Attorney fees that pertain to property division (such as in a divorce) are not deductible.
Whether or not certain legal fees paid are deductible can become a complicated issue. The IRS’s position is that you can usually deduct legal fees that you incur in attempting to produce, protect or collect taxable income. However, if the income you are trying to collect is tax exempt, then none of the legal fees are deductible. If the income is partially taxable, then a portion of the attorney fees may be deductible.
Any fees that are not deductible can perhaps be used to increase your basis in the subject property or investment, and either reduce your capital gain, or increase your capital loss upon disposition of the asset or investment.
Contingent Attorney Fees
One area to be careful about is the proper handling of contingent attorney fees. In a successful lawsuit that seeks compensation or damages that are taxable with a contingent fee agreement with the attorney, the arrangement may be that the attorney gets his or her portion of the award paid to him or her directly, with the balance to the plaintiff. The plaintiff may be under the impression that he or she needs to only report that part of the award received, and that the portion that the attorney receives does not have to be reported.
Most of the circuits have ruled that the full amount of the award (we’ll assume it is all taxable for this example) must be reported in income, and the part of the award that was paid directly to the attorney is a miscellaneous deduction, subject to the 2% AGI limitation. In very large award situation, the deduction for the attorney’s fee may be totally lost (because of the 2% AGI limitation). It is very important that if you receive a judgment or award and incurred attorney fees – whether or not it was a contingent arrangement – you need to seek professional advice on its treatment for tax purposes.
Here is a site to a case in the 2nd Circuit that addresses this very issue:
RAYMOND v. U.S., Cite as 93 AFTR 2d 2004-416, 01/13/2004 , Code Sec(s) 61
The Second Circuit, reversing a Vermont district court, held that an individual who settled a wrongful termination suit cannot exclude from income the portion of the settlement paid directly to his attorneys under a contingent fee arrangement. Instead, these amounts had to be included in income and deducted as miscellaneous itemized deductions subject to the 2%-of-adjusted-gross income floor.
FTB Initiates Audits on Contingent Attorney Fees
Here is an article from the FTB news that appeared in August 2006:
In the Attorney Fees Study, auditors are investigating noncompliance associated with attorney contingency fees resulting from lawsuits. Damage awards or settlements are often taxable, and cannot be excluded from the taxpayer’s gross income. When taxable, attorney fees associated with the settlement must be taken as a miscellaneous deduction, subject to a two percent limitation.
When damage awards are excludible from gross income, the attorney fees associated with the settlement cannot be deducted.
Using creative sources like legal periodicals and newspapers, FTB auditors contact taxpayers to determine whether they correctly followed the law.
The study’s early results show a high ratio of non-compliance. Based on these results, we expect to conduct more of this type of audit.
TAX COURT DECISION ADDRESSING THE DEDUCTIBILITY OF LEGAL FEES
In 2011, the Tax Court issued a Memorandum Decision addressing the issue of legal fees paid by a principal of a corporation pertaining to corporate business operations who deducted the fees on his personal income tax return. The Court cites several positions supporting their denial of the deduction:
Attorney/business owner-operator wasn’t entitled to Code Sec. 162 deduction for legal expenses allegedly relating to his business operations: taxpayer didn’t show to what business operations legal fees/lawsuits related, why he was making payments for same out of account that he used for personal expenses vs. out of corp. accounts, or why corps. themselves weren’t claiming deductions. He also failed to show business relation of multiple other claimed expenses, including expenses for law license for year during which he didn’t practice law, payment to express shipping service for shipments to ex-wife, and bank overdraft charges, so deductions for those items were also denied. (Martin G. Plotkin v. Commissioner, (2011) TC Memo 2011-260)