“Lawyers are seldom loved but often needed,” according to Robert B. McCay, who was a former dean at NYU Law School. In the course of your business, you’re likely to incur legal expenses, some of which may be modest, but some may be substantial. If you thought that all legal fees paid by your business or by you in connection with your business are deductible, you’d be wrong.
During the course of starting a business, you may incur legal fees for incorporating or forming a limited liability company, drawing up contracts with suppliers, obtaining a lease from a landlord, and addressing other legal matters. Instead of merely capitalizing the costs, you can elect to deduct up to $5,000 of startup costs as a deduction in the first year of the business. Cost over $5,000 can be deducted ratably over 180 months. However, where startup costs exceed $50,000, the upfront deduction may be reduced or eliminated.
You can only deduct certain legal fees on your tax return.
Advice related to operations
Legal fees that constitute ordinary and necessary business expenses or are related to determining, collecting, or obtaining a tax refund are deductible. There’s no dollar limit capping the deduction. Examples of currently deductible legal fees:
- Advising on the legality of various actions (e.g., termination of an employee)
- Collection activities for money owed by customers
- Defamation actions against the business’s reputation
- Defending intellectual property claims (e.g., a trademark challenge)
- Defending the business against discrimination and other employment-related claims by workers or former workers
- Drawing up contracts and agreements
- Legal services related to the sale of property
- Tax advice
Important: The business may need to send the attorney Form 1099-MISC if fees are $600 or more. This is so even though the “lawyer” is a law firm that is a corporation or professional limited liability company (PLLC).
Legal fees paid to acquire business assets are not currently deductible. Instead, they are added to the basis of the property acquired. For example, if the business buys a building, the legal fees for the acquisition become part of the cost basis on which depreciation is figured.
Personal matters involving the business
Legal fees for most personal matters are not deductible business expenses:
- Divorce. When a business owner divorces, ownership of the business may become a matter of contention, resulting in legal fees to settle the question of ownership. Usually legal fees in a divorce matter are nondeductible personal expenses. The U.S. Supreme Court has made it clear that this is so even though business assets are at stake and the owner could lose income. However, if the bill itemizes the portion of the work related to tax advice, then that portion is currently deductible (the attorney’s allocation will be respected under Rev. Rul. 72-245). As a practical matter, however, the deduction can be taken only as a miscellaneous itemized deduction on the owner’s personal return. As such, only amounts in excess of 2% of adjusted gross income (AGI) actually produce a tax benefit, and many business owners’ AGIs are too high to reap any benefit from such a write-off.
- Estate planning. Drawing a will is viewed as a personal matter so that legal fees are not deductible. However, as in the case of a divorce, fees for tax advice which are part of estate planning can be deductible if the attorney’s bill is itemized to specify this portion.
If you have questions about the legal fees your firm or you have paid, talk to your CPA or other tax adviser.