Currently under the federal income tax rules, legal expenses incurred by individuals are typically not deductible. Instead, they’re most often treated as either part of the cost of acquiring an asset, such as real estate, or as personal outlays (which are nondeductible).
In the acquiring asset situation, legal costs usually aren’t deductible right away; instead, they may be capitalized and amortized over a number of years if the asset is used for a business or rental activity.
A recent U.S. Tax Court decision and IRS Private Letter Ruling (PLR) showcase exceptions to the general rule and when taxpayers may be eligible for current deductions for legal expenses.
Tax Court Decision
In Ellen Sas v. Commissioner (T.C. Summary Opinion 2017-2), an employee was allowed to write off legal expenses as a miscellaneous itemized deduction when she was fired by her employer.
Here, the taxpayer received a $612,000 bonus from her employer before being terminated for alleged breach of fiduciary duty. The employer attempted to recover the bonus, so the taxpayer counterattacked, alleging employment discrimination.
All claims against the employee were dismissed eventually, and she was allowed to keep the bonus. However, she incurred almost $81,000 in legal fees and wanted to deduct them on her personal tax return as part of the expenses for a business that she and her husband operated.
IRS auditors concluded that the legal expenses constituted unreimbursed employee business expenses, which should be classified as miscellaneous itemized deductions. This category of deductions can be claimed only to the extent that they exceed 2% of your adjusted gross income (AGI). But you’re allowed to combine unreimbursed employee business expenses with other miscellaneous itemized deduction items — such as job search costs, fees for tax advice and tax preparation, and expenses related to taxable investments — when attempting to clear the 2%-of-AGI threshold.
Important note: Miscellaneous itemized deductions are disallowed under the alternative minimum tax (AMT) rules. So, if you’re subject to the AMT, these deductions won’t benefit you.
Though the taxpayer took her case to the Tax Court, it agreed with the IRS that the legal costs were unreimbursed employee business expenses because they arose from the taxpayer’s business of being an employee (albeit a former employee at the point they were incurred).
IRS Private Letter Ruling
In a recent PLR, the taxpayer had experience managing closely held companies, and he had agreed to serve as the managing shareholder of a newly formed corporation in exchange for a management fee. The taxpayer was sued for alleged breach of contract, breach of fiduciary duty and fraud after another shareholder became dissatisfied with the corporation’s performance.
Legal fees were incurred by the taxpayer to unsuccessfully defend against these charges and unsuccessfully appeal the initial court decision against him. In addition, he paid fees to accounting consultants and an expert witness. And, he had to pay court-ordered compensatory and punitive damages to his legal adversary, as well as the adversary’s legal fees.
The taxpayer wanted to deduct all of these expenses, which clearly originated in the conduct of his business as the managing shareholder of the troubled corporation. Therefore, the IRS concluded that the taxpayer’s payments to satisfy the final judgment against him (including compensatory and punitive damages and his adversary’s legal costs) and his own legal expenses and related costs to unsuccessfully defend against the claims could be currently deducted as business expenses.
Important note: By requesting a PLR, a taxpayer asks the IRS, for a fee, to provide guidance on federal income tax questions. PLRs interpret and apply tax laws to that particular taxpayer’s specific set of facts. A PLR helps eliminate uncertainty before the taxpayer’s return is filed — and it’s binding on the IRS if the taxpayer fully and accurately described the proposed transaction in the request and carries out the transaction as described. Technically, a PLR can’t be relied on by other taxpayers. However, as a practical matter, PLRs are often used by tax professionals as guides to the IRS position on issues. The conclusion in the case above won’t necessarily apply to other taxpayers in the same or a similar situation.
Personal vs. Business
There are times when individuals in Maine will incur legal expenses that are legitimately business-related and, therefore, deductible. However, if you’re audited, the IRS will routinely disallow legal expense deductions unless you can adequately prove that the expenses are indeed business-related (including related to the business of being an employee).
In the right circumstances, your tax advisor can help you put together evidence to support deductible treatment for legal expenses.