As a small business owner, you know how important it is to seek legal advice and services when needed. From drafting contracts to resolving disputes, legal fees can quickly add up. However, many types of legal fees are tax-deductible, potentially saving you money come tax season. Just which legal fees are eligible for tax deductions? And are there any tax advantages of legal services worth exploring?
What Types Of Legal Fees Are Tax-Deductible?
Certain legal fees incurred by you in the operation of your business are tax deductible, such as:
Legal fees incurred during this process can be deducted up to $5,000 in the business’s first year if you’re creating or buying a business. This includes fees associated with creating legal documents or paying state incorporation fees. Any remaining startup costs must be amortized over time. This is important to remember when starting a new business, as the costs of creating or buying a business can quickly increase.
Legal fees for defending or protecting your business from lawsuits can be deductible. This includes fees for attorneys, court costs, and other related expenses.
For instance, if a customer sues your company for a defective product or a supplier sues you for breach of contract, the legal fees for defending yourself in court can be deducted. (That said, this significant expense can often be avoided by having proper legal documentation in place—specifically, contracts and agreements.)
Tax Advice or Preparation
Legal fees related to tax advice or tax preparation are also deductible. This includes fees for tax attorneys, accountants, and other professionals who provide tax advice or prepare tax returns. This is a critical deduction to remember, as tax preparation and advice can be essential in ensuring your business complies with tax laws and regulations.
How Much Can You Deduct?
The amount a business owner can deduct in legal fees in a year depends on the type of legal expenses incurred.
Business expenses are defined as costs incurred “while operating a necessary and ordinary business.” These expenses are typically fully deductible on a business’s tax return. Examples of business expenses include rent, salaries, supplies, and utilities. The IRS allows businesses to deduct the total cost of these expenses from their taxable income, reducing the amount of tax owed.
The 2% rule applies to miscellaneous itemized deductions, meaning you can only deduct a portion of an expense if it exceeds 2% of your adjusted gross income (AGI). However, recent changes to tax rules have impacted which expenses qualify as miscellaneous deductions.
While some fees are fully deductible, such as startup costs, others may limit the amount you can deduct. This can make navigating the deduction process complex and time-consuming, which is why many businesses turn to professionals to ensure they maximize their deductions.
For startup costs, the IRS allows a deduction of up to $5,000 in the business’s first year. Any remaining startup costs must be amortized over time. You can deduct a portion of the startup costs each year until you’ve deducted the full amount. The amortization period typically lasts for 15 years, but there are exceptions for certain types of businesses.
There’s no limit to the legal fees you can deduct for defense costs. However, it’s important to remember these fees must be directly related to defending or protecting your business from lawsuits. Legal fees related to personal matters aren’t deductible.
For tax advice or preparation, the amount of deductible legal fees vary depending on the type of service provided. For instance, legal fees for tax preparation and advice are deductible in full. However, legal fees for tax planning, such as setting up a tax shelter or tax avoidance scheme, may be subject to limitations.
It’s important to note the IRS has strict rules about what legal fees are tax deductible. So, working with a tax professional or accountant is always a good idea to ensure you’re deducting the correct amount.
Additionally, documentation of legal fees is essential for tax purposes, so keep accurate records of all legal expenses incurred throughout the year.
Which Legal Fees Are Not Tax Deductible?
It’s important to note legal fees related to personal matters, such as divorce or estate planning, can’t be deducted. Additionally, legal fees that aren’t directly related to your business aren’t deductible. This includes legal fees for personal lawsuits or disputes unrelated to your business.
For example, if a former employee is suing you, but the lawsuit has nothing to do with your business, you can’t deduct the legal fees for defending yourself against this suit.
However, these fees are deductible if the suit relates to a business dispute (such as an employee suing for unpaid wages).
The IRS also does not allow you to deduct legal fees for the following:
- Personal lawsuits or other legal disputes unrelated to your business.
- Legal fees for divorces, child custody issues, and similar matters.
- Legal expenses related to criminal activities.
Keeping track of your legal fees throughout the year is essential, as working with a tax professional or accountant to determine the tax advantage of legal services for your business. Deducting legal fees is a small but important way to keep your business financially healthy. For more on the intersection of legal help and tax law, contact us.