While filing taxes, one of the most important and confusing questions which pops up in the mind of taxpayers is deductions. The deductions keep changing every year and that’s what makes things complicated for the taxpayers. If you aren’t updated with the new tax regulations then you might miss out on some of the benefits or fall into the unwanted trap of penalties due to the wrong filing of taxes.
There is a long list of deductions that a taxpayer need to know in order to enjoy the benefits of tax filing but in this blog post, we are going to talk about legal fees as deduction. One of the most important questions for taxpayers which keeps on confusing them is whether they can deduct their taxes or not. The answer to this question is it depends on the situation in which the legal fees have been paid. On one side, this tells us that in some cases, you can deduct legal fees in your taxes and on the other side, it also tells us that you can’t deduct each and every type of legal fees in your taxes.
In most of the cases, if you are paying legal fees for your personal reason then it will not fall into the category of deductibles. For example, if you are filing a case against someone for a personal injury, then you will not be able to deduct your lawyer’s fees from your taxes. Such costs have to be paid by you only.
Earlier, there were few types of legal fees which were deductible as miscellaneous expenses, subject to a floor of 2 % of adjusted GI (Gross Income). Such costs included particular legal fees like the cost associated with a divorce proceeding or legal fees for managing investment property. But all such miscellaneous expenses were wiped out by the new Tax Cuts and Jobs Acts law for 2018 through 2025.
But you will be glad to know that legal fees paid in the case of bonafide business reasons 100 % deductible. There is no restriction like the 2 floor AGI in this deduction and even the TCJA can’t do anything with this type of deduction.
Let’s understand legal fees deduction for taxpayer with an example
A couple living in New York City divorced in 1977 but they continued to live together. After the divorce, they continued to share their assets and bank accounts and they always kept a track of their joint expenses through a ledger system.
With the passage of time, the gap between the couple grew larger and finally, the husband decided to move to Florida in 1992. But even after the husband moved to Florida, their expenses weren’t separated. After 1 year in Florida, the husband decided to invest $300,000 with his ex-wife for trading in communities. The husband believed that the amount invested will turn into profit, but just in a few months, the ex-wife lost all the money.
After the loss, the husband sued his wife three times. The lawsuit filed by the husband included claims for alleged financial damage for not repaying the loan and for illegally occupying a property which they bought together.
While filing taxes in 2014, the husband deducted around $200,000 in legal fees stemming from his ex-wife’s alleged misdeeds. The husband said that they were related to his business but the IRS declined the claim.
So, in this example, even the tax court agreed with the IRS on not including such legal fees in deduction as for a legal fee to qualify as a deduction, it should be directly connected with the taxpayer’s business. The court wasn’t able to find a proper connection between the deductable filed by the husband as legal fees and his business and that’s why his filed taxes with the above-mentioned deductibles were denied. But is it also true that a particular amount of the fees related with the investment could have been included as miscellaneous fees but that was applicable only before the intervention of TCJA.
So, if you are running a CPA firm and if you want to educate your clients well on the tax filing and deductible then let them know about the situations when their legal fees fall under the deduction category. If your client is looking for including his/her legal fees then tell them to know about the new rules applied by TCJA which has not only changed the deduction but wiped out some miscellaneous expenses as well. With better information, your clients will not be in the dilution that their legal fees will be categorized under deductibles while filing taxes.