When Must Legal Fees Be Capitalized

Example 9: T worked for an investment firm. In the course of his employment, he improperly sold inside information. When this was discovered, the SEC filed a lawsuit against him. T incurred legal costs in his defence. T cannot deduct the lawyer`s fees because they were not incurred in the course of a commercial activity. The misuse of the information was not part of his employment. Even if his insider dealing did not reach the level of an activity or trade, he does not fall within the scope of section 162.14 Finally, since the lawyers` fees did not generate any income and derived from the actions brought against T personally, they are not deductible under section 212. Instead, section 262 fees are not allowed. If attorneys` fees are incurred and result in damages that are excluded from income (for example, because of the application of section 104), the fees are not deductible.

Paragraph 265 does not allow deductions for items that can be attributed to exempt income. If legal fees generate both tax-free and taxable income, the costs can be split between the two types of income. Article 67 provides that various individual evidence is deductible only to the extent that the total amount exceeds 2% of the AGI. Section 67 lists various deductions that are not treated like other individual deductions. Lawyers` fees are not included in the list; Therefore, if they are deductible from the AGI, they are subject to the 2% limit. Businesses often incur costs associated with the construction or use of capital assets. These expenses can be capitalized and recognized in the calculation of the basic costs of capital assets. Cost and cost are two terms that are used interchangeably in everyday language. In accounting, however, the two terms are distinct. A price is an expenditure of money to pay for a particular asset while an expense is money that is used to pay for something on a regular basis. The difference allows capitalized costs to be spread over a longer period of time, such as capital assets, and the impact on profits is longer. Okay, what difference does it make? A big one.

If Mylan determines that the lawyers` fees are ordinary business expenses, it can deduct those expenses as soon as they are incurred (which they did on their tax returns in a timely manner for those years). Otherwise, Mylan will have to cover its legal fees over a period of fifteen years by depreciations and depreciations (ouch!). Since Mylan has currently deducted the fee as an ordinary business expense, Mylan will also incur interest and penalties (salt in the wound) if the service ultimately prevails and these deductions are denied. If attorneys` fees arise from different claims, an allocation is necessary to determine the tax treatment.27 For example, if a person incurs attorney`s fees to maintain the fair value of a property conviction, the attorneys` fees arise from the conviction and are part of the real estate transaction (capitalizable). If the award also contains pre-conviction interest, the associated attorneys` fees are deductible. Attorneys` fees must be divided between the two arbitral awards so that the correct tax rules can be applied. Note: In this case, it would not be appropriate to allocate legal fees on the basis of the overall indemnity (i.e., 160/300) because they do not reflect the work done to obtain interest.28 Example 17: B&C`s personal home was damaged by flooding and then destroyed by the city. B and C filed an action for annulment of their sentences against the city. The agreement with his lawyer provided for a success fee of 25% plus $125 per billable hour worked. They received $140,000 for conviction and $160,000 in pre-conviction interest. Applying the claim origin test, attorneys` fees attributable to $140,000 are not deductible under section 263, while fees attributable to interest are deductible under sections 212 and 62 of the AGI. The lawyer spent 3% of his total billable hours on obtaining the allocation of interest.

The purpose of the investigation is to establish the « nature of the transaction » at the origin of the dispute. In doing so, account must be taken of the issues at issue, the nature and objectives of the dispute, the defences relied on and the purpose for which the deductions claimed were used, the context of the dispute and any facts relating to the dispute.6 The origin of claim test is the approach that individuals must use to determine the nature of their legal fees and thus decide: How they are treated for tax purposes. It is important to investigate the facts of the lawsuit and ask why the person hired a lawyer. Answering these questions should then allow practitioners to determine whether the fees are personal expenses that are non-deductible, business- or income-related, or capitalizable expenses related to a property interest. The possible consequences of not seeking legal assistance are not relevant to the classification of fees. Many judgments are useful in applying the criterion of the origin of the claim. Example 5: E incurred legal fees to try to recover damages from a carpet cleaning company that damaged carpets in her personal residence. The origin of the claim is the maintenance of E`s personal residence, so the expenses are not deductible. If the origin of a claim that caused the attorneys` fees is personal, the fees are not deductible (under section 262). However, if the origin is linked to taxable income or comes from a commercial or entrepreneurial activity, it is likely to be deductible.

The following examples illustrate situations where the origin of attorneys` fees was personal or related to the preservation of property held to generate income or used in a trade or business. In accounting, the cost of an item is allocated to the cost of an asset and is not an expense if the business plans to consume that item over an extended period of time. The cost of the item(s) is capitalized and amortized over its useful life. If a company cannot prove a link between costs and future revenues, these costs should be recognized immediately as expenses. In the area of software development, all related costs incurred before technological feasibility is achieved are recorded as expenses. Research and development costs are another example of current expenditures due to the high risk profile and uncertainty about the future benefits of these costs. While it is not clear whether the taxpayer was an employee or an independent contractor (self-employed), the courts have applied common law rules to determine whether the payer has a right to control the taxpayer. If a taxpayer is both an employee and a self-employed person, disputes have arisen over how to classify attorneys` fees to protect both statuses. In all cases, once the facts were established, the examination of the origin of the claim was applied in order to understand why the lawyers` fees were incurred.

The following examples illustrate the application of the test where the taxpayer`s employment status was not assured or more than one status was affected. Example 7: S have incurred legal fees in connection with a divorce judgment. The origin of the claim is personal, so attorneys` fees are not deductible under section 262. However, if any of the attorneys` fees incurred arise from the production or collection of taxable support (section 71), that portion of the attorneys` fees is deductible under section 212.12 The U.S. Tax Court today issued an opinion stating that the legal fees required for FDA approval of the taxpayer`s generic drug manufacturing must be capