Small businesses use legal services for a variety of reasons, and the fees for these services can be hefty.
Small businesses, for example, are particularly vulnerable to frivolous lawsuits designed essentially to extort a settlement (a few years ago more than one-third reported that they had have been sued) and they incur substantial legal fees in these actions.
Unfortunately, not all legal fees are immediately tax deductible. The tax treatment of legal fees usually depends on what you incur them for.
Starting a Business
When you start your business, you may incur legal fees to help you incorporate or form a limited liability company. You may pay to have a partnership agreement drawn up. The legal fees incurred for starting your business are viewed as part of startup costs, partnership formation costs, or incorporation costs; startup and organizational costs have a unique tax treatment.
Taxwise, you can deduct up to $5,000 of total costs, which include legal fees. If you have more than $5,000 of such costs, the balance is amortized (deducted ratably) over 15 years. However, the $5,000 deduction is reduced by the amount your total start-up or organizational costs exceed $50,000; if they exceed $55,000, then all of the costs must be amortized over 15 years and there is no $5,000 upfront deduction. For more details on writing off start-up costs, see IRS Publication 535.
Legal fees related to the purchase of a franchise are not currently deductible. However, they may be amortized over 15 years.
Most legal fees incurred for actions related to the conduct of your business are viewed as ordinary and necessary business expenses, which are currently tax deductible.
Examples of actions or activities for which fees are deductible include:
- Employee actions against the business, such as wrongful discharge, discrimination, or sexual harassment
- Obtaining tax advice (including the filing of a private letter ruling request with the IRS)
- Collecting from late-paying customers
- Contracts for the sale of goods or performance of services (e.g., drafting of consulting agreements)
- Defending against charges of mismanagement of the company’s retirement plan
Legal fees incurred to acquire a capital asset, such as a building, are not separately deductible. Instead, they are added to the basis of the asset acquired.
For example, if you buy an office building for your business and incur legal fees, the fees cannot be deducted in the year you pay them. The fees are added to the basis of the building and recovered through depreciation. In effect, as you depreciate the office building over 39 years (the period fixed by the tax law), you are actually deducting the $2,500 over the 39 years. It is not a separate deduction; it is part of the depreciation allowance for the building.
If there are any legal claims made with respect to title to your property, legal fees to quiet these claims are not immediately deductible. Again, they are added to the basis of the property.
Owner’s Personal Activities
Just because legal fees have some relationship to your business doesn’t make them all tax deductible. If the main reason (called the “origin of the claim” in legal terms) for the fees is a personal one, rather than a business one, the legal fees are personal despite some business connection or impact. The fees may be tax deductible, but only on a personal return.
Personal injuries. If you suffer a personal injury on a business trip, the legal fees cannot be deducted as a business expense. The legal fees are personal expenses handled on your personal tax return.
Last year, a business owner was denied a tax deduction for legal fees he paid in defending against an assault charge brought by an employee of one of the owner’s clients. (The owner had the client’s employee drive him home, which was 40 miles away, and then, in his home, the owner kissed the employee). The Tax Court said the origin of the claim was not related to the owner’s business even though the relationship giving rise to the action arose in a work setting, so the legal fees were not a deductible business expense.
Divorce. Owners who divorce must treat the legal fees as a personal expense even though the property settlement involves a business. A divorce is viewed as a personal action despite the fact that it may entail preserving a business interest. However, if the attorney provides tax advice as part of his or her services and the bill for the fees itemizes this aspect, then the portion of the fees for tax advice can be tax deductible — but only on a personal tax return.
Estate planning. Owners may seek legal advice for estate planning, including how to plan what happens to a business interest after death. The costs for preparing a will are not tax deductible, even though the costs cover planning for the business interest. However, if the portion of fees related to estate tax advice is allocated, then this portion is tax deductible on a personal return.
Still wondering how to treat your legal fees for tax purposes? Ask your accountant; this advice is surely tax deductible.
Barbara Weltman is an attorney, prolific author with such titles as J.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business, and trusted professional advocate for small businesses and entrepreneurs. She is also the publisher of Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® at www.barbaraweltman.com and host of Build Your Business radio. Follow her on Twitter @BarbaraWeltman.