Are Personal Legal Fees Tax Deductible?

Tax deductions for legal fees can reduce your taxable income, but the rules are not always straightforward. The Internal Revenue Service (IRS) categorizes expenses as personal, living, or family expenses, which are not deductible. However, specific exceptions exist where legal fees may qualify as a tax deduction. Understanding these distinctions is important for individuals seeking to manage their tax obligations effectively. This article explores the principles of non-deductibility and then delves into the circumstances under which legal fees can be deducted.

Understanding Non-Deductible Personal Legal Fees

Most legal fees incurred for personal matters are not tax deductible. These expenses are considered personal and do not directly relate to generating income or a business activity. For example, legal fees associated with divorce proceedings, child custody battles, personal injury lawsuits, drafting a personal will or trust, purchasing a personal residence, or defending against personal criminal charges are not eligible for a tax deduction. These expenses are viewed as personal expenditures, distinct from those incurred in the pursuit of a trade, business, or investment.

Legal Fees Related to Income Generation or Business

Legal fees can be deductible if they are considered “ordinary and necessary” expenses directly related to producing or collecting taxable income, managing or maintaining property held for income production, or operating a trade or business. An ordinary expense is common and accepted in your industry, while a necessary expense is helpful and appropriate for your business.

For business owners, legal fees for setting up a business, drafting contracts, negotiating agreements, or defending against lawsuits related to business operations are deductible. This includes costs associated with employee disputes, compliance advice, or business bankruptcy. These expenses are reported on Schedule C (Form 1040) for sole proprietors.

Legal fees connected to investment activities are deductible if they relate to managing, conserving, or maintaining property held for producing income. This includes fees for tax advice related to investments or defending title to investment property. Many investment-related fees previously deductible as miscellaneous itemized deductions are no longer allowed after the Tax Cuts and Jobs Act of 2017.

Legal fees paid to collect taxable alimony, for divorce decrees issued before 2019, may be deductible by the recipient. This deduction applies to the portion of legal fees attributable to producing taxable alimony. Fees paid for tax advice, preparing tax returns, or defending against tax audits are deductible. If these tax-related legal fees pertain to a business reported on Schedule C, they can be deducted as a business expense.

Legal Fees for Specific Tax Situations

Certain specific situations allow for the deduction of legal fees. These deductions are “above-the-line,” meaning they reduce your adjusted gross income (AGI) and are not subject to the limitations that previously applied to miscellaneous itemized deductions.

Legal fees and court costs paid in connection with whistleblower awards are deductible. This includes awards from the IRS for detecting tax law violations, the Securities and Exchange Commission (SEC), and Commodity Futures Trading Commission (CFTC) whistleblower programs. The deduction for these fees cannot exceed the amount of the award included in your gross income for that tax year.

Attorney fees and court costs related to unlawful discrimination lawsuits are deductible. This deduction applies to claims brought under various federal, state, and local anti-discrimination laws. Like whistleblower awards, the deduction is limited to the amount of the judgment or settlement included in income. These deductions are claimed as an adjustment to income on Schedule 1 (Form 1040).

Legal fees incurred to recover amounts from a qualified retirement plan may be deductible. This applies when legal action is necessary to access or recover benefits from a retirement plan.

How to Claim Deductions and Keep Records

Claiming deductible legal fees on your tax return requires attention to where the expense is reported. For legal fees related to a trade or business, they are reported on Schedule C (Form 1040), Profit or Loss from Business. Legal fees associated with rental properties are reported on Schedule E (Form 1040), Supplemental Income and Loss. For specific “above-the-line” deductions, such as those for whistleblower awards or discrimination lawsuits, the fees are reported on Schedule 1 (Form 1040), which adjusts your gross income before arriving at adjusted gross income.

Maintaining meticulous records is essential for substantiating any tax deduction. Keep detailed invoices from your attorneys that clearly describe the services rendered and the costs associated with each service. These invoices should differentiate between deductible and non-deductible services if the legal matter involves both personal and business aspects. Payment records, such as canceled checks, bank statements, or credit card slips, are crucial to prove the expense was incurred.

Retaining correspondence, court documents, or settlement agreements related to the legal matter provides additional support for your deduction. The IRS recommends keeping records for at least three years from the date you filed your original return or two years from the date you paid the tax, whichever is later, if you claim a refund. For significant items or substantial income underreporting, the IRS may look back six years or more. Organizing these documents systematically will simplify the process if your tax return is ever selected for review.