Which Legal Fees Are Tax Deductible?

Understanding the tax deductibility of legal fees can be complex, as not all such expenses qualify for a deduction. Whether a legal fee is deductible largely depends on the specific nature of the legal matter and its connection to income-producing activities or a trade or business. The Internal Revenue Service (IRS) provides guidelines that differentiate between deductible and non-deductible legal expenses.

Core Rules for Deductibility

For legal fees to be deductible, they must be “ordinary” and “necessary” in the context of a trade or business or an activity engaged in for the production of income. An “ordinary” expense is one that is common and accepted within a particular industry or activity. A “necessary” expense is considered helpful and appropriate for the activity, even if it is not indispensable. The fees must have a direct connection to a trade or business or an income-producing activity. Some legal fees, however, are not expensed immediately but instead must be capitalized, meaning they are added to the cost basis of an asset. This capitalization occurs when the legal fees are incurred to acquire, defend title to, or improve property, rather than for the day-to-day operation of a business.

Business-Related Legal Fees

Legal fees incurred by a business are deductible if directly related to its operation, protection, or management. This applies to various business structures, including sole proprietorships, partnerships, S-corporations, and C-corporations. For instance, legal expenses from contract disputes or debt collection efforts are deductible. Legal advice and representation for employment-related matters, such as defending against wrongful termination claims or navigating labor laws, are also considered ordinary and necessary business expenses.

Fees for protecting intellectual property, like trademarks, copyrights, or patents, are often deductible; however, costs for initial acquisition or registration of these assets may be capitalized. General legal counsel for ongoing operations, including advice on corporate governance or regulatory compliance, is deductible. Legal fees for business tax advice, such as preparing business tax returns or seeking guidance on business tax matters, are typically deductible business expenses.

Investment and Income-Producing Legal Fees

Legal fees related to investments and activities engaged in for the production of income can be deductible under specific circumstances. For example, legal advice obtained to recover income-producing property, such as securities or other investments, may qualify. Legal fees incurred for the management or conservation of income-producing property, like rental properties, are also deductible. This can include expenses for evicting tenants or resolving lease disputes. Fiduciaries, such as executors or trustees, may deduct legal fees incurred in the administration of an estate or trust if these fees are directly related to the production or collection of income or the management, conservation, or maintenance of property held for the production of income.

Non-Deductible Legal Fees

Many common legal fees are not deductible for tax purposes, particularly those related to personal matters or capital expenditures. Legal fees incurred for personal matters, such as divorce, child custody disputes, or drafting a personal will, are not deductible. Legal fees from personal injury lawsuits are non-deductible, unless the recovery of taxable income is the primary purpose of the suit. Legal costs associated with adoption proceedings are also non-deductible personal expenses.

Legal fees considered capital expenditures are not immediately deductible. These include fees to acquire, defend title to, or improve property, whether personal or business-related. For instance, fees paid when buying a home or defending title to a personal asset are added to the asset’s basis, which can reduce capital gains upon sale. Legal fees incurred for fines and penalties imposed by a government, or for defending against criminal charges, are also generally non-deductible, as tax law typically disallows deductions for such payments.

The Tax Cuts and Jobs Act (TCJA) of 2017 suspended the deductibility of most miscellaneous itemized deductions subject to the 2% adjusted gross income (AGI) floor for tax years 2018 through 2025. This suspension means that legal fees previously deductible as miscellaneous itemized deductions, such as unreimbursed employee business expenses or certain investment expenses, are currently not allowed. This is important for individuals to understand.

Reporting Deductible Legal Fees

Once legal fees are determined to be deductible, they must be reported on the appropriate tax form. For sole proprietors, deductible business legal fees are reported as an expense on Schedule C (Form 1040), Profit or Loss from Business. Businesses structured as corporations or partnerships report these expenses on their respective business tax returns, such as Form 1120 for C-Corporations, Form 1120-S for S-Corporations, or Form 1065 for partnerships. For individuals with rental property, certain deductible legal fees related to the property’s operation are reported on Schedule E (Form 1040), Supplemental Income and Loss. Legal fees incurred by estates and trusts that are deductible are reported on Form 1041, U.S. Income Tax Return for Estates and Trusts.

It is important to remember that legal fees that must be capitalized are added to the asset’s cost basis and recovered through depreciation or upon sale. Maintaining meticulous records, including invoices and receipts that clearly detail the purpose of the legal services, is essential to substantiate any claimed deduction in the event of an IRS inquiry.