Legal Fees and Taxes: A Primer
To understand if legal fees for criminal defense are tax deductible, it is first important to understand what legal fees are in general, and what the basic principles of tax deductions are. Legal fees are expenses that you pay for the services of a lawyer or other legal professional to represent you in a legal matter. This can include a wide range of services, from simple consultations to complex representation in court. Tax deductions, on the other hand, are a reduction in the amount of income that is subject to taxation . They are intended to lower your overall tax liability, allowing you to keep more of your hard-earned income. Deductions can come in many forms, such as standard deductions, itemized deductions, and above-the-line deductions, among others. It is necessary to know if the expense is deductible, and if so, which category the deduction falls into, in order to claim it on your tax returns. Understanding these basics can be helpful when looking to file your taxes, as well as for those who are facing legal issues.
Are Legal Fees Deductible?
Generally, legal fees that are incurred to secure taxable income are tax deductible under the "ordinary and necessary" rule. If the legal fees are incurred for a type of expense that is not business-related or is for personal matters, then they are not tax deductible.
For example, fees paid by a taxpayer to help collect taxable alimony from an ex-spouse are deductible for the individual paying the fees, according to the IRS. In this case, the legal fees were incurred to generate taxable income.
Likewise, legal fees for a taxpayer’s participation in a whistleblower program, where the taxpayer provides information that results in recovery of tax proceeds to the government, are deemed to be deductible because the recovery will be taxable to the taxpayer. On the other hand, fees incurred by a taxpayer primarily to determine whether to file suit against the IRS for an alleged refund of taxes are not deductible.
Section 62(a)(20) only allows for the deduction of those legal fees that are deductible by an individual under Sec. 162 in calculating AGI. Thus, Sec. 62(a)(20) does not apply with respect to fees that are subject to deduction where the AGI has already been computed, such as fees under Sec. 222 (tuition and fees deduction and the education credits), Sec. 6693(a) (undeclared foreign financial accounts penalty disclosure), Sec. 6695(g) (failure to furnish a copy of a taxpayer return for services performed), Sec. 6698(b) (penalty for failure by tax shelters to file annual returns), Sec. 6699(b) (penalties for failure to file partnership returns), Sec. 170(j)(2)(C) (additional tax based on net investment income), Sec. 170(c)(2)(C) (denial of deduction for certain termination interest), Sec. 1864(e) (deduction of excise taxes from gross income) and Sec. 6871(c)(2) (tax recovery for certain trusts).
Legal fees incurred to defend one’s personal reputation are treated as nondeductible personal expenditures. Likewise, legal fees incurred for tax planning are also not deductible.
Some fees may be deductible under multiple provisions of the Code. For instance, legal fees incurred to document and sign a pre-nuptial agreement would be deductible both in computing AGI under Sec. 62(a)(20) and as a "qualified residence interest" under Sec. 163(h)(3) because married couples are allowed to deduct mortgage interest on a primary residence.
Deductibility of Legal Fees for Criminal Matters
The general rule for amounts that are deductible as business expenses is that they must be incurred in a trade or business or for the production of income. Legal fees are different, but depend on the nature of the activity involved. For example, legal fees that relate to the determination, collection or refund of any tax are deductible as an expense of production of income on Schedule A or B. Legal fees are also deductible as ordinary and necessary business expenses under Internal Revenue Code (Code) Section 162. However, legal fees incurred in connection with the acquisition of a capital asset are not deductible. There is no bright-line rule for determining whether the legal fees are capital in nature or whether they are incurred in the ordinary course of business. Note that Code Section 165(g) disallows deductions related to losses from securities when these losses are incurred by an individual in a non-business context.
In the case of legal fees incurred by a taxpayer in defending themselves in a criminal matter, Code Section 262 specifically disallows a deduction for personal living expenses. Fees to defend a charge of criminal fraud are generally disallowed, but may qualify as a deductible business expense if the factual and legal issues are so intertwined with the business that the fees are a necessary part of the business operation. In the case where corporate officers are defending against criminal fraud charges, it is possible that the legal fees could be characterized as a necessary business expense.
Taxpayers claiming a deduction for legal fees associated with criminal fraud must be able to prove that the amounts deducted are business expenses and not otherwise personal expenses. As a result, taxpayers should maintain contemporaneous records establishing the business purpose for the legal fees deducted.
Exceptions and Special Rules
It’s important to know just how narrow the exceptions are to the rule when it comes to criminal defense legal fees. Board of Trade v. Commissioner is one case in which the appellate court permitted a deduction of legal fees, but the court acknowledged that it was creating an exception specifically for that case. The defense was that a business officer had violated a statute, that on its face appeared to be a personal transaction, regarding his ability to buy certain municipal bonds, which would have violated a prohibition for county officers. The court permitted a deduction because the officer was acting within the scope of his corporate authority and the activity, while appearing to be personal, was "sufficiently closely related" to the taxpayer’s job function to permit the deduction.
