Tax Court Rules …Legal fees were only deductible as “Miscellaneous Itemized deductions”…watch out !

Legal fees were only deductible as miscellaneous itemized deductions

Ellen Sas, TC Summary Opinion 2017-2TC Summary Opinion 2017-2

The Tax Court has held that taxpayers must deduct legal fees that they incurred as miscellaneous itemized deductions subject to the 2% limitation in Code Sec. 67(a), rather than as either legal fees paid in connection with an action involving a claim of unlawful discrimination under Code Sec. 62(a)(20) or as ordinary and necessary business expenses under Code Sec. 162.

Background. Under Code Sec. 62(a)(20), attorneys’ fees and court costs paid by, or on behalf of, a taxpayer are deductible from gross income to determine adjusted gross income (AGI) in connection with an action involving:


  • A claim of unlawful discrimination (as defined under Code Sec. 62(e);
  • A claim of a violation of subchapter III of chapter 37 of title 31, United States Code (Claims Against the U.S. Government); or
  • A claim made under section 1862(b)(3)(A) of the Social Security Act (42 U.S.C. 1395y(b)(3)(A)) (private cause of action under the Medicare Secondary Payer statute).

The above-the-line deduction is limited to “the amount includible in the taxpayer’s gross income for the tax year on account of a judgment or settlement (whether by suit or agreement and whether as lump sum or periodic payments) resulting from such claim”. (Code Sec. 62(a)(20))

Code Sec. 162(a) allows a deduction for all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business.

The deductibility of legal fees under Code Sec. 162 depends on the origin and character of the claim for which the legal fees were incurred and whether that claim bears a sufficient nexus to the taxpayer’s business or income-producing activities.

The Supreme Court stated that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test”. (Gilmore, (S Ct 1963) 11 AFTR 2d 75811 AFTR 2d 758)

In Gilmore, in a divorce proceeding, the taxpayer’s then wife was claiming a more-than one-half interest in the taxpayer’s controlling stock holdings in three franchised General Motors dealerships as her community property. The taxpayer fought her claims because the loss of his controlling stock interest to his hostile wife might cause him to lose his job as the corporations’ president and general manager, and because there was a danger that his wife’s sensational and reputation-damaging charges of marital infidelity might cause GM to cancel his dealer franchise.

The Supreme Court ruled that the tax character of the costs of resisting a claim depended on whether or not the claim arises in connection with the taxpayer’s profit-seeking activities. It didn’t depend on the consequences that might result to a taxpayer’s income-producing property from a failure to defeat the claim. Because the origin and character of the taxpayer’s claim were personal, his legal expenses weren’t deductible.

In Test, the taxpayer pursued legal claims related to her employment with the University of California (University) as director of the Center of Prehospital Research and Training in part because she feared harm to her reputation which, in turn, would harm a business, Save-a-Life Systems (SLS), that she operated independent of her position at the University. While she was launching SLS, the taxpayer’s University department became the subject of a State audit. The taxpayer retained counsel to respond to negative publicity and attempt to prevent the public release of the draft of the audit report, among other things. The taxpayer claimed that she did so primarily to maintain her professional reputation which was important to the success of SLS. The Tax Court held that it had to look to the origin of the claim and that the taxpayer’s motives were not relevant. Because the claim originated in her employment at the University, not with her operation of SLS, the legal fees could not be claimed as business deductions on Schedule C (Profit or Loss From Business), but rather were properly claimed as miscellaneous itemized deductions. (Test, TC Memo 2000-362TC Memo 2000-362, affd (CA 9 2002) 90 AFTR 2d 2002-659690 AFTR 2d 2002-6596)

Unlike business expense deductions under Code Sec. 162(a), miscellaneous itemized deductions under Code Sec. 67(a) are allowed only to the extent that they, in the aggregate, exceed 2% of adjusted gross income (AGI).

Facts. In 2008, Seattle Bank hired Ellen Sas as president and chief executive officer. On or around July 9, 2010, Ms. Sas received a “change of control” bonus of $612,000. Ms Sas and Rodger Jones (the taxpayers) reported the bonus as wage income on their 2010 tax return.

On Sept. 14, 2010, Seattle Bank terminated Ms. Sas’ employment. On Nov. 3, 2010, Seattle Bank filed a complaint against her alleging breach of fiduciary duty and attempted to recover the $612,000 bonus. Ms. Sas counterclaimed, alleging employment discrimination.

All parties involved signed a settlement agreement and mutual releases effective May 17, 2011. The settlement agreement and mutual releases provide that Seattle Bank and Ms. Sas each paid nothing and released and dismissed all claims against each other. The taxpayers paid $25,000 and $55,798 in legal expenses associated with this lawsuit in 2010 and 2011, respectively.

During 2010 and 2011, the taxpayers maintained an accounting and consulting business. They filed a Schedule C with their 2010 Form 1040, reporting Mr. Jones as the sole proprietor. For 2011, the taxpayers reported no income on Schedule C and $293,385 on Schedule E (Supplemental Income and Loss). On the taxpayers’ return for 2010 and 2011 they reported “other income” in the negative amounts of $25,000 and $55,798, respectively, for the legal fees paid for the lawsuit with Seattle Bank.

On audit, IRS disallowed these expenses as negative “other income”, but allowed them as miscellaneous itemized deductions subject to the limitation in Code Sec. 67(a), reducing the deductible amounts to $4,525 and $50,579 for 2010 and 2011, respectively. The taxpayers sought relief in the Tax Court.

 This is an important change and needs to addressed this year !


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About William Murphy

William F. Murphy is the owner of Murphy Financial Group, P.C. The firm emphasizes in providing tax consulting and financial planning services to corporations, professional practices and individuals. He also provides consultation services on tax and financial planning issues to various news and publishing organizations on current tax law changes occurring within federal and state government. He is also the author of the “Murphy Minute” that is syndicated through various news organizations. Mr. Murphy is also associated with the law firm of Mallor Grodner LLP. The firm has offices in both Indianapolis and Bloomington Indiana. He assists in providing tax, valuation and financial analysis services focusing in the areas of Family law and business tax planning.