When and whether legal fees are deductible depends upon the underlying purpose of the fees. If deductible, some fees are considered capital in their nature, and must be combined with depreciable or amortizable assets, and deducted over time.
First Rule: In general, legal fees incurred by a business for business purposes are currently deductible, if not associated with a capital asset. Accordingly, you may deduct legal fees that are "ordinary and necessary" to the conduct of your trade or business.However, the rules are not as clear in respect to non-business expenses.
Second Rule: To be deductible, a non-business legal expense must be incurred under one of the following circumstances:
- The collection or production of taxable income.
- Managing, conserving or maintaining income-producing property.
- The determination, collection or refund of any tax.
Legal expenses of a purely personal nature are not tax deductible. Frequently legal services involve a mixture of personal and business matters which require the attorney to be aware of applicable tax law, and to perform a proper allocation within an opinion letter to the client for tax purposes.
Third Rule: If the fee incurred is associated with acquiring a capital asset, to the extent it is deductible, it is generally first capitalized into the asset acquisition cost, then depreciated or amortized.
TAX COURT CASE: Melat divorced his wife in 1989. In the division of marital property, Melat presented expert testimony on the value of his law partnership to the court. On his 1989 Federal Income Tax return, Melat deducted legal fees respecting his divorce of $28,000, which was 75% of his total fees.
Fees paid in connection with a divorce are usually nondeductible personal expenses. Melat claimed that the fees were deductible because they were incurred to conserve "the future stream of income" from his law practice. The Tax Court noted that the underlying action was personal in origin. Result: no deduction (Melat, TC Memo 1993-247).
Note: Only fees in connection with a rental property or other income producing property may be deducted from gross income. Other legal fees which fit into the "determination, collection or refund of taxes" category generally must be deducted as miscellaneous expenses. Miscellaneous expenses are deductible only to the extent in excess of 2% of your adjusted gross income.
