The question of whether legal expenses are deductible can be complicated. The key to being able to write them off generally lies in the nature of the legal fees: Are they business or personal expenses?
In Denise McMillan v Commissioner, the U.S. Tax Court allowed an individual taxpayer to claim business deductions for legal expenses incurred in litigation against her condo homeowners association (HOA). The legal expenses were also paid by the taxpayer to defend against misdemeanor criminal charges that were related to the HOA lawsuit. Let’s take a look at why the court allowed the business deduction claim for what sounds like a personal expense.
Facts Underlying the Court Decision
For the tax year in question, the taxpayer operated an information technology (IT) venture as a sole proprietorship. That year, the taxpayer reported $65,000 of gross revenue from the IT business and net income of $14,809 after claimed expense deductions on Schedule C, “Profit or Loss from Business.” The taxpayer lived in a condo where she maintained a deductible home office. She deducted 50% of various condominium expenditures as home office expenses on her tax return.
Four years earlier, the taxpayer sued the condo HOA and several of her neighbors. The cause of action involved claims for damages due to:
- Neighbors’ dogs running wild around the property,
- Construction defects that caused mold in her bathroom, and
- Issues with the building construction that caused noise problems.
Specifically, the grounds for the complaint were breach of contract, breach of fiduciary duty and nuisance. During the year in question, the taxpayer became embroiled in a separate legal action involving misdemeanor criminal charges against her due to her attempts to gather evidence to support the HOA litigation.
On her Schedule C for the IT business, the taxpayer deducted 100% of her $26,312 of legal expenses for the year. The expenses consisted of $21,100 paid to one attorney for legal representation in the HOA litigation, $5,000 paid to another attorney for representation in connection with both the HOA litigation and misdemeanor charges, and $212 in sheriff’s department and court costs.
After an audit, the IRS disallowed the deductions for legal expenses on the grounds that they were nondeductible personal expenses related to her use of the condo as a residence. The taxpayer took her case to Tax Court.
What the Tax Court Concluded
The court allowed the taxpayer to deduct 50% of her legal expenditures ($13,126) as a business expense on Schedule C. The court noted that, in the IRS’s own arguments, the tax agency had correctly stated that taxpayers are allowed to deduct all ordinary and necessary expenses paid or incurred in carrying on an active trade or business.
Legal expenses constitute ordinary and necessary business expenses when they arise from — or are related to — an active business venture.
The court accepted the taxpayer’s argument that the complaints listed in the HOA litigation negatively affected the use of her home office in the condo — and thus, hurt her business. The IRS failed to prove to the contrary.
Because the IRS didn’t challenge the taxpayer’s treatment of 50% of the condo expenses as a home office where she conducted her IT business, the court concluded it was reasonable to allow her to deduct 50% of the legal expenses — because they were clearly related to the use of the property.
The Lesson for Other Taxpayers
Individual taxpayers who operate unincorporated businesses (such as sole proprietorships and single-member limited liability companies treated as sole proprietorships for tax purposes) may incur legal expenses that are legitimately business-related and therefore deductible.
However, if you get audited, the IRS may disallow deductions unless you do a good job of proving that the expenses are indeed business-related. Your tax adviser can help you prove this and hopefully head off an IRS challenges before it occurs.
(Denise McMillan v Commissioner, T.C. Memo 2015-109)
Exceptions to the General Rule
While personal legal fees are generally not deductible, there are some exceptions.
For example, if individuals incur legal fees related to their jobs or to collect alimony, they can deduct them as miscellaneous itemized deductions, which are subject to the 2% of adjusted gross income floor.
And if the expenses are incurred to acquire a business asset, they can be deducted but they must be capitalized as part of the asset’s cost.
However, these factors weren’t an issue in Denise McMillan v Commissioner. (See main article.)
There are other exceptions. Ask your tax adviser if you have legal expenses and want to know whether they’re deductible.