When Are Legal & Professional Fees Tax Deductible?

Legal and professional fees include payments to lawyers, accountants, and other consultants. Their tax treatment depends on the purpose of the expense. A fee can be deducted immediately, capitalized as part of an asset’s cost, or be a non-deductible personal expense based on the specific circumstances. For example, a fee for drafting a business contract is treated differently from one for preparing a personal will, a distinction guided by Internal Revenue Service (IRS) rules.

Deducting Fees for a Trade or Business

For a professional fee to be deductible as a business expense, it must be considered both “ordinary and necessary.” An ordinary expense is one that is common and accepted in your trade or business. A necessary expense is one that is helpful and appropriate for your business, though it does not have to be indispensable.

Common examples of deductible business fees include payments to attorneys for drafting customer contracts, reviewing vendor agreements, defending the business against a lawsuit, or collecting money owed by a client. Fees for accounting, bookkeeping, business-related tax advice, and consulting to improve operational efficiency are also deductible in the year they are incurred.

It is important to distinguish these deductible expenses from other payments. Fines or penalties paid to a government are generally not deductible, even if they result from a business activity. This includes penalties for late performance of a contract or for violating local regulations. The law disallows these deductions to prevent businesses from reducing the financial sting of breaking the law.

Treatment of Fees for Individuals

The tax treatment of legal and professional fees for individuals is more restrictive than for businesses, as the deduction for most miscellaneous itemized expenses was suspended through 2025. As a result, most professional fees for personal matters are non-deductible. This includes legal fees for divorce proceedings, drafting a personal will, creating a living trust, or defending against a personal lawsuit.

There are specific exceptions where individuals can still deduct professional fees. Fees incurred in producing or collecting taxable income separate from a formal business can be deductible. A primary example is expenses related to rental properties, such as drafting lease agreements or resolving tenant disputes, which are reported on Schedule E.

Another area involves investment-related advice. Fees paid to an advisor for managing investments that produce taxable income, such as stocks and bonds, could be deductible. The “origin of the claim” test is often used to determine if the expense is tied to income production or is a personal expense.

Capitalizing Professional Fees

Some professional fees related to business or investment activities must be “capitalized” instead of immediately deducted. This means they are added to the cost basis of an asset and recovered over time through depreciation or by reducing the taxable gain when the asset is sold. This treatment applies to fees that facilitate the acquisition, creation, or enhancement of a long-term asset.

A common scenario involves acquiring property. Legal and accounting fees paid to acquire a business or real estate, including costs for drafting purchase agreements and conducting due diligence, are capitalized. These expenses become part of the property’s basis.

Similarly, costs associated with organizing a business entity must be capitalized. Fees paid to draft articles of incorporation or a partnership agreement are considered organizational costs. Corporations and partnerships may elect to deduct up to $5,000 of these costs in the year the business begins, with the remainder amortized over 180 months.

This requirement creates a clear distinction from immediately deductible expenses. For example, while fees for routine contract reviews are expensed, fees for negotiating the purchase of a new building are added to the asset’s value. This aligns the cost of the service with the long-term value the asset provides.

Required Documentation and Reporting

Properly deducting or capitalizing professional fees requires meticulous record-keeping, as the burden of proof is on the taxpayer to substantiate the expense’s purpose. The most important document is an itemized invoice from the service provider. This invoice should clearly describe the services rendered, separating charges for different tasks if they have different tax treatments.

For example, a legal bill related to a business acquisition should detail the hours and rates for due diligence versus general business advice. This allows for accurate allocation of fees, as a canceled check or credit card statement alone is insufficient proof of the work performed.

The location for reporting these fees on tax forms depends on their character. For a sole proprietorship, deductible legal and professional fees are reported on Schedule C (Form 1040). For rental activities, these expenses are reported on the appropriate expense line on Schedule E (Form 1040).

Capitalized costs are not deducted in the current year but are instead added to the basis of the related asset. This increased basis is then used to calculate annual depreciation deductions, which are reported on Form 4562, Depreciation and Amortization. When the asset is eventually sold, the higher basis reduces the calculated capital gain, thereby lowering the tax on the sale.