Identifying Business-Related Legal Expenses
Determine if the fees are personal legal fees or business fees. The general rule of thumb is that legal expenses may be deducted for anything revolving around producing or collecting taxable income, and calculating, collecting, or acquiring a refund of any tax. Business-related legal fees are the most commonly deductible legal fees, though a variety of non-business related legal fees are also available. If you are unsure whether your legal fees are personal or business fees, ask yourself if you would have incurred the expense if you were not conducting business.
Perform an origin of the claim test. This test is widely accepted by courts throughout the U.S. use it to determine whether or not legal fees are a business-related expense. To perform this test, you need to look at the origin and character of the legal fee. Then you will need to determine whether the fee arose from a personal or a capital transaction. In other words, was this fee part of a business or personal activity? For example, legal fees from a divorce proceeding are personal, but legal fees paid to defend your company's reputation are business related.
Learn what business legal fees qualify. Business fees are those that are incurred while carrying on a trade or conducting business. While there is a fair amount of wiggle room in these definitions, to qualify as a business legal expense, the expense and the consultation must be: Ordinary and necessary. Ordinary expenses are those that are common and acceptable in your line of business. Necessary expenses are those that are helpful and appropriate for your trade. Reasonable in amount. Expenses must "resemble 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." Fees must have been paid by the person who received counsel, and incurred while carrying on a trade or engaging in business. If someone else paid your legal fees, you're not able to deduct those fees on your taxes.
Distinguish between the more difficult cases. In some cases, such as home-based or self-employed family businesses or expenses, it can be difficult to differentiate between legal fees that are deductible and personal expenditures. If the fee is both a personal and business expense, allocate the appropriate percentage of the expense to personal expenses, and the remaining sum to business expenses. For example, legal fees incurred to maintain a home-based office within your personal residence would qualify as deductible. As another example, if you paid $300 to have your personal and business taxes prepared, with each return costing the same amount, then you would have $150 in personal legal expenses and $150 in business legal expenses.
Consider IRS approved factors to help you determine if a deduction allocation is reasonable. If you are having trouble determining how much you can deduct, consider these factors to help you decide: time required of legal counsel difficulty of the tax questions presented to legal counsel amount of tax involved legal fees customarily charged in your locality for the legal services performed favorable or unfavorable outcome obtained as a result of the legal services
Know the difference between contingent and non-contingent legal fee agreements. A contingent legal fee agreement is when a client cannot pay all or part of the attorney’s legal fees up front, so the attorney takes a percentage of the client’s award if the case is won. A non-contingent legal fee agreement is when a client pays the attorney’s legal fees up front. Contingent attorney fees may not be deductible, but non-contingent attorney fees may be deductible. Before deducting these fees, talk to a tax specialist to determine if the fees are deductible based on the details of your case.
Understand when to capitalize your fees rather than deduct them. If your fees are related to starting up or organizing a business, they must be capitalized over a period of 15 years rather than deducted. The exception is if the total business expenses, including the fees, are less than $5,000, in which case you can deduct the full amount the first business year. If your fees are related to purchasing property or are part of your closing costs, add them to the basis of the property rather than deducting them.
Identifying Deductible Personal Legal Expenses
Decide whether or not your personal legal fees had to do with collecting income. Personal legal fees are subject to the same requirements as business legal fees. They must be incurred in the service of collecting taxable income for them to be deductible, though not necessarily "business" or "trade" related income.
Eliminate the possibility that your personal legal fee falls under a category that is non-deductible. Examples of legal services provided for personal legal expenses that are not deductible include: child custody proceeding breach of promise to marry lawsuit civil or criminal charges resulting from a personal relationship personal injury damages awarded - except whistle-blower claims and unlawful discrimination claims perfection of title to real property for personal use or any defense thereto, including preparation of title preparation of a last will and testament or any codicil thereto property claims or property settlement in a divorce proceeding regardless of whether or not the legal proceeding relates to the loss of income-producing property campaign expenses for any candidate running for office - including qualification and registration fees for primary elections legal fees incurred for the defense of charges arising from participation in a political campaign
Talk to your lawyer. Legalese is difficult to understand and even harder to negotiate come tax time. You may be confused about whether or not your legal fees may have been in some way related to income. If you're not sure, the best person to ask is always your lawyer. It's always best to discuss these matters before you talk to your lawyer about hiring them and taking on fees. Know what you'll be able to deduct before you hire on for representation and counsel.
Learn the common non-business deductions. Depending on your personal situation and legal fees, a lot goes into determining whether or not they'll be deductible. In general, though, a variety of deductions are commonly awarded. These include the following deductions, which may be made in most cases: Deduct counsel related to collecting alimony. If you consulted a lawyer to collect alimony from an ex-spouse on your behalf, those fees may be deducted from your taxes. Deduct legal fees related to necessary medical care. While legal fees related to the guardianship of estates and other affairs related to medical care are not deductible, expenses directly related to necessary medical care, including mental illness diagnoses, may be included in medical legal fee deductions. Deduct legal fees related to receiving your share of a class action lawsuit, or collecting back taxes, or any fees related to legal issues related to your employment.
Determine if your legal fees were related to producing or collecting taxable income or getting advice. These types of legal fees are deductible as a personal expense. You can deduct legal expenses incurred in your attempts to produce or collect taxable income as well as legal fees you pay in connection with the determination, collection, or refund of any tax.You can also deduct legal expenses that are related to: performing your job maintaining your employment defending yourself against criminal charges that arose out of the performance of your trade or business related to divorce tax advice when the legal billing specifies the reasonable allocation of fees toward tax advice collection of taxable alimony
Look for the "gray-area" cases. Some expenses, like those related to income-production may not actually be trade or business related, so they can't be strictly "personal" or "capital" expenses. These are still deductible, however. Examples of this include legal fees: Related to the "management, conservation, or maintenance of property held for the production of income," or fees paid related to the "determination, collection, or refund of any tax." If you own property, say, and needed to consult a lawyer to clear your legal title to a house that you use as a home office, you may be able to claim a deduction based on those fees. The best way to find out is to ask your lawyer.
Claiming Your Deductions
Use Form 1040 if you aren't taxed as a corporation. If your business operates as a sole proprietorship or a single member LLC and you haven't elected to be taxed as a corporation, deduct your legal expenses on Form 1040 Schedule C.
Claim the deductions on your business tax return if you are taxed as a corporation. Alternatively, deduct your legal fees on your business tax return if your business is a C corporation, S corporation, partnership, multi-member LLC, or single member LLC and you've elected to be taxed as a C or S corporation.
Categorize personal expenses if applicable. If you will itemize expenses, determine which category the personal legal expenses fall under so you can claim them correctly. Note that certain types of legal fees related to discrimination suits as well as money awarded to whistleblowers may be deductible as an "above the line" deduction. This means they are deducted in a different place on the tax return (not as an itemized deduction). Note that you can no longer deduct unreimbursed medical expenses nor tax preparation fees as per the 2017 Tax Cuts and Jobs Act.
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