Taxing Lessons From Court Decisions

Decisions — Legally related

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Image source: Yale Law Library from New Haven, CT, USA (Arbor dividui et individui, 1538) [CC BY 2.0 (http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons
Image source: Yale Law Library from New Haven, CT, USA (Arbor dividui et individui, 1538) [CC BY 2.0
(http://creativecommons.org/licenses/by/2.0)], via Wikimedia Commons

Where do legal expenses fall on the tax code scale of ordinary and necessary?

When you pay the fees in the course of carrying on your trade business, internal revenue code section 162 governs whether you have a deduction.

Look to code section 212 when you hire a lawyer in the course of producing income, managing, conserving, or maintaining property held for the production of income, or determining, collecting, or refunding a tax. However, the regulations under that same code section (1.212-1(h)) say ordinary and necessary expenses incurred in connection with the management, conservation, or maintenance of property you hold for use as your residence are not deductible.

Code section 262(a) disallows a deduction for personal expenses in general.

The origin and character of the expense determines whether it is deductible as a trade or business expense or as a non-business, profit-seeking expense, as opposed to a nondeductible personal expense.

In a bench opinion (Docket No. 28863-14 – Chan), the taxpayer worked out of his home, making equipment that he sold to the defense industry. He deducted attorney fees of $135,471 on the schedule C attached to his 2011 federal income tax return, and $164,427 in 2012.

The legal fees deducted in 2011 and 2012 arose from a prior lawsuit. In that case, the taxpayer had sued his neighbors over the pruning of trees that the taxpayer said were on his property. That lawsuit was for actual and treble damages and attorneys’ fees for trespass, negligence, and hiring of unlicensed contractors to perform licensed services. The case was settled as a result of mediation in 2008, and the taxpayer agreed to not replant trees within a 10-foot front setback.

In 2009, the taxpayer hired another attorney to have the agreement reached in the first suit withdrawn. That attorney filed a lawsuit for the taxpayer against the attorneys who represented the taxpayer in the first suit.

During 2011 and 2012, three different law firms represented the taxpayer. The invoices for the three law firms were for fees regarding the legal malpractice claim in the dispute with the taxpayer’s neighbor. The invoices did not mention the taxpayer’s business.

The IRS disallowed the legal expenses, saying they were personal expenses related to the taxpayer’s residence.

The taxpayer contended the legal claims were related to his business. He testified that he needed to keep his equipment cool and that the trees provided shade that kept his property cool. He said the reason the complaint was silent regarding his business was because he did not want to make it public that he operated a business from his residence because of the value of the equipment. He also testified that trees helped lower temperatures, and heat could affect the equipment he manufactured.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

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.

The origin of the taxpayer’s legal claims was personal in nature. The taxpayer failed to provide evidence that the civil lawsuit against his neighbor proximately related to his trade or business.

The taxpayer’s lawsuit did not arise directly out of his business affairs. The circumstances out of which the litigation arose were the result of the taxpayer’s use of the property as his primary residence.

The taxpayer’s legal claims were also not related to a non-business, profit-seeking motive. The record is devoid of evidence establishing that the taxpayer’s legal expenses were incurred for the production of income, the management, conservation, or maintenance of property held for the production of income, or determining, collecting, or refunding a tax.

Instead, the record establishes that the taxpayer’s legal expenses were incurred for the management, conservation, or maintenance of property held for use as a residence by him.

As such, the taxpayer is not entitled to deduct his legal expenses, under either 162(a) or section 212.

Accordingly, we sustain the deficiency determined by the IRS, and a decision will be entered for the IRS.

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