When Are Legal Fees Deductible?

By: Louis W. Pierro and Arthur F. Dicker

Anyone who pays legal fees would like to be able to deduct them for income tax purposes.  Unfortunately that is not often the case.  Section 262(a) of the Internal Revenue Code section provides, “Except as otherwise provided in this chapter, no deduction shall be allowed for personal, living, or family expenses.”   Most legal fees fall into this category.

            The exceptions appear in sections 162 and 212 of the Code.  Section 162(a) provides a deduction for the “ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. …”  Section 212 provides a deduction, in the case of an individual, for the ordinary and necessary expenses paid or incurred during the taxable year (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.”   (We will refer to section 212 as the “investment activity” exception for short.)

            Given a colorable argument, taxpayers sometimes try to characterize their legal fees as falling into one of these exceptional categories.  Pursuant to United States v. Gilmore, 372 U.S. 39 (1963), on remand, 245 F. Supp. 383 (N.D. Cal. 1965), the deductibility of legal fees depends on the “origin” of the underlying claim.  If the case has its origin in personal activity (e.g., divorce, DWI, etc.), legal fees are not deductible even though the case may have serious and substantial effects on the taxpayer’s investment activity or his trade or business.  For example, in the Gilmore case, the husband’s divorce proceeding threatened the loss of his car dealerships.  Nevertheless, the Supreme Court held that his legal fees were personal in origin and therefore not deductible.

            Even if they are deductible, certain legal fees will fall into the category of “miscellaneous itemized deductions,” e.g., investment activity expenses and employee business expenses.  As such, not only are they subject to the 2%-of-AGI limitation, but they are disallowed altogether for purposes of the alternative minimum tax calculation.  Whereas legal fees relating to a business activity do not suffer from such restrictions.

            Subject to these limitations, legal fees for tax advice are always deductible as investment activity expenses, even if they are related to divorce or other personal matters. 

            If a client has a matter whose fees may be deductible in part, it behooves the client to get a statement from the attorney breaking out the bill between deductible and nondeductible amounts.  For example, a substantial portion of legal fees for estate planning may be attributable to tax advice.