The tax law does not specifically mention legal fees as deductible items. Therefore, the deductibility of such expenditures depends on the context in which they are incurred. The absence of specific provisions for legal fees in the Code has resulted in many interesting and important developments concerning their deductibility.
Trade or Business Legal and Professional Fees
Fees Must Be Incurred in Carrying on a Trade or Business
Fees Must Be Ordinary and Necessary
Fees Must Be Reasonable in Amount
Fees Must Be Paid or Incurred During Taxable Year
Fees Must Be Paid by Person to Whom Services Are Rendered
Deductible Non-Business Legal and Other Professional Expenses
Fees Paid or Incurred in Connection with the Production or Collection of Income
Fees Paid in Connection with the Management, Conservation, or Maintenance of Property for the Production of Income
Fees Paid in Connection with the Determination, Collection, or Refund of Any Tax
Legal and Other Professional Fees Constituting Personal Expenses or Capital Expenditures
Origin of the Claim Test
Allocation of Legal and Other Professional Fees Which Are Partly Personal Expenses or Capital Expenditures
Amounts paid for legal and other professional services may, depending on the factual circumstances and the ability of the taxpayer to meet the applicable legal requirements for deduction, have the following tax consequences: (1) a deductible expense or as one of the three categories of deductible nonbusiness expenses: (2) a personal expense which is nondeductible; (3) a capital expenditure which is nondeductible, but which may be subject to depreciation or amortization; (4) a deductible loss; or (5) a combination of the foregoing.
In order to be deductible as a trade or business expense, legal and professional fees must be: (i) incurred in carrying on a trade or business; (ii) ordinary and necessary; (iii) reasonable in amount; (iv) paid or incurred during the taxable year in which the taxpayer seeks to deduct them; and (v) paid by the person to whom the services are rendered. These requirements are discussed briefly below.
A taxpayer cannot deduct legal and professional fees paid or incurred in a taxable year (even if they are shown to be ordinary, necessary and reasonable and meet the other requirements herein discussed) unless the taxpayer can show that the expense was paid or incurred in carrying on a trade or business. Whether the taxpayer’s activities amount to engaging in a trade or business is a factual question.
The Code does not provide any specific definition of “trade or business.” There are, however, literally hundreds of contradictory cases, which interpret the term in different ways. In general, the taxpayer must be engaged in an activity on a continuous and regular basis (rather than intermittently or sporadically) in order to qualify as engaging in a trade or business. One indication that a taxpayer is engaging in a trade or business is that he devotes a substantial portion of time to the business.
A taxpayer is engaged in a trade or business while acting as an employee. However, it is preferable for an expense to qualify as an expense that is related to a trade or business other than the trade or business of being an employee, because legal fees that are related to the trade or business of being an employee, are miscellaneous itemized deductions, which are subject to the floor and the overall limitation on itemized deductions. Moreover, a taxpayer that is subject to the alternative minimum tax is precluded from deducting certain expenses, including attorney’s fees that would otherwise be allowable as miscellaneous itemized deductions.
A taxpayer is not engaged in a trade or business if he engages in investment-management activities on a full-time basis, although such expenses, including professional fees, may be deductible under the rules for expenses incurred for the production of income.
In addition to the requirement that the taxpayer be regularly and continuously engaged in business activity, the taxpayer must also be engaged in the activity with the predominant purpose of making a profit in order to be engaged in a trade or business.
In order to be deductible as a trade or business expense, an expenditure must be both (i) ordinary and (ii) necessary. Since there is no fixed rule as to what expenditures will constitute “ordinary and necessary expenses,” the question is treated as essentially one of fact, and thus no broad generalizations regarding what expenditures will qualify can be made. The “ordinary and necessary” requirement should be fairly easy to meet for most legal fees, since the taxpayer will generally have good reasons for using such professional services.
Legal expenses that otherwise qualify for deduction are deductible only as long as they are also reasonable in amount. The regulations indicate that expenses coming “must be reasonable in amount and must bear a reasonable and proximate relation to the production or collection of taxable income or to the management, conservation, or maintenance of property held for the production of income.”
The fact that a service provider renders or provides a legal, or other professional service to the taxpayer in a particular tax year does not mean that the fee can be deducted in that year. Deductibility depends on whether the fee is paid or incurred in the taxable year in which the deduction is sought, which, in turn, depends upon the taxpayer’s method of .
Another requirement for deductibility is that the expenses that the taxpayer seeks to deduct must be those of the taxpayer and not of someone else. Thus, generally, a corporation must incur legal and other professional fees for its own benefit and cannot deduct fees incurred only for the benefit of its stockholders. Legal expenses, however, and amounts paid by a corporation in defending or settling suits against employees arising out of the business are deductible by the corporation since such expenditures are deemed to be for the benefit of the corporation. incurred for the production or collection of income. The Commissioner argued unsuccessfully that the payments were capital in nature.
The courts generally hold that a shareholder’s legal and other professional fees are deductible by the corporation where the shareholder is successful as a plaintiff against the corporation, and where, by reason of state law, court order, or court-approved settlement, the corporation is required to pay the fees. Officers’ and directors’ legal fees in derivative suits for breach of fiduciary duty in the conduct of the corporation’s affairs have also generally been held deductible. The corporation’s payment of such fees is deemed to be for the benefit, and an ordinary and necessary part, of the corporation’s business.
