The general rule is that the fees paid to attorneys, accountants, appraisers, and other experts in connection with divorce, child custody, and paternity matters are not tax deductible. However, there are instances where professional fees are deductible. There are three Internal Revenue Code sections addressing the deductibility of fees. Internal Revenue Code § 162 provides that those business expenses that are ordinary and necessary in the conduct of business are deductible; Internal Revenue Code § 212 which allows taxpayers to deduct expenses that are incurred to produce taxable income; and Internal Revenue Code § 263 which allows the taxpayer to capitalize certain expenses to increase the basis of an asset.
Occasionally a client will attempt to reduce taxes by paying their legal fees incurred for their marital dissolution through their business. Divorce-related attorneys' fees are not a business expense and therefore are not deductible by the business. Attorneys' fees incurred in connection with a divorce are personal expenses, even though the litigation may have important business implications. For example, if fees are expended for the purpose of protecting a family business, they are still considered personal (Melat v. Commissioner, TC Memo. 1993-247). Husband cannot deduct cost of disputing the value of his share of unpaid law firm contingency fees. It may be appropriate, however, to deduct fees related to the corporation’s response to being joined in the divorce action when one spouse is contending that the income from the corporation is his/hers.
In Liberty Vending and John Poulos v. Commissioner, T.C. Memo 1998-177, Husband was the sole shareholder of a C-corporation and an S-corporation that together operated a video game arcade. Husband suffered a heart attack and was hospitalized for 2-3l days. While he was in the hospital, wife filed for divorce, obtained a restraining order, and filed an ex-parte order of protection. These actions gave her emergency possession of the two corporations and put the corporate bank accounts in escrow under the supervision of the family courts. Then, wife and boyfriend fired all the employees, took large amounts of cash and equipment, and removed the corporate records from the corporations’ place of business. Husband incurred legal fees to regain control of the corporations and litigate his divorce. The Court ruled that husband’s legal fees were deductible, “if the origin of the claim arose from their profit seeking, rather than Mr. Poulos’ personal activities. See United States v. Gilmore [63-1 USTC ¶9285], 372 U.S. 39, 48 (1963). Mr. Poulos’ legal fees were incurred for the purpose of establishing his right to possession of, or participation in the income from, the corporations, and therefore, such expenses arose from Mr. Poulos’ profit seeking actvities. See, e.g. Hahn v. Commissioner [Dec. 33,765 (M)].”
Legal fees, arising from a divorce of the shareholder of a corporation are deductible only to the extent that such fees were incurred to resist actions that interfered with the business activities of the corporation. In Dolese v. United States [79-2 USTC ¶9540], 605 F.2d 1146, 1152 (10thCir. 1979)) for example, Husband’s corporations were restricted by the Court from taking certain actions. The business valuation, however useful to the corporation for several reasons, had its “origin” in the divorce action, and was therefore a personal expense. The test of deductibility for legal fees is the “origin and character of the claim.”
Attorneys’ fees incurred in connection with a marital dissolution are deductible as miscellaneous itemized deductions on a person’s individual tax return in a few circumstances. They are deductible only to the extent they exceed 2% of the taxpayer's adjusted gross income and they are subject to a phase-out when the adjusted gross income exceeds a certain amount. For the 2001 tax year, itemized deductions begin to be phased out at $132,950 of adjusted gross income for single and head of household taxpayers. Legal fee deductions are also subject to the alternate minimum tax. Thus, the deduction may be lost if it is significant in comparison to the other amounts on the tax return. In order to take advantage of the 2% rule, it is best if all deductible legal fees are paid in one year -- although that may trigger the alternative minimum tax.
Attorneys’ fees and other litigation costs paid by the taxpayer in the tax year are deductible to the extent that they are incurred:
1. For the production or collection of income;
2. For the management, conservation, or maintenance of
property held for the production of income;
3. In connection with the determination, collection, or
refund of any tax, or
4. In connection with getting and collecting alimony
(spousal support).
