Legal fees for your business can be high, with hourly rates reaching $500 or more, depending on where you are located and what type of services and expertise are in involved. Legal fees may be deductible as an ordinary business expense, with no dollar cap or other special limitations on the amount that is deductible (other than that they must be reasonable). However, there are some situations in which fees may not be currently deductible. Here are the four tax rules you need to know about legal fees.
1. Basic rule
Generally, legal fees may be currently deductible as ordinary and necessary business expenses. Examples of legal actions in which fees are currently deductible include:
- Creating or reviewing contracts and agreements, suing for breaches or defending against claims of breach of contract
- Assistance in collecting outstanding accounts payable
- Defending against trademark, patent or copyright infringement claims
- Defending against wrongful discharge or other employee (or former employee) claims
- Obtaining tax advice, actions involving the IRS or state tax departments or obtaining an IRS ruling
2. Rule for start-up costs
When a business is getting started, there may be legal fees involved. Special rules apply in this case. Legal fees related to creating a partnership or corporation are immediately deductible up to $5,000.
Excess costs can be written off ratably over 180 months (15 years). However, if legal fees exceed $50,000, then the $5,000 up front deduction is reduced by one dollar for every dollar over $50,000; no upfront deduction can be claimed if fees are more than $55,000. For example, if you pay $2,500 to the ABC Law Firm to create articles of incorporation and another $500 to your state to incorporate, you can deduct the $3,000 in legal fees in the corporation’s first year.
3. Rule for capitalized costs
No deduction can be claimed for legal fees that are viewed as capital expenditures. These are costs related to creating, acquiring, or protecting a capital asset, such as real estate and intellectual property. These costs are added to the basis of the capital asset.
However, in some cases, the legal fees that are capitalized may be recovered through depreciation or amortization. For example, your company buys an office building and incurs legal fees of $3,000. Because the fees relate to the acquisition of a capital asset—the building—the fees are added to the cost basis of the building. The cost of the building (minus the land) can be depreciated over 39 years, so effectively the fees will be written off over 39 years.
Examples in which legal fees must be capitalized and are not currently deductible:
- Fees to defend title to realty
- Fees for suing for trademark, patent or copyright infringement
4. Rule for personal costs
No deduction is allowed for legal fees that are purely personal in nature and not otherwise deductible (i.e., do not relate to the production of income, such as a recovery of a taxable award in a lawsuit). For example, no deduction can be claimed by a business owner for obtaining a divorce, even though the business is a marital asset subject to division or distribution during the course of the divorce.
When it comes to the deductibility of legal fees, don’t make assumptions. In the case of fees related to lawsuits, look at the “origin of the claim” giving rise to the legal action. If it relates to business issues and is not required to be capitalized, a current deduction may be appropriate. Discuss the deductibility of any legal fees with your tax advisor.
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 barbaraweltman.com and host of Build Your Business radio. Follow her on Twitter @BarbaraWeltman.
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