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The Tax Verdict On Legal Expenses

Is there any justice when it comes to deducting legal expenses? It depends on your point of view. Certain legal fees are currently deductible, others must be capitalized and still others provide no tax benefit whatsoever. Let's take a closer look at the tax treatment of the different types of legal expenses.

Is it business or personal? As a general rule, legal fees incurred by a business are currently deductible (assuming they are not capital expenditures). According to the relevant section of the tax law, you may deduct a legal expense that is “ordinary and necessary” to the conduct of your trade or business. However, the rules are considerably more complicated for nonbusiness expenses.

To be deductible, a nonbusiness legal expense must be incurred due to one of the following circumstances:

*The collection or production of taxable income;

*The management, conservation or maintenance of income-producing property; or

*The determination, collection or refund of any tax.

While nonbusiness legal expenses incurred in connection with a rental property may be deducted from your annual gross income, other costs generally are deducted as miscellaneous expenses. Key point: Miscellaneous expenses are deductible only to the extent that the total for the year exceeds 2% of your adjusted gross income (AGI). In other words, you may not get the full tax benefit of these legal expenses.

Example: Mr. Smith has an annual AGI of $100,000. In 2006 he incurs $2,200 in miscellaneous expenses, including $1,000 for legal expenses related to personal stock investments. As a result, Smith can deduct only $200 ($2,200 less 2% of AGI) on his 2006 tax return.

As a general rule, legal expenses incurred to acquire property or defend or protect its ownership must be capitalized and added to the “basis” of the property. This may allow you to claim depreciation deductions over a period of time or cut your taxable gain when the property is sold. Similarly, legal fees that are incurred in connection with buying a personal residence are added to its basis. When the home is sold, legal expenses may reduce the taxable gain.

On the other hand, legal costs related to personal or family matters generally do not provide any tax benefit. This includes fees paid in connection with a divorce or separation. Exception: The portion of the cost associated with determining the tax ramifications of alimony or other tax aspects may be deductible.

You should ask your attorney for an itemized bill spelling out the cost for various services rendered. It won't do you much good if your bill simply states that you paid for “legal services.” At the very least, make sure your attorney specifies the amount of the fee (if any) that is tax deductible. This is particularly important in the estate-planning area, where taxes can be a significant factor.

Note: These same basic principles also apply to the accounting profession. Accounting fees incurred in connection with a business generally can be deducted currently, while some individual expenses are deductible as just discussed.

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