Case — Deductibility of Legal Fees

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TL Case Summ

THE QUESTION

Can a taxpayer deduct legal fees paid to establish an interest in property sale proceeds?

THE DISPUTE

Taxpayer Says: The legal expenses were paid for the purpose of collecting a portion of the property sale proceeds, i.e., to collect income, and are therefore deductible.

Internal Revenue Service Says: The legal expenses are nondeductible because the expenses derive from a suit that originated in a personal or family matter and therefore are personal, living, or family expenses.

THE LAW

From Internal Revenue Code Section 212(1): Ordinary and necessary expenses paid for the production or collection of income are generally deductible.

From Internal Revenue Code Section 262(a): Personal, living, and family expenses are generally not deductible.

From Internal Revenue Code Section 263: Legal fees paid or incurred in perfecting title to a capital asset are nondeductible capital expenditures.

From Woodward v. Commissioner, 397 U.S. at 577-578: Whether legal fees are deductible under section 212, or nondeductible under section 262 or 263, depends on the origin and character of the underlying claim, not on its potential effects on the fortunes of the taxpayer or the taxpayer’s purpose for undertaking the litigation.

From United States v. Patrick, 372 U.S. 53, 57 (1963): Legal fees paid or incurred in connection with a divorce are generally nondeductible because the claims underlying the legal fees typically originate from personal or family matters, not from an income-producing activity.

From Hahn v. Commissioner, T.C. Memo. 1976-113: However, a deduction for legal expenses is not necessarily precluded simply because the taxpayer’s underlying claim arose in a divorce action.

From Peters, Gamm, West & Vincent, Inc. v. Commissioner, T.C. Memo. 1996-186: Rather, we must identify the underlying claim that gave rise to the legal expenses at issue and then determine whether the origin of that claim is personal in nature.

THE CAUSE OF THE DISPUTE

Determining whether or not you can deduct legal fees on your federal income tax return depends on the origin of claim doctrine. For legal fees, that means if the expenditure arose in the course of your business or profit-making activity, you generally can deduct it. If the legal fees arose from a personal activity, they are nondeductible personal expenses (with certain exceptions).

For instance, legal fees such as those you incur while working out a divorce property settlement are typically personal and non-deductible. However, legal fees related to tax advice regarding your divorce are deductible, as are fees to collect taxable alimony. Legal fees are also deductible when related to doing or keeping your job, or if you pay the fees to produce or collect taxable income.

The lack of clarity surrounding the origin of claim doctrine leads to disputes, as in this case, where the taxpayer appealed a court decision regarding proceeds received from a land sale.

The taxpayer and his wife purchased the land in 1991 for $55,000. In 1995, they divorced, and in 1996, the land was placed in trust to pay for education for the benefit of their two children. In 2007, the land sold for $2,025,000. The taxpayer’s ex-wife wanted to put the proceeds into the trust. The taxpayer refused. He said the value of the children’s trust exceeded the funds needed to finance the children’s education and that any funds not used for the children’s education should be equally divided between himself and his ex-wife.

The family court found that the taxpayer and his ex-wife never intended to retain an interest in the property; rather, they both agreed to transfer “all the right, title, and interest” in the property to their children’s trust in 1996. Accordingly, the family court ordered that all of the sale proceeds be distributed to the children’s trust. The taxpayer appealed the order to the state supreme court, which affirmed the family court’s decision.

The taxpayer paid legal fees to his divorce attorney in 2008 and 2009 for the appeal, and deducted the fees on his tax returns for those years.

The Internal Revenue Service denied the deduction, arguing that the expenses were nondeductible because they derived from a suit that originated in a personal or family matter and therefore were personal, living, or family expenses.

The taxpayer argued he paid the fees in connection with litigation to collect a portion of the proceeds from the sale, which was taxable income. In addition, he says that because the claims underlying the expenses derive from the property sale in 2007, over a decade after his divorce, those claims were not personal, living, or family expenses.

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, 34KB)

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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. The tax treatment of the legal expenses hinges on the origin and character of a taxpayer’s claims, not the possible consequences on his fortunes if those claims were to prove successful or his purpose for undertaking the litigation. The property sale was “the event that prompted” the taxpayer to bring suit. However, the record establishes, and we conclude, that the property sale was personal in character. Pursuant to their child custody, child support, and community property agreement, the taxpayer and his ex-wife placed the property in their children’s trust to provide funds for their children’s education. They sold the property in their capacities as co-trustees of their children’s trust. Although the property sale occurred over a decade after the divorce, the record establishes that the personal character of the transaction was not changed by the passage of time. Therefore, we conclude that the legal fees originated from a personal and family matter stemming from the taxpayer’s marital relationship.
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