Treatment of legal fees incurred by individuals: depending on the claim that generated them, individuals' legal fees may be characterized in a variety of ways, from fully deductible to deductible only as a miscellaneous itemized deduction to totally nondeductible. This article explains the possible tax treatments, outlines how to determine the proper treatment, and highlights recent judicial and legislative developments.

• Author: Nellen, Annette

EXECUTIVE SUMMARY

* If the origin of a claim that generated legal fees is personal, the fees are not deductible.

* Possible favorable treatment for legal fees includes either above-the-line deductions or adjustments to basis or selling price in a property transaction.

* Some taxpayers have claimed described legal fees in such a way that they directly reduce the related income.

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Expenses are not tax deductible unless a specific provision in the Code allows their deduction. When an expense is connected with taxable income, taxpayers are highly motivated to find ways to deduct the expense. This is particularly true of legal fees because the income they are associated with might never have materialized without legal assistance, and the legal fees may be substantial.

Possible favorable treatments for deducting legal fees include either above-the-line deductions or adjustments to basis or selling price in a property transaction. However, legal fees incurred by individuals may also fall into less favorable categories: personal, nondeductible expenses or miscellaneous itemized deductions limited by the 2%-of-adjusted-gross-income (AGI) limit for regular tax and not allowed for alternative minimum tax (AMT) purposes.

The existence of less favorable deduction categories has led taxpayers to claim that their legal fees fall into the favorable categories or to describe the fees in such a way that they directly reduce the related income, thereby making deduction rules unimportant. Due to taxpayer efforts to get favorable tax treatment, complicated fact patterns, and lack of clarity in the law, there have been numerous court decisions on the treatment of legal fees incurred by individuals. This article explains the possible tax treatments of legal fees and how to determine the proper treatment. Several court decisions are used as examples, and recent developments in the area are explained. An analysis of how the current rules measure up under certain tax principles is also included.

General Rules

Code

Several Code provisions are relevant in determining the tax treatment of legal fees incurred by an individual. Sec. 162 allows ordinary and necessary expenses incurred in carrying on a trade or business. Sec. 212 provides a similar rule, but for the ordinary and necessary expenses incurred for income production or collection or for the management, conservation, or maintenance of property held for income production. In contrast, Sec. 262 denies deductions for personal, riving, or family expenses.

Individuals have the added complication of determining if deductible expenses are deductible for AGI (above the line) or from AGI (below the line). The preferred treatment of deductions for AGI has led to much litigation. Sec. 62 treats expenses attributable to a trade or business carried on by an individual as deductible for AGI; however, this treatment does not apply to expenses arising from services performed as an employee. An exception to the employee rule allows above-the-line treatment for reimbursed employee expenses if paid under an arrangement for reimbursement or expense allowance (an accountable plan). (1) Thus, legal fees not required to be capitalized that come within Sec. 162 are deductible for AGI, while legal fees related to employment or income production (Sec. 212), if deductible, are deductible from AGI (as itemized deductions), subject to the limitations of Sec. 67.

Sec. 67 provides that miscellaneous itemized deductions are deductible only to the extent the total amount exceeds 2% of AGI. Sec. 67 lists various deductions that are not treated as miscellaneous itemized deductions. Legal fees are not included in the list; thus, if deductible from AGI, they are subject to the 2% limitation.

Another downside of legal fees classified as miscellaneous itemized deductions is that Sec. 56(b)(1)(A)(i) does not allow any deduction for miscellaneous itemized deductions for AMT purposes. An individual with significant legal fees that may be deducted from AGI can easily face an AMT liability. This has also led to litigation as taxpayers find alternative ways to obtain a more favorable tax treatment, particularly when taxable income was generated from the legal fees that are included in calculating both regular tax and AMT--despite the fact that the related legal fees are not deductible for AMT purposes. Some of these cases are discussed later, along with the limited relief provided by the American Jobs Creation Act of 2004 (AJCA).

Sec. 263 requires expenditures related to improvements or an increase in value of property to be capitalized (rather than expensed). For example, legal fees paid to defend or perfect title to real property must be added to the basis of the property, rather than deducted. (2)

Court Decisions

The leading case on the classification of expenditures as business or personal (as well as deductible versus capitalizable (3)) is the Supreme Court decision in Gilmore. (4) This case examined the tax treatment of legal fees to defend a divorce action and protect the husband's business assets against claims by the wife. The husband argued that the fees were deductible because they were incurred to conserve property (stock) held for the production of income, a position the lower court had agreed with.

The Court reversed the lower court and held that the characterization of legal fees as business or personal depended on whether the claim's origin and character were the taxpayer's profit-seeking activities. The characterization did not depend on the consequences that might result from not defending or defeating a legal claim or action. The Court found that this approach tied to the language of Code provisions allowing deductions for business and profit-seeking activities. The Court also found that this was the equitable result likely intended by Congress. For example, if two individuals involved in car accidents while driving for personal pleasure were able to deduct related legal fees only if the lawsuit damages were to be paid from income-producing assets (rather than from income), the law would unfairly favor the driver with investment assets to protect.

The Gilmore decision created the "origin of the claim" test for characterizing legal fees as deductible, capitalizable, or nondeductible. The U.S. Claims Court has further elaborated on this test:

The object of the "origin of the claim" test is to find the transaction or activity from which the taxable event approximately resulted, Gilmore, 372 U.S. at 47, or the event that "led to the tax dispute." Keller, 688 F.2d at 681.The origin is defined by analyzing the facts and determining what the basis of the transaction is, and does not rely on purpose, consequence or result. (5)

Further elaboration from the Tax Court provides:

The inquiry is directed to the ascertainment of the "kind of transaction" out of which the litigation arose.... Consideration must be...