BGBC Partners, LLP Tax Update: Deducting Legal Fees
We live in a litigious society and unfortunately that includes store owners like you. Lawyers and legal services of all kinds are a necessary cost of doing business. But are they all deductible? That is the topic of this week’s Tax Update.
As you know, legal fees can be significant depending on the events of a particular year. The hope is that a tax deduction can provide some economic relief. But not every category of legal fee is deductible.
Let’s start with an obvious limitation, fees for personal legal expenses. If any portion of a legal invoice are personal in nature (i.e., not connected with any trade or business or “for profit” activity), those legal fees are nondeductible. Personal legal fees on the other side are generally not deductible. A typical example would be if an owner of a grocery store incurs legal fees during a divorce. Even though the owner could potentially lose part of the ownership of the store and might affect the business, the related legal fees are not deductible. Courts ruled that if the “origin-of-the-claim” is personal in nature and thus cannot be deducted. However, this is a complex area and certain positions can be taken for a deduction depending on the facts and circumstances.
Another category of legal fees which are not currently deductible are those which are “capital” in nature. These legal fees are capitalized since their benefit is spread over a long period, or the life of the benefit is undeterminable. For example, a legal expense is capitalized when it is incurred to acquire, defend, or perfect a title to property. Another example, are legal fees associated with buying a new building. Any legal cost incurred to acquire the building is added to the building cost and subject to depreciation rather than expensed.
Legal fees incurred in connection with starting a new grocery store can be expensed in the year incurred. Certain limitations do apply. You can deduct these “start-up” costs up to $5,000 and any amount over will be amortized over 180 months. If, however, your start-up costs (legal fees and other expenses that are related to starting the new grocery) exceed $50,000, then the $5,000 expense amount would have to be reduced for each dollar above $50,000. For instance, if the total costs end up being $54,000, this reduces your $5,000 expense allowance by $4,000 and thus you are only allowed to expense $1,000 for the current tax year. Taking it further, if your total starting costs are over $55,000, the entire amount will be subject to the 180 month capitalization rule.
The key is to determine whether a particular legal fee is currently deductible since its nature is more operational or a period cost, or is the legal fee so closely tied to a longer term asset that it too must be capitalized like the underlying asset. Or is it personal (or partially personal) in nature.
These days many of us have, or will have, legal expenses. Analyzing whether your legal fees are deductible or not can be somewhat confusing. For any further information or advice, be sure to consult with your tax professional about proper treatment.
