Attorney Fees: Deductible?

published January, 2011

Sometimes attorney fees are deductible, and sometimes they aren’t. Even when they are deductible, the way they get deducted makes a difference.

Attorney fees for divorce are generally not deductible, except to the extent that you’re receiving tax advice or to get or collect alimony.

If your business incurs attorney fees, the fees are probably deductible by the business. (Startup fees are usually amortized.)

If you incur attorney fees personally, the fees MAY be deductible. If the fees were for the preservation of income, they are usually deducted on Schedule A, and are subject to the “2% haircut” as Mike Power, E.A. calls it—the expense is reduced by 2% of your AGI (Adjusted Gross Income), and is combined with other itemized expenses like mortgage interest and property taxes on your personal residence.

Each year, you compare your itemized expenses with the “standard deduction” (for 2010 standard deduction is $11,400 for a MFJ couple) and choose the higher deduction. Because attorney fees are a “preference item,” disregarded in the AMT world, you may be subject to AMT tax on the amount you paid your attorney—paying tax on money you don’t have. There’s an IRS case about this where the taxpayer argued his payment of contingent fees to his attorney should be the attorney’s income only, not the taxpayer’s income first then deducted on Schedule A as an itemized deduction; the IRS won. (See Commissioner v. Banks, 543 US 426 (2005).)

There are certain circumstances when attorney fees are deducted “above the line”—and not subject to AMT. This is certainly the situation to be desired. In 2004, there was legislation that led to IRS Code Section 62(a)(20) specifically for attorney fees in discrimination cases. It would appear this covers attorney fees in ERISA cases, but consult your tax preparer to be sure, as your situation may not be included in this code section. One labels these kinds of fees as “UDC” (for Unlawful Discrimination Claim) on line 36 for 2010 Form 1040s, and the deduction is limited to the income from the discrimination claim. For more information, see IRS Publication 525.