Are Legal Fees Tax Deductible in California?

Understanding the tax deductibility of legal fees can be complex, especially in California where state tax laws differ from federal regulations. While some legal expenses can reduce taxable income, this is not a universal rule and depends on the legal service’s nature. The Internal Revenue Service (IRS) and the California Franchise Tax Board (FTB) have distinct guidelines. This article clarifies the general principles governing legal fee deductibility under both federal and California tax laws.

General Principles of Legal Fee Deductibility

For a legal fee to be deductible under federal tax law, it must be “ordinary and necessary” and directly related to income-producing activities or a trade or business. An “ordinary” expense is common and accepted in an industry, while a “necessary” expense is helpful and appropriate. These expenses must also directly support income-generating efforts.

The Tax Cuts and Jobs Act (TCJA) of 2017 eliminated most federal miscellaneous itemized deductions subject to the 2% adjusted gross income (AGI) limit for tax years 2018 through 2025. This impacts legal fees related to income production or collection, or tax determination, collection, or refund, which were previously deductible.

California tax law does not conform to the TCJA’s elimination of these deductions. Therefore, while certain legal fees are no longer federally deductible, they may still be deductible on your California state tax return. These state deductions are subject to the 2% AGI limitation, similar to federal rules prior to the TCJA.

Legal fees related to acquiring, defending title to, or improving property are not immediately deductible. Instead, these costs must be capitalized. This means they are added to the asset’s cost basis and may reduce any taxable gain when the asset is sold.

Specific Scenarios for Deductible Legal Fees

Legal fees incurred in a trade or business are deductible as ordinary and necessary business expenses. This includes expenses for contract disputes, intellectual property protection, or defending against business-related lawsuits. These fees are deductible for both federal and California tax purposes, typically reported on business schedules.

For employment-related legal fees, federal tax code allows an “above-the-line” deduction for certain claims. This includes fees for whistleblower actions under Internal Revenue Code Section 62, or claims of unlawful discrimination. These deductions are subtracted from gross income to arrive at adjusted gross income, making them deductible even with TCJA changes. California conforms to these federal deductions for employment and whistleblower claims.

Legal fees for tax advice, preparation, or representation in tax audits are also considered for deduction. While these fees are no longer federally deductible for individuals due to TCJA changes, California law maintains their deductibility. On your California state tax return, these fees can be claimed as a miscellaneous itemized deduction, subject to the 2% adjusted gross income limit.

Legal fees to collect taxable alimony from divorce or separation agreements predating 2019 were historically deductible. Federally, the TCJA eliminated this deduction. However, for California state tax purposes, these fees may still be deductible as a miscellaneous itemized deduction, subject to the 2% AGI threshold, provided the alimony is taxable under pre-2019 rules.

Legal Fees That Are Not Deductible

Legal fees for purely personal matters are not deductible for tax purposes. This includes expenses for drafting a will, personal injury lawsuits where damages are not taxable, or legal matters unrelated to a business or income-producing activity.

Legal fees incurred during divorce or separation proceedings are not deductible. This includes costs related to child custody, property division, or general divorce litigation. A narrow exception existed for fees directly related to collecting taxable alimony from agreements prior to 2019, but federal law largely eliminated this.

Legal fees associated with acquiring or defending title to property, or improvements to property, are not deductible but must be capitalized. These costs are added to the property’s basis, which can reduce the taxable gain upon sale. Examples include fees for purchasing a home or defending real estate ownership. Additionally, legal fees incurred to produce tax-exempt income are not deductible.

Reporting Deductible Legal Fees

For legal fees related to a trade or business, sole proprietors report these as “other expenses” on Schedule C (Form 1040), Profit or Loss from Business. Those with rental properties may report them on Schedule E (Form 1040), Supplemental Income and Loss, and farmers on Schedule F (Form 1040), Profit or Loss from Farming. These forms allow direct deduction against business income.

Specific employment-related legal fees, such as those for whistleblower awards or unlawful discrimination claims, are reported as an adjustment to income on Schedule 1 (Form 1040), Additional Income and Adjustments to Income. This allows an “above-the-line” deduction, which reduces your adjusted gross income. The deduction is generally limited to the amount of the award includible in your gross income.

For California state tax returns, legal fees no longer federally deductible due to the TCJA but deductible under state law (e.g., for tax advice or income-producing activities) are reported as miscellaneous itemized deductions. These amounts are entered on Schedule CA (540), California Adjustments, Part II, then transferred to Schedule A (540), Itemized Deductions. The deduction is subject to the 2% AGI limitation and applies only if you itemize deductions on your California return.

Maintaining meticulous records of all legal fees is important. This includes invoices, statements, and detailed descriptions of the legal work performed. Proper documentation is necessary to substantiate any claimed deductions if your tax return is reviewed.