Interpreting Legal Costs: What’s Tax Deductible?
Generally, taxpayers can only deduct legal fees if they paid them for the production or collection of taxable income or for the management, conservation or maintenance of property held for the production of interest, dividends or royalties. Furthermore, legal fees incurred in connection with the determination, collection or refund of any tax are deductible; however, legal fees related to the sale or transfer of property are not. Legal fees incurred for tax advice or in connection with a tax return are also deductible, but fees related to defending against a civil tax penalty are not. The taxpayer seeking the tax deduction must own the subject matter of the dispute.
Deductible legal fees can be claimed on Schedules A and C. Schedule A is used by individuals to itemize their deductions, whereas Schedule C Businesses Sole Proprietorships report their income and expense activity . Taxpayers can only deduct legal fees to the extent they are not reimbursed by receiving the following forms of payment: payments to another party via direct negotiation or settlement, recovery of fees from another party under an agreement or judgment payment via insurance or via court award. To deduct the fees, taxpayers will need Form 1040, Schedule A, Itemized Deduction, and Form 1040, Schedule C, Profit or Loss from Business forms depending on the deductible expenses incurred.
Examples of deductible legal fees include: fees incurred to contest a taxable loss, fees paid to recover rejected or returned goods including postage, fees paid because a deceased person’s creditors made claim against an estate as well as legal fees paid to collect an unpaid debt. Non-deductible legal fees include: fees incurred to obtain divorce or child support, fees incurred to arrange a property settlement agreement, fees incurred to file a tax return or to obtain an individual taxpayer identification number.
Tax Deductible Criminal Defense Attorney’s Fees?
Tax Deductibility of Criminal Defense Legal Fees: Are They Tax Deductible?
If and when you need to hire an attorney, it’s only natural to think about the financial implications of the various fees and costs. Finding an attorney that you trust is the first priority, but once that’s done, it’s important to know what kind of expense the engagement will be. In most cases, you can take a tax deduction for your attorney’s fees and the cost of legal representation as an "ordinary and necessary" expense of the business or trade you’re in. This includes legal expenses incurred to produce or collect taxable income, defend or perfection a title to property or obtain business advice. But the rules change when it comes to criminal defense attorney fees.
The Short-Lived Intent to Benefit Taxable Business or Trade In a 2014 decision by the U.S. Tax Court, Frederick J. Naffi was convicted of willfully failing to file a federal income tax return in violation of Section 7203 of the Internal Revenue Code. Naffi then hired a tax attorney in an attempt to get his conviction overturned. When Naffi looked to claim a tax deduction for the legal fees he paid to his attorney, the Tax Court noted that the legal fees were not incurred to benefit his business or trade. Rather, they were incurred to defend against a criminal charge. Although the underlying services performed by his attorney eventually benefited his "law and accounting business," the Tax Court held that his legal fees were incurred for criminal matters, not for business expenses. Thus, they weren’t deductible. Because "fee shifting" is rare in criminal matters, the taxpayer couldn’t even deduct the fees by imputing them to his business.
Ordinary and Necessary Expenses According to IRC Sec. 162(a): "There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. Under IRC Sec. 212, taxpayers can also deduct ordinary and necessary private or trade or business expenses related to producing or collecting taxable income or determining or collecting any tax. But there are limitations to the scope of Sec. 162. Unless other provisions permit a deduction, Sec. 162 does not allow for the following: And like the IRS, the courts have historically held that legal fees incurred from violations of the law or with criminal prosecution are generally not tax deductible. In the case of Pine v. U.S., the Tax Court pointed out that legal fees connected with a criminal prosecution include investigation and testimony, legal advice on pleading, competency to testify, or appointment of counsel (if indigent) and securing a writ of certiorari. As a result, the taxpayer could not claim a deduction for his attorney’s fees. "Mr. Pine’s criminal tax investigation, prosecution, and conviction were not ‘ordinary and necessary’ expenses in his money-lending, real estate rental, or insurance businesses," the court stated. And, because the legal fees were connected to repairing allegations of criminal wrongdoing, the taxpayer could not attribute them to his business, because the fees weren’t incurred while pursuing a business profit.
