When Legal Fees are Tax Deductible

The government looks to tax every time something of value changes hands, so it should be of no surprise that lawyers need to be aware of the tax implications to their clients in the matters in which the lawyers are providing services.

Lawyers are required to advise their clients of the tax consequences of matters the lawyer is handling – even if it is simply to advise the client to hire an accountant or tax attorney to give the advice. Clients who are surprised on tax day that they owe a lot of money for taxes their lawyers never told them about will be unhappy and may have a claim for legal malpractice. 

Clients definitely need to know whether the attorney fees for handling a matter are tax deductible.  

Generally, a business that spends money on legal fees can deduct the legal fees as an expense of doing business, or add the legal fees to the tax basis in an asset acquired.

Individuals who spend money on an attorney to collect money that will be taxed can deduct the attorney fees from the money recovered and only pay tax on the net amount recovered. For example, if James is injured in a car accident, he may sue the other driver, John, for the wages James lost because the car accident injuries kept James out of work. Wages are taxable. Assume James recovers $50,000 in lost wages and pays his lawyer $10,000. James can deduct the attorney fees against the recovery and only pay taxes on $40,000.

The attorney fees spent by individuals to collect money that will not be taxed are not tax deductible under the new tax law which became effective in 2018 and is known as the Tax Cuts and Jobs Act of 2017. Under the prior tax law, attorney fees were deductible as a miscellaneous deduction to the extent that the attorney fees exceeded 2% of adjusted gross income and the taxpayer itemized deductions and were not subject to the Alternate Minimum Tax. 

Now let’s assume Jane makes a $50,000 interest-free loan to Joan. Jane gets the money from her savings account. The money in Jane’s savings account comes from Jane’s paycheck and therefore, that money has already been taxed. So the money in Jane’s bank account is Jane’s “capital.” The government does not tax someone who sues and recovers her capital. 

Joan does not make payments so Jane sues Joan to collect $50,000. Jane pays her attorney $10,000 for the services and she recovers $50,000 from the lawsuit with Joan.

Since the government does not tax the return of capital to an individual, the lawsuit proceeds are not taxable money. Since the lawsuit proceeds are not taxable money, then the attorney fees paid by Jane to her attorney are not tax deductible. The loan payments to Jane are not taxable because that is simply the return to Jane of her capital, that is, the money she already paid taxes on.  

The difficult situations is when the client pays legal fees out of the money recovered in the lawsuit.  In the example above, Jane was paying her lawyer fees from money she had in her bank account. Now let’s assume that based on the loan documents, Jane was entitled to recover not only the amount due on the loan, but also legal fees if she was required to sue. Jane sues and recovers $50,000 for the balance owed on the loan plus $$8000 for the legal fees spent on the lawsuit, for a total of $58,000. Joan pays the $58,000 and $50,000 goes to Jane and $8,000 goes to the lawyer.

The government will treat the $8,000 paid to the lawyer as income to Jane. That is new money to Jane, it did not come from her bank account. It was a payment by Joan to pay a debt that Jane owed her lawyer. The government treats the money paid by another person for your debt as income to you. Since it is income to Jane, Jane will have to pay taxes on the $8,000.  

There are exceptions to this rule. Attorney fees paid to recover damages for physical injuries arising from an accident are not treated as income to the injured individual. Attorney fees recovered in a case where the individual sued for damages under the “whistleblower” laws are not treated as income and are not taxed. 

Sometimes, strategies can be put into play to allocate the money recovered into categories that are not taxed. The lesson here is that clients need to prompt their attorneys for information and advice on the tax implications of the recovery of money in a lawsuit.