, complicated fact patterns, and lack of clarity in the law, there have been numerous court decisions on the treatment of legal fees incurred by individuals. This article explains the possible tax treatments of legal fees and how to determine the proper treatment. Several court decisions are used as examples, and recent developments in the area are explained. An analysis of how the current rules measure up under certain tax principles is also included.
Several Code provisions are relevant in determining the tax treatment of legal fees incurred by an individual. Sec. 162 allows ordinary and necessary expenses incurred in carrying on a trade or business. Sec. 212 provides a similar rule, but for the ordinary and necessary expenses incurred for income production or collection or for the management, conservation, or maintenance of property held for income production. In contrast, Sec. 262 denies deductions for personal, living, or family expenses.
Individuals have the added complication of determining if deductible expenses are deductible for AGI (above the line) or from AGI (below the line). The preferred treatment of deductions for AGI has led to much litigation. Sec. 62 treats expenses attributable to a trade or business carried on by an individual as deductible for AGI; however, this treatment does not apply to expenses arising from services performed as an employee. An exception to the employee rule allows above-the-line treatment for reimbursed employee expenses if paid under an arrangement for reimbursement or expense allowance (an accountable plan). Thus, legal fees not required to be capitalized that come within Sec. 162 are deductible for AGI, while legal fees related to employment or income production (Sec. 212), if deductible, are deductible from AGI (as itemized deductions), subject to the limitations of Sec. 67.
Sec. 67 provides that miscellaneous itemized deductions are deductible only to the extent the total amount exceeds two percent of AGI. Sec. 67 lists various deductions that are not treated as miscellaneous itemized deductions. Legal fees are not included in the list; thus, if deductible from AGI, they are subject to the two percent limitation.
Another downside of legal fees classified as miscellaneous itemized deductions is that Sec. 56(b)(1)(A)(i) does not allow any deduction for miscellaneous itemized deductions for AMT purposes. An individual with significant legal fees that may be deducted from AGI can easily face an AMT liability. This has also led to litigation as taxpayers find alternative ways to obtain a more favorable tax treatment, particularly when taxable income was generated from the legal fees that are included in calculating both regular tax and AMT — despite the fact that the related legal fees are not deductible for AMT purposes. Some of these cases are discussed later, along with the limited relief provided by the American Jobs Creation Act of 2004 (AJCA).
Sec. 263 requires expenditures related to improvements or an increase in value of property to be capitalized (rather than expensed). For example, legal fees paid to defend or perfect title to real property must be added to the basis of the property, rather than deducted.
The leading case on the classification of expenditures as business or personal (as well as deductible versus capitalizable) is the Supreme Court decision in Gilmore (Gilmore, 372 U.S. 39 (1963)). This case examined the tax treatment of legal fees to defend a divorce action and protect the husband’s business assets against claims by the wife. The husband argued that the fees were deductible because they were incurred to conserve property (stock) held for the production of income, a position the lower court had agreed with.
The Court reversed the lower court and held that the characterization of legal fees as business or personal depended on whether the claim’s origin and character were the taxpayer’s profit-seeking activities. The characterization did not depend on the consequences that might result from not defending or defeating a legal claim or action. The Court found that this approach tied to the language of Code provisions allowing deductions for business and profit-seeking activities. The Court also found that this was the equitable result likely intended by Congress. For example, if two individuals involved in car accidents while driving for personal pleasure were able to deduct related legal fees only if the lawsuit damages were to be paid from income-producing assets (rather than from income), the law would unfairly favor the driver with investment assets to protect.
The Gilmore decision created the “origin of the claim” test for characterizing legal fees as deductible, capitalizable or nondeductible. The U.S. Claims Court has further elaborated on this test:
The object of the “origin of the claim” test is to find the transaction or activity from which the taxable event approximately resulted, Gilmore, 372 U.S. at 47, or the event that “led to the tax dispute.” Keller, 688 F.2d at 681. The origin is defined by analyzing the facts and determining what the basis of the transaction is, and does not rely on purpose, consequence or result.
Further elaboration from the Tax Court provides:
The inquiry is directed to the ascertainment of the “kind of transaction” out of which the litigation arose … Consideration must be given to the issues involved, the nature and objectives of the litigation, the defenses asserted, the purpose for which the claimed deductions were expended, the background of the litigation, and all facts pertaining to the controversy.
