I’ve heard my fair share of entrepreneurs and small business owners worry about the cost of attorneys and legal services — while they recognize the necessity of lawyers, they’re still none too happy about the cost. However, it may be possible for your business to deduct legal fees as a business expenditure.
There are limitations on the deduction rule. In order to be deductible, the legal fees must be:
1) incurred in carrying on a business
2) ordinary and necessary, and reasonable
3) paid in the taxable year in which the deduction is sought
4) paid by the person or entity to whom the services are rendered
In addition to these requirements, there are limitations relating to incorporation/business organization legal fees and legal fees relating to capital goods.
Legal fees incurred in the formation of a corporation, partnership, LLC, etc. may be immediately deductible up to $5000; above $50,000 the immediate deduction allowance decreases one dollar for every dollar above $50,000, so that legal fees above $55,000 are not entitled to any immediate deduction. However, legal fees that are incurred in the acquisition or defense of a capital good, such as real estate or intellectual property, are not deductible and are instead considered part of the capital expense itself and subject to those taxation rules, but legal fees paid for the management, conservation, or maintenance of property held or used for income may be deductible.
It goes without saying that personal legal fees, even ones that may be related to the business (such as litigation involving a family business during a divorce proceeding) are generally not deductible; however, if the expenditure is deemed to be for the benefit of the business, it may be deductible (although possibly only to the extent that the fees benefit the business). The test courts use to determine the deductibility of expenditures such as legal fees is the “origin of the claim” test, which asks what kind of claim brought about the expenditure of legal fees. If the claim is a personal matter or involves the acquisition, disposition, or defense of title to property or other capital goods, the legal fees will accordingly be classified as personal or capital in nature and will not be permitted to be deducted.
Entrepreneurs and small business owners should work with their tax advisors to determine the extent to which the expenditures their businesses made on legal and other professional fees may be deductible (even the tax advisor’s fees may be deductible!).