Celebrity deductions: case law provides guidance for celebrities looking to deduct legal fees.

• Author: Wood, Robert W.
• Position: TAXISSUES

Celebrities often pay extraordinary legal fees. Winona Ryder's shoplifting charge racked up far larger legal fees than the typical shoplifting case. Michael Jackson reportedly paid up to $20 million in legal fees in his trial. And telephone-brandishing supermodel Naomi Campbell not only faced assault charges, but also an expensive suit against London's Daily Mirror over photos of her leaving a drug treatment center.

Or take Martha Stewart, whose legal fees were huge, eclipsing many times over the amount at stake in her sale of Imclone stock.

She sold 75,000 shares of Martha Stewart Living Omnimedia, Inc. (raising $4.67 million) to pay legal fees ["Martha Stewart Sells Shares for Legal Fees," New York Times, June 12, 2004]. And she sought reimbursement (as an officer and director) for $3.7 million of fees ["Martha Stewart Starts Appeal," CNNMoney.com, March 17, 2005].

The $3.7 million was for her successful defense on a single criminal count that she tried to lift her own company's share price by declaring that she was innocent of insider trading.

Huge legal fees should prompt celebrities and their advisers to ask: Are such whopping fees deductible? And if so, how?

DEDUCTIBILITY OF LEGAL FEES

Legal expenses are deductible as "business expenses" if paid in a trade or business.

Deductions for trade or business expenses are much more useful than deductions for investment expenses because of various percentage limitations and the alternative minimum tax.

Much of the tax law surrounding the deductibility of legal fees concerns the line between trade or business expenses and investment expenses.

Fees for tax advice always are deductible as investment expenses, even if they are related to divorce or other personal matters.

Legal expenses of a personal nature yield no deduction. Yet, what is considered "personal" can be debated. Celebrities may be in a unique position regarding legal fees since few personal decisions are not in the public eye, and few are devoid of economic consequences. Let's take a closer look at this area.

PROBLEMS WITH PERSONAL EXPENDITURES

Not all expenses in connection with personal, living or family expenses are deductible, according to IRC Sec. 262.

For example, legal fees in connection with a divorce, separation or decree for support by either party are not deductible [Reg. Sec. 1.262-1(b)(7)]. In United States v. Gilmore, legal fees and associated expenses of divorce litigation were held to be nondeductible personal expenditures, even though an adverse decision would destroy the taxpayer's business [372 U.S. 39, 83 S. Ct. 623 (1963), on remand, 245 F. Supp. 383 (N.D. Cal. 1965)].

The claim's origin was the divorce, rather than its potential consequences to the business.

Cases that deny deductions for legal expenses in connection with criminal representation typically have referred to the lack of a nexus between the crime and the defendant's business.

For example, a management consultant was not allowed to deduct legal expenses incurred in...