In Practice: Borderline Situations
In Woodward, the Court observed that a standard such as origin of the claim was likely to lead to borderline cases in which it is not easy to determine the nature of the origin. As noted earlier, the tax treatment of legal fees is a well-litigated area, and there are many court cases to consider in resolving borderline situations. This section provides guidance on identifying the origin of legal fees as capitalizable, business, employment, investment or personal.
Capitalize vs. Expense
If legal fees have their origin in ownership or protection of property, they should be capitalized rather than expensed.
Example 1: B incurs legal fees to defend a challenge to the title of his rental property. The origin of the claim that leads B to incur legal fees is protection of his investment property. Thus, B must capitalize the fees per Sec. 263.
Example 2: J is the majority shareholder of X Corp. J voted to extend the corporate charter, which the minority shareholders did not approve. State law requires J to purchase the shares of the minority shareholders. In a dispute as to the shares’ value, legal fees were incurred. Application of the origin-of-the-claim test indicates that the legal fees were incurred to acquire the minority shares, rather than to maintain J’s property. Thus, the legal fees must be capitalized, rather than expensed.
Example 3: T’s rental property was condemned by the state. T incurred legal fees to challenge the value set by the state and to receive interest on the delayed proceeds. T eventually received a higher payment for the property plus interest income. T must capitalize all of the attorney’s fees. None of the fees can offset the interest income; the origin of the claim was the condemnation, and this is what T’s attorney devoted his time to. There would have been no interest income if there had been no condemnation.
Business or Investment vs. Personal
If the origin of a claim that generated legal fees is personal, the fees are not deductible (under Sec. 262). However, if the origin is connected with taxable income or stems from a trade or business activity, it is likely to be deductible. The following examples illustrate situations in which the origin of legal fees was personal or tied to maintenance of property held for the production of income or used in a trade or business.
Example 4: E incurred legal fees in at-tempting to recover damages from a rug-cleaning business that damaged the carpets in her personal residence. The origin of the claim is the maintenance of E’s personal residence, and therefore the fees are not deductible.
Example 5: The facts are the same as in Example 4, except that the residence is rental property. The origin of the claim is now management and maintenance of property held for investment and deductible under Sec. 212.
Business vs. Employment
Due to the different tax treatment of business expenses (deductible for AGI under Sec. 162) versus most employment-related expenses (deductions from AGI and limited to Sec. 67’s 2%-of-AGI rule), taxpayers have sometimes argued that legal fees are business expenses rather than employment-related expenses.
Taxpayers have claimed that they are not employees because they were no longer employees during the time that the legal fees were incurred, even though the fees related to prior employment. Taxpayers have also argued that payments from an employer were part of a reimbursable plan, thereby allowing deduction of the legal fees for AGI under Sec. 62(a)(2)(A).
When it is not clear whether the taxpayer was an employee or independent contractor (self-employed), courts have applied the common-law rules to determine whether the payor had the right to control the taxpayer.
Finally, when a taxpayer is both an employee and self-employed, disputes have arisen as to how to categorize legal fees incurred to protect both statuses. In all of the situations, the origin-of-the-claim test was applied, once the facts had been determined, to understand why legal fees were incurred.
The origin-of-the-claim test is the approach individuals must use to determine the nature of their legal fees and thereby decide how they are treated for tax purposes. It is important to examine the facts of the claim and ask why the individual hired an attorney. Answering these questions should then enable practitioners to determine if the fees are nondeductible personal expenses, business or income related or capitalizable as related to a property interest. The potential consequences of not obtaining legal assistance are not relevant to classify the fees. There are many rulings to provide assistance in applying the origin-of-the-claim test.
Perceived inequities in the treatment of large awards and legal fees due to the two percent-of-AGI limitation of Sec. 67 and the AMT rules have been partially but not completely addressed by recent law changes. Government revenue concerns make it unlikely that these perceived inequities will be completely removed from the law. Practitioners should help clients analyze settlement options and legal fee arrangements by explaining the regular and AMT consequences of the fee arrangements before fee structures and settlements are finalized.
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Annette Nellen, CPA, Esq., is a Professor at the Department of Accounting and Finance, San José State University, San José, CA. Nellen is also a Fellow at New America Foundation, Washington, D.C.