Because spousal support is includable in gross income, the fees incurred in obtaining the spousal support or in collecting delinquent spousal support are deductible (IRC §§ 212(1); Regs. §§ 1.262-1(b)(7); Wild v. Commissioner, 42 TC 706 (1964)). Accountants’ appraisers’, actuary, or vocational counselors’ fees are tax deductible to the extent their work involves obtaining spousal support.
Fees and costs in connection with spousal support modification proceedings are also tax deductible. Attorneys’ fees incurred for the purpose of obtaining an interest in a retirement plan are also deductible, to the extent that retirement income is includable in gross income. The fees of the actuary used to value your client's interest in the plan and the costs of preparing the QDRO may also be tax deductible. The fees incurred in obtaining the client's interest in royalties, residuals, and other income taxable to the client will also be tax deductible.
Fees are also deductible to the extent they are paid for tax planning advice or services (IRC § 212(3); Carpenter v. United States, 338 F.2d 366 (Ct.Cl.1964); Rev. Rul. 72-545, 1972-2 CB 179). The following advice and services may be allocated to tax planning:
1. Costs of structuring a property division to produce
desired tax effects, i.e., advice re: rollover residence,
the one-time tax exclusion of capital gain for taxpayers
55 and over, etc.
2. Costs of determining the adjusted basis of assets in
the property settlement.
3. Costs of planning an alimony trust or annuity agreement
to avoid some of the restrictions on deductible
spousal support.
4. Costs of estate planning that assure proper estate and
gift tax consequences for the payment or receipt of
support or property division.
5. Costs of preparing a settlement agreement to assure
deductible support payments during the separation
period.
6. Costs of maximizing the deductible portion of spousal
support or of minimizing the taxable portion of spousal
support.
7. Costs of allocating dependency exemptions.
8. Costs of obtaining advice regarding the tax consequences
of divorce or separation instrument or of gathering
information for and preparation of tax returns.
9. Costs of drafting a QDRO and submitting it to the plan
administrator for approval and enforcing the
QDRO. (These may also be deductible as fees incurred to
produce taxable income.)
Fees incurred in establishing or defending title to property may be capitalized and added to the basis of property (Serianni v. Commissioner, 80 TC 1090, 1103 (1983), affirmed on appeal without discussion on this issue, 765 F.2d 1051 (11 Cir. 1985); Gilmore v. United States, 245 F. Supp. 383, 386 (ND CA 1965)). Even though the fees incurred for this purpose are not currently deductible, they will result in a tax benefit when the asset is sold sometime in the future. Such fees could include the cost of a business valuation, real property valuation issues, cost of preparing and filing a deed to put the house in your name, and the tracing of separate property.
An effective way to address the deductibility of attorneys’ fees is by itemizing separately on each bill the services that involve tax advice and the "production or collection of income.” Set up your time-keeping method to track time spent on these services. You may wish to state in your fee agreement, if the IRS causes you to substantiate your allocations, you will be paid your normal hourly rates for this work. At the end of the year, the bills can be reviewed and summarized in a letter to clients explaining that a portion of their attorneys’ fees may be deductible. If you are qualified to provide this advice, send the client a letter at the conclusion of the case that expressly identifies the deductible vs. non deductible services rendered. Confirm with your malpractice carrier that you are covered if your client relies of your tax advice. In the event the client's deductions are disputed, the IRS must receive such an allocation letter in evidence (Goldaper v. Commissioner, TC Memo. 1977-34). If you are not qualified to render tax advice, you should consult with an accountant to determine which services billed during the tax year are deductible, which expense can be capitalized and which services are non-deductible. The accountant could then summarize their determination in a letter.
Through tax planning, parties can use the tax deductibility of attorneys’ fees to allocate fees between the spouses. If, for example, Husband pays to Wife $10,000 for her attorney's fees as temporary spousal support and Wife pays her attorney's fees in that same year, Wife may be able to deduct a significant portion of her attorney's fees. That transaction can benefit both parties. Husband pays Wife's attorney's fees by making them tax deductible as spousal support and gives Wife the partial tax deduction for attorney's fees when incurred for production of income or for tax advice.
Tax law impinges on almost every aspect of a family law case. By paying attention to the tax deductibility of your fees, you will reduce your client's obligations, and perhaps even give them an incentive to pay your bill.