Some expenses, which are paid or incurred in connection with income-producing activities (such as investing) of a noncorporate taxpayer, are not actually trade or business expenses and also cannot be characterized as either personal expenses or capital expenditures. These expenses are deductible. Thus, legal and other professional fees which might otherwise appear to be nondeductible, are in fact deductible if they are (i) paid or incurred for the production or collection of income, (ii) paid or incurred for the management, conservation, or maintenance of property held for the production of income, or (iii) paid or incurred in connection with the determination, collection, or refund of any tax.
It should be noted, however, that deductible nonbusiness legal and other professional expenses must still meet all the other requirements of deductible trade or business expenses. Thus, such expenses must be ordinary and necessary and reasonable in amount. Instead of the standard that requires that trade or business expenses be incurred in the carrying on of a trade or business, the tax law imposes a requirement that the expenditure bear a reasonable and proximate relation to the production or collection of income or to the management, conservation, or maintenance of property held for the production of income.
The first category of expenses that are deductible comprises those paid or incurred “for the production or collection of income.” It is not necessary that they relate to the production or collection of income in the current taxable year, as long as the legal expenses were currently paid or incurred. Thus, in defining “income”, the regulations state that the term includes income that was realized in a prior year, is realized during the current year, or may be realized in subsequent years. The regulations further provide that the term “income” is not confined to recurring income, but applies as well to gains from the disposition of property.
Actual collection of income is not required, provided there is an effort to collect, i.e., an undertaking involving legal services pursued with the expectation of realizing income or profit. The deduction only applies with respect to taxable income; legal and other professional fees paid or incurred in connection with the production or collection of tax-exempt income are nondeductible.
Ordinary and necessary expenses paid or incurred for the management, conservation, or maintenance of property held for the production of income are deductible. Even though the property may not be currently productive and there is no likelihood that the property will be sold at a profit or otherwise will be productive of income, expenses paid or incurred in managing, conserving or maintaining it may be deductible. This is also true where the property is held merely to minimize a loss. Furthermore, ordinary and necessary expenses paid or incurred in the management, conservation, or maintenance of a building devoted to rental purposes are deductible notwithstanding that there is actually no income there from in the taxable year, and regardless of the manner in which, or the purpose for which, the property in question was acquired.
Legal fees and other expenses paid for the management or conservation of real property held in connection with a taxpayer’s hobby or similar activity, or as the taxpayer’s residence are not deductible. If, however, the taxpayer vacates and converts his residence to rental property, legal expenses incurred in its management as rental property are deductible.
For purposes of the rule concerning the maintenance, conservation, and management of property held for the production of income, the terms “maintenance” and “conservation” seem to refer to actions taken with regard to the property itself, such as safeguarding or upkeep, rather than the taxpayer’s retention of its ownership.
An individual taxpayer is entitled to deduct any legal or other professional fee, which is ordinary and necessary and paid or incurred during the taxable year in connection with the determination, collection, or refund of any tax.
Planning for future transactions is clearly deductible.
Although the Code specifically allows a deduction for certain personal expenses (e.g., alimony, charitable contributions, etc.), as a general rule, expenditures that are strictly personal are not allowed as a deduction. Since there is no specific allowance in the Code for legal and other professional expenditures that are personal in nature, such expenses are nondeductible. Similarly, legal and other professional expenses that are capital in nature and thus not deductible in the year in which they are paid or incurred will be either nondeductible or deductible, if at all, in a taxable year occurring after the current taxable year. It should be noted, however, that although no immediate tax benefit is derived from legal or other professional expenses that are categorized as personal, capital expenditures are added to the basis of the property and may be recovered either when the property is disposed of, or as depreciation or amortization deductions over a number of years.
Because not all litigation expenses are deductible, it may be necessary to apply a judicially-developed test to determine deductibility. This is particularly true where it is unclear whether the expense is personal, capital in nature, or deductible. The courts have created the “origin of the claim” test to assist in this endeavor; the test applies regardless of whether it is the plaintiff or the defendant who seeks the deduction.
Under this theory, the origin and character of the claim with respect to which the legal or other professional fee was paid or incurred is examined to determine whether it arose from a personal or capital transaction or whether it is related to a business or profit-seeking activity. For example, legal fees incurred in a divorce proceeding to dissolve a marital relationship clearly originate from a claim that is personal in nature. Such fees, therefore, are nondeductible as personal expenditures. Similarly legal fees paid or incurred in the acquisition or disposition of, or in perfecting title to, property originate from a claim that is capital in nature, and must be capitalized.
If the transaction in which a legal or other professional fee is incurred is partially attributable to a trade or business or a nonbusiness activity and partially to nondeductible living, personal, and family activities or to capital expenditures, the taxpayer will not be entitled to deduct the entire fee. Instead, the taxpayer must allocate the fee between a deductible portion and a nondeductible portion. Thus, in filing a tax return, the taxpayer (or the IRS or a court, if the taxpayer failed to do so, or has done so incorrectly) must allocate the fees between deductible fees and nondeductible fees.
Since allocations are inherently factual, no hard and fast rules can be advanced for how an allocation must be made. Fees need not be allocated in exactly the same proportions as the underlying claims.
The IRS has indicated that it will consider the following factors when determining whether an allocation is reasonable:
(a) the time required;
(b) the difficulty of the tax questions presented;
(c) the amount of tax involved;
(d) the fees customarily charged in the locality for the services performed; and
(e) the results obtained.