Whether you’re hiring an attorney for personal reasons or business-related issues, legal fees can quickly add up. Many individuals and businesses wonder whether these expenses can be deducted from their tax returns. While personal legal fees are generally not tax deductible, legal fees related to business often are. To ensure compliance and maximize your deductions, it’s wise to consult a financial advisor with tax expertise who can provide guidance tailored to your unique situation.
What Legal Fees Are Tax Deductible?
The Internal Revenue Service (IRS) enables taxpayers to consider legal fees linked to their trade or business as a deduction on their tax return. So, a landlord wrestling with eviction proceedings or a contractual dispute with a tenant could potentially deduct these expenses. Likewise, legal fees tied to claims for tax advice or specific types of lawsuits may be deductible. However, tax-deductible status also depends on personal tax situations, adding another layer of complexity to the mix.
The legal fees associated with the following types of expenses and claims are typically tax deductible:
Business Expenses
Legal fees that are “ordinary and necessary” to business operations – like those related to contract negotiations, employee disputes and compliance issues – typically tend to be deductible. Consider a small business owner who incurs legal fees while negotiating a contract with a supplier – these fees can usually be rolled into tax deductions as a business expense.
Similarly, legal costs tied to resolving an employee dispute or ensuring compliance with industry regulations are also typically deductible. By strategically leveraging these deductions, businesses can reduce their tax liability, further emphasizing the value of thorough tax planning in successful business operations.
Business Taxes
When businesses require legal counsel on complex tax issues or need representation in a tax dispute involving the IRS, the fees paid are generally deductible as a business expense. Tax planning and preparation fees are also typically deductible.
Whistleblower Claims
Personal legal fees related to certain whistleblower claims are typically deductible. For example, you may qualify for a tax deduction if your claim is related to a violation of federal tax laws or SEC regulations.
Child Adoption
One of the primary mechanisms through which adoptive parents can potentially recover some adoption-related expenses is the Adoption Tax Credit. This tax credit was established to alleviate the financial burden of adoption and encourage more families to consider adoption as an option. Qualified expenses include adoption fees, court costs, attorney fees and other directly related expenses.
Discrimination Claims
Legal fees that individuals incur during discrimination claims at their workplace are typically deductible. This rule applies to a range of cases, from sexual harassment to racial discrimination against their employer.
Farm Income and Expenses
Farm-related income and expenses also draw implications for legal fees with tax-deductibility in mind. A farmer may deduct legal fees tied to a land dispute or a disagreement over farm equipment. Other specific examples relating to farm-related legal expenses include legal costs related to inspections, compliance regulations or rental disputes, which are all deductible if they’re linked to farming operations.
What Legal Fees Are Not Tax Deductible?
It’s crucial to note that most personal legal fees don’t qualify for tax deductions. Legal costs tied to personal matters like divorce, child custody disputes or criminal charges typically aren’t deductible. In addition, legal fees related to buying a house, purchasing a personal vehicle or procuring personal legal advice aren’t deductible.
Legal fees related to disputes over inheritance or will contests are also generally not tax-deductible. If you’re involved in a civil lawsuit unrelated to your business, the legal fees incurred in such cases are usually not tax-deductible.
How TCJA Changed Deductions for Legal Fees
The Tax Cuts and Jobs Act (TCJA), enacted in 2017, brought about several significant changes to the U.S. tax code, including modifications to the deductions for legal fees.
Prior to TCJA, deductions were more broadly applicable, covering a wide array of situations. Common scenarios included legal expenses related to issues such as divorce, wills, and personal injury claims. However, this law introduced notable alterations to these deductions, impacting how individuals can claim them.
One of the key changes introduced by TCJA was the elimination of miscellaneous itemized deductions. These deductions, which previously allowed taxpayers to write off various expenses that exceeded 2% of their adjusted gross income, included legal fees. As a result, many individuals who previously benefited from deducting personal legal expenses found this option no longer available.
How to Deduct Legal Fees on Your Taxes
If you operate a sole proprietorship, single-member LLC, or are self-employed, you’ll likely report your business income and expenses on Schedule C, which is part of your personal tax return (Form 1040). Legal fees related to your business can be deducted on this form as ordinary and necessary business expenses. Ensure that you keep detailed records of these expenses, including invoices and receipts, in case of an audit.
For those involved in rental real estate activities, legal fees incurred for issues related to your rental property can typically be deducted on Schedule E. This form is also attached to your personal tax return. It’s essential to maintain accurate records and documentation for these expenses.
Meanwhile, Schedule F is used to report farm income and expenses. Legal expenses incurred in the ordinary course of your farming business can be deducted as business expenses by reporting them on Schedule F.
Bottom Line
While some legal fees are deductible, it’s crucial for taxpayers to grasp the inherent rules and seek professional advice when uncertain. Legal fee deductions can be intricate and are sensitive to changes in tax law. Hence, taxpayers need careful planning and consistent record-keeping. As a general rule, most personal legal expenses are not tax-deductible, while those related to business expenses often are.
Tips for Reducing Your Tax Bill
- While a tax deduction lowers your taxable income, and in turn, reduces your tax liability, a tax credit is a dollar-for-dollar reduction. As a result, knowing which tax credits you may qualify for can be extremely valuable during tax season.
- SmartAsset’s capital gains tax calculator can help you estimate how much your tax bill could be when selling an asset. Meanwhile, tax-loss harvesting or using investment losses to offset gains is a common strategy for reducing capital gains.
- A financial advisor with tax expertise may be able to help you optimize your tax strategy and save you money. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
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