Therefore, if you are involved in a case that can potentially be viewed as falling within this realm, you will have to successfully argue that the necessary elements mentioned above apply to your case. This is a heavy burden to bear, and you need to do so with the help of your criminal defense attorney.
Another circumstance where a deduction may apply, but is extremely unlikely is when there has been an actual conviction for a business crime, which has then resulted in civil liability under the Sarbanes-Oxley Act of 2002 (SOX) or the Securities Exchange Act of 1934, which was amended to include the Sarbanes-Oxley Act of 2002, under 31 U.S.C. § 5321(a)(5). These statutes specifically make the officer personally liable for fines or restitution of up to twice the monetary gain or loss, up to a maximum of $500,000 for individuals and up to $2.5 million for corporations. The prevailing argument is that these statutes nudge these individuals toward criminal activity, so the legal expenses associated with defending against these business-crime related allegations should be deductible.
Since the above mentioned exception is novel and oppressive in its requirements, it is not likely possible unless hiring the very best criminal defense attorney who can make your case distinct from the long line of court holdings that go against these types of deductions.
Filing and Documentation Tips
If you are a criminal defendant and wish to deduct any or all of your legal fees, then you must fulfill certain documentation requirements on your tax return to establish the amount of the legal fees you are trying to deduct is correct. They include:
- (1) A detailed listing of the criminal charges against you contained in the indictment or information. You would need to provide a complete list of the charges, including an indication of which charges you defended against and whether or not you were found guilty of a particular charge or charges. It is important to note that, if you were acquitted of some or all of the charges, the IRS requires that you specify which charges were adjudicated either in your favor or against you…if all the charges pertained to a "wrong" offense, there is a good chance that the IRS will question your facts as we will discuss in the section "Additional Issues to be Aware Of".
- (2) A description of the "factual" issues you defended.
- (3) A description of the "legal" issues you defended .
- (4) The total amount of fees incurred related to a given claim that you are claiming as a deduction. Specific invoices or other substantiation is important. There should be separate total amounts listed for "factual" and "legal" issues, or if one invoice covers both issues, be sure to itemize these charges.
- (5) Provide copies of the invoices showing the date paid, the type of services provided, the name of the person providing the services, how the invoice amount was computed, and a separate amount for "factual" and "legal" charges if applicable.
- (6) Copies of all check stubs or similar records to show to whom the payment was made, when it was made, and the amount that was paid.
- (7) Copies of all IRS forms and documents that were filed in your case are essential to supporting your contention that you are entitled to deduct certain legal costs.
As mentioned above, proper documentation is essential to supporting your position that the legal fees you are attempting to deduct from your taxes are related to the defense of a "wrong" offense.
Consult a Tax Professional
Consulting a tax professional is invaluable when you face the uncertain question of whether certain legal fees are tax deductible. If you broke the law, and it led to your arrest or charge against you, you may be in the position to deduct your attorney’s fees from your taxable income. When it comes to criminal defense fees, the answer depends on several factors, including the nature of your case, the results of your case, and whether you had a previous agreement in writing that your attorney would use the fees you paid as a deductible.
Like legal fees, tax codes are labyrinthine, and it does not take much to lose your way. However, by consulting a tax professional who can help you determine the right course for you, you can assume that you are taking the correct action. These professionals have in-depth knowledge of the tax codes and how they apply to different situations.
Tax professionals also have a thorough understanding of what kind of documentation is necessary for various tax breaks. A tax professional may also know about other tax breaks that could apply to your situation that a layman might overlook. This is particularly important because you cannot usually go back to claim a tax break if you miss it on your tax return initially.
Finally, in addition to finding out about whether legal fees are deductible, working with a tax professional can help clarify additional tax questions you may have. While you don’t necessarily want to use one person for all of your business and personal needs, it can be useful to have someone who has a good knowledge of both areas.
Conclusion and Considerations
Throughout this article we discussed several important factors to keep in mind when deciding whether your legal fees are deductible. Many people make rash decisions when it comes to their taxes and that is a very important area to avoid making such a decision. From the get go, consider your legal fees and taxes as a whole; weigh out all the pros and cons of taking a deduction for your legal fees or not. Some of the questions to ask yourself should be: Upon coming to a conclusion about whether or not your legal fees will be deductible, deductibility is not the final answer. There is still the important issue of analysis and timing for deducting the legal fees . There can be significant policy considerations at stake for you that could delegate the decision to deduct the legal fees out of your hands. Therefore, whether you say yes or no to the deduction, and when to take such a deduction, you should always consult with a profession. I look over some circumstances like this at least once a month, where a thoughtful period of strategy and consideration is critical, and the decisions on how to proceed with the case will have an impact on other areas of the law such as taxes. Such choices require professional planning from multiple perspectives, including the criminal and tax viewpoints.