Personal vs. Business Attorney’s Fees
Regardless of where the need for an attorney arises, what is certain is that one is required to file a tax return at year-end; and during that process, all taxable income must be reported, and all appropriate and applicable expenses reduced from the gross income so as to arrive at net income. In cases where one has income, such as in the case of whether one’s trade or business will have a net profit, or whether it will end up as a net loss, that determination, with the related tax ramifications, should be relatively straightforward. The same cannot be said, however, with respect to whether legal expenses are personal or business in nature, and the ability (or inability) to further reduce one’s taxable income by writing off all legal expenses, and where the distinction between personal and business legal expenses impacts the bottom line in terms of taxes, with a business context limiting one’s write-off while expenditures for personal legal matters are not deductible at all. For example, in the case of an ordinary divorce, where one hires an attorney to handle the divorce proceeding, part of the fee may be deductible if the couple actually shares a business together, where the fees incurred are due to the need to divide the marital estate and allocate assets between the spouses. This would not be the case in a contested divorce where one spouse turns the whole matter over to the attorney to handle as the spouse sits back and does nothing except to await the final legal outcome. However, in the case of a business divorce where one spouse seeks to obtain a higher level of alimony, the matter ends up being more so one where a financial analysis is required, as opposed to where criminal issues and facts are involved, so that the attorney’s fees for a true "business" divorce are more situation-specific, so to speak, and less "inherently personal" as in the case of a contested divorce where one party simply awaits the final results of a contested proceeding. The matter of what is for business as opposed to personal expense (and therefore deductible for tax purposes) is therefore a highly subjective decision that each taxpayer should apply in order to ascertain just how much of the total billed amount should be deducted as an expense on their tax return.
Holding the Risk of Misstating Deductions
Failing to properly claim criminal defense legal fees (and related expenses) as tax-deductible could not only have important consequences for taxpayers, but may also impact their trusted advisors. Clients who have improperly claimed criminal defense-related deductions put their trusted advisors at risk. Advisors who give bad advice (whether knowingly or unknowingly) may be subject to reports to the IRS, other regulatory agencies and even the California State Bar. Taxpayers who place too much reliance on their advisors, and who are later investigated by the IRS or the State Bar, could make their advisors the clients’ scapegoat for their own misdeeds.
The IRS could audit a taxpayer to review claimed tax deductions and, if the taxpayer has claimed criminal defense lawyer’s fees as a business expense, the IRS will likely attempt to disallow the deduction and collect any unpaid taxes, interest and late payment penalties . Audits of non-business income tax returns typically happen at the federal level, and such audits could result in the IRS writing a report to the FTB. It is also possible that a case could be referred to a Special Agent of the IRS for investigation as a criminal case, which could be particularly damaging to a taxpayer already suffering under indictment.
Additionally, taxpayers could be investigated and prosecuted by other agencies, such as the California Franchise Tax Board (FTB), which conducts tax audits and may pursue felony tax evasion cases in certain circumstances.
If taxpayer has business income (as opposed to "stacked" wages), they should claim all of their deductible business expenses incurred within the taxable year in question. But, whether deducting criminal defense costs can legitimately be included as deductible business costs is a different question altogether.
Seek a Tax Professional
It is always a good idea to consult with a tax professional who specializes in issues such as the deductibility of criminal defense legal fees so that you can be fully informed of the potential risks that may be involved in litigating these types of issues. Your tax professional ultimately will be responsible for providing the IRS with an explanation of why your legal fees are deductible if your deduction relies on your argument. Having a professional who is experienced in this area will help to ensure that you receive the best possible outcome , since the risks of losing the claim and potentially being required to pay back your taxes plus interest and penalties should not be taken lightly.