Proper characterization of deductible legal fees.

• Author: Bakale, Anthony

The proper characterization of deductible legal fees can have a significant effect on the related tax benefit, if any. For example, legal fees incurred for the recovery of royalty income may be fully deductible regardless of the treatment of miscellaneous deductions under the alternative minimum tax (AMT).

IRS Position

The IRS issued a Market Segment Specialization Program (MSSP) internal training module on Lawsuits Awards and Settlements in November 2000. The MSSP guide explicitly directs Service agents to verify that the taxpayer reported taxable amounts at gross, rather than reporting them net of legal fees paid. Further:

* Allowable legal fees should be deducted on Schedule A as miscellaneous itemized deductions, unless the origin of the claim litigated is related to a Schedule C (independent contractor) or a capital transaction.

* The legal fees deducted on Schedule A are a tax preference item for A/MT purposes.

* For purposes of the AMT credit, the legal fees that created AMT do not generate the credit. They are an "exclusion" item.

The MSSP guide contains a section captioned "Amount To Be Included in Income" It states:

In cases involving contingent fee arrangements, the gross award/settlement, without diminution for attorneys' fees or costs, should be included in the taxpayer's income. This treatment is in accord with IRC section 61 and the long established principle, `the fruit of the tree' theory, that income is taxable to the person who earns it and cannot be assigned to someone else.

The guide states that taxing the gross amount from lawsuit proceeds has been upheld in Tax Court, as well as in various circuits. Citing Kenseth, 114 TC 399 (2000), the guide states that the Tax Court held that anticipatory assignment principles require a taxpayer to include in gross income the entire amount of judgment/settlement proceeds undiminished by any contingent fee, regardless of the state in which a fee arrangement is signed. The Tax Court expressly rejected the principles enunciated in cases holding to the contrary. The IRS cautions that examiners handling cases involving payments of attorneys' fees in lawsuits in Alabama, Michigan and Texas should be aware that there is contrary authority based on an interpretation of applicable state law.

Until the issue is resolved, the IRS position is that taxpayers should not be allowed to net the proceeds of the direct payment of attorneys' fees in all cases arising under any law other than Alabama...