Deduct This: History of the Tax Attorney’s Fees Deduction

Wait? You mean that you didn’t know that there was such a thing as the tax attorney’s fees deduction?

Well, perhaps that’s because it’s not actually called the tax attorney’s fees deduction. Tax attorneys like me just like to call it that. It’s technically part of the Job Expenses and Certain Miscellaneous Deductions subject to the 2% floor and it can be found at line 23 on Schedule A (downloads as a pdf). You might overlook it since it’s labeled as “Other expenses” cause it’s that important.

Miscellaneous deductions are the third most popular of the itemized deductions (you can read more about itemized deductions in this prior post). Those deductions are currently only allowed to extent they exceed 2% of your adjusted gross income (“AGI”), similar to the way that you figure the deductions for medical expenses. The threshold for the deductions is often referred to as a “floor.”

Here’s a quick example: assuming you have miscellaneous deductions that total $5,000 and AGI of $50,000, you can only deduct $4,000. The math is: $5,000 (total expenses) less $1,000 “floor” ($50,000 x 2%) = $4,000 in deductions on Schedule A.

So, which fees qualify as deductible? Usually, legal fees related to individuals are not deductible. When it comes to attorney’s fees you pay to defend the action from your crazy neighbor about your tree, not deductible. But attorney’s fees related to tax may be deductible. To qualify, your legal fees must be:

* To produce or collect income that must be included in your gross income,

* To manage, conserve, or maintain property held for producing such income, or

* To determine, contest, pay, or claim a refund of any tax.

That means generally, tax planning advice related to your income or income-producing property (including estate planning that is related to tax planning) and some tax controversy work would be deductible. This also extends to tax advice rendered in the course of planning for divorce or to collect alimony; divorce-related attorney fees are otherwise not deductible.

Great news, right? It’s like a rebate on your tax attorney bill. It is worth noting (so that I don’t get virtually egged by my colleagues) that the IRS also allows a deduction at line 23 for “tax advice fees” not restricted to that provided by attorneys, so advice provided by your accountant, CPA and investment advisor may also be deductible.

Tax-related legal expenses may also be deductible if they are tied to doing or keeping your job. This includes fees paid to defend yourself against criminal charges arising out of your trade or business – good news for “Whitey” Bulger.

(Other business-related legal fees may also be deductible – just on other tax schedules.)

The history of the deduction is interesting in that the statutes didn’t change wildly for most of the history of the Code, though the interpretations of the deduction did. The language in the Tax Code which allows for deductions for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business” remained virtually unchanged in most versions of the Tax Code, including those from 1926 (downloads as a pdf) and 1939 (downloads as a pdf) and included tax-related legal fees.

The difficulty was in the interpretation. The courts, of course, read this language strictly meaning that the taxpayer had to be involved in a trade or business, not merely producing income. (See Higgins v Commissioner, 312 U. S. 212 (1941)) That meant that taxpayers who incurred fees to produce income not in the course of business were not able to take the deduction. The fact that the income was taxable but not deductible because of the wording in the law clearly bothered many on the bench and in Congress. The Revenue Act of 1942 changed that by adding language which clarified that fees related to profit-seeking activities, including personal investments and hobbies, would be deductible so long as the respective income was taxable.

The deduction survived for decades until the 1980s. As part of Reagan’s sweeping tax changes, the Treasury issued a report on November 27, 1984, referred to as the “Tax Reform for Fairness, Simplicity, and Economic Growth.” In the report, it was proposed that a floor be imposed on miscellaneous itemized deductions. The suggested floor was 1% of AGI and the justification was based on simplification. The report (downloads as a pdf) stated:

Allowance of the various employee business expense deductions and the miscellaneous itemized deductions complicates recordkeeping for many taxpayers. Moreover, the small amounts that are typically involved present significant administrative and enforcement problems for the Internal Revenue Service. These deductions are also a source of numerous taxpayer errors concerning what amounts and what items are properly deductible.

In terms of administration, the deduction was a bear. In addition to the confusion behind what was properly deductible (miscellaneous is just so vague), the report noted that the sheer number of returns claiming the deduction was overwhelming. Further, the value of those deductions was tiny: in 1982, half of the taxpayers who itemized claimed miscellaneous deductions worth less than 1/2 of 1% of their AGI.

However, the Treasury also recommended that the “expenses be deductible by the taxpayer, whether or not he itemizes deductions.” (Emphasis added and yes, the Treasury used the word “he”, not me)

Congress took the Treasury up on some of its advice and did impose a floor on miscellaneous deductions when it enacted the Tax Reform Act of 1986. Section 67 of the Tax Code now allows for a deduction for miscellaneous expenses “only to the extent that the aggregate of such deductions exceeds 2 percent of adjusted gross income.”

Congress did not take all of the Treasury’s advice and continued to restrict the deduction to those taxpayers who itemize. The deduction is also disallowed if a taxpayer is subject to the AMT.

The Regulations have since clarified what is and is not deductible under the Code including, at Section 1.212-1, subparagraph (l):

Expenses paid or incurred by an individual in connection with the determination, collection, or refund of any tax, whether the taxing authority be Federal, State, or municipal, and whether the tax be income, estate, gift, property, or any other tax, are deductible. Thus, expenses paid or incurred by a taxpayer for tax counsel or expenses paid or incurred in connection with the preparation of his tax returns or in connection with any proceedings involved in determining the extent of his tax liability or in contesting his tax liability are deductible.

The Regulations have further clarified that tax advice connected to alimony and tax is deductible at Section 1.262-1:

Generally, attorney’s fees and other costs paid in connection with a divorce, separation, or decree for support are not deductible by either the husband or the wife. However, the part of an attorney’s fee and the part of the other costs paid in connection with a divorce, legal separation, written separation agreement, or a decree for support, which are properly attributable to the production or collection of amounts includible in gross income under section 71 are deductible by the wife under section 212.

There’s been no real movement on the deduction over the past 25 years. The deduction as written in 1986 stands today, still subject to the 2% floor.

You don’t hear a lot about the deduction for legal fees come tax time which is odd since, in theory, these fees could add up a lot more quickly than medical expenses which you do hear a lot about. My advice, which is, of course, self-serving, is to ask your tax professional about the deduction. Remember that you don’t have to run a business to qualify – all sorts of life events from getting a divorce to having an account overseas – can result in the need for tax and legal advice. Knowing that it might be deductible might make it a little less painful, right?