Taxing Lessons Case Summaries

Case — Deductibility of Legal Settlements and Fees

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TL Case Summ

THE QUESTION

Are legal settlements and fees currently deductible or should they be capitalized?

THE DISPUTE

Taxpayer Says: The settlement payments and legal fees are ordinary and necessary business expenses and are currently deductible.

Internal Revenue Service Says: The settlements and fees were related to transfers of asset title and must be capitalized, not currently deducted.

THE LAW

From Internal Revenue Code Section 162(a): There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.

From Federal Tax Regulation 1.263(a)-2(c): The costs incurred in litigating title to property are capital expenditures.

THE CAUSE OF THE DISPUTE

As a general rule, you can deduct business settlement payments and legal fees when those expenses are necessary to carry on or defend your business in the normal course of operations. However, tax law typically requires you to capitalize these items when the payments relate to ownership or property title.

Because the tax treatment of legal expenses is not always clear, disputes arise when taxpayers seek the more favorable outcome of current deductibility. In these situations, courts use a legal doctrine called “origin of claim” to determine if the expenses are deductible, capitalizable or nondeductible. Under this doctrine, the tax treatment is based on the origin and character of the expenditure.

In this case, the settlement payments and legal fees related to the resolution of lawsuits brought against the taxpayer by state attorneys general who alleged that a merger between the taxpayer and several nonprofit organizations negated the charitable purposes of the nonprofits. The lawsuits sought to have the value of the assets acquired by the taxpayer in the merger returned to charitable purposes. The settlement funds were used for that purpose.

The taxpayer argues the lawsuits did not challenge title to specific assets. In addition, the origin of the lawsuits was a challenge to the way the taxpayer conducted business. The settlements and legal fees were necessary to defend the business and were incurred to avoid interruption of business activities and loss of goodwill, making them currently deductible as ordinary and necessary business expenses.

The IRS contends the expenditures were related to resolving title to the assets and should be capitalized or, alternatively, that they are neither capitalizable nor deductible.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 22KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
For the IRS. None of the lawsuits in question was brought to enjoin or change the business practices of the taxpayer. In each case, the origin of the claim was a dispute over the equitable ownership of assets allegedly impressed with charitable trust obligations. The settlements and legal fees are capitalizable and not currently deductible.
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