When Are Attorney Fees Tax Deductible?

The deductibility of attorney fees is determined by the nature of the legal services provided. Whether the costs are connected to business operations, investment activities, or personal matters dictates their tax treatment. The Tax Cuts and Jobs Act of 2017 (TCJA) revised the rules for individuals, eliminating many previous deductions. The core principle is that fees must be linked to an income-producing activity to be considered for a deduction.

Deducting Business-Related Legal Fees

Legal fees that are “ordinary and necessary” for the operation of a trade or business are deductible. An ordinary expense is one that is common and accepted in your specific industry, while a necessary expense is one that is helpful and appropriate for your business. These costs are reported against the income generated by the business, lowering the taxable profit.

For sole proprietors, independent contractors, and single-member LLCs, these expenses are reported on Schedule C, “Profit or Loss from Business.” Examples of deductible fees include the cost of hiring an attorney to draft contracts for clients, pursue collections on unpaid invoices, or defend the business against a lawsuit. Keeping records, such as invoices and payment receipts, is necessary to substantiate these deductions.

Owners of rental properties report their income and expenses on Schedule E, “Supplemental Income and Loss.” Legal fees related to these rental activities are deductible on this form. Common examples include costs for an attorney to handle the eviction of a tenant, draft lease agreements, or resolve property line and zoning disputes.

Farmers report their operational income and expenses on Schedule F, “Profit or Loss From Farming.” Legal fees must be directly related to the farming operation to be deductible. This could include legal costs associated with negotiating land leases, resolving disputes over water rights, or defending against claims related to farm operations.

When Legal Fees Must Be Capitalized

Not all business-related legal fees can be deducted immediately. Certain legal costs must be capitalized, which means they are added to the tax basis of a business asset. This treatment applies when the legal services are part of acquiring a long-term benefit for the business, rather than relating to day-to-day operations.

Instead of an immediate deduction, the cost of these legal fees is recovered over time. For tangible assets like buildings, this recovery happens through depreciation. For other assets, the capitalized fees reduce the amount of taxable gain or increase the deductible loss when the asset is eventually sold.

An example of a capitalized legal expense is the cost incurred during the acquisition of a business asset. This includes attorney fees for negotiating the purchase of a commercial building, conducting due diligence for a business acquisition, or securing a patent or trademark. These costs are considered part of the asset’s acquisition cost and are added to its basis.

Legal fees associated with defending or perfecting the title to a property are also required to be capitalized. Fees for organizing a business entity, such as a corporation or partnership, are treated as capital expenditures. However, a business can elect to deduct a portion of these costs in its first year of operation, with the remainder being amortized over 15 years.

Allowable Deductions for Personal Legal Fees

Following the TCJA, the deduction of personal legal fees has been restricted. Most miscellaneous itemized deductions, which previously allowed for some personal attorney fee deductions, were suspended. However, a few specific types of personal legal fees remain deductible as “above-the-line” deductions, which reduce a taxpayer’s Adjusted Gross Income (AGI) and can be claimed even if the taxpayer does not itemize.

One of the remaining deductions is for legal fees paid in connection with certain unlawful discrimination claims. This applies to actions alleging discrimination based on factors such as race, sex, age, or disability in an employment context. The amount of the deductible legal fees cannot exceed the amount of the judgment or settlement included in the taxpayer’s gross income for the year.

Legal fees related to specific whistleblower actions also qualify for an above-the-line deduction. This includes fees for assistance in an action that results in a monetary award from the IRS, the SEC, or the CFTC, as well as actions under the federal False Claims Act. The deduction is limited to the amount of the award included in income.

Common Non-Deductible Legal Fees

The general rule is that legal fees for personal matters are not deductible. These costs are viewed by the IRS as personal expenses and do not qualify for a tax deduction. Common non-deductible legal fees include:

• Fees for a divorce or separation. This includes payments to an attorney for negotiating the division of property or for litigation. An exception exists for the portion of legal fees allocated to providing tax advice in connection with the divorce, but the cost of litigating child custody is never deductible.
• Legal fees incurred in personal injury lawsuits. Because the compensatory damages awarded for physical injuries are not taxable income, the costs associated with obtaining that award are not deductible. This rule applies even when the attorney is paid on a contingency basis.
• Criminal defense fees. These are considered non-deductible personal expenses, regardless of the outcome of the case. A limited exception may exist if the criminal charge arises directly from the taxpayer’s trade or business.
• The costs associated with personal estate planning. Fees paid to an attorney to draft a will, create a living trust for personal assets, or develop a general estate plan are not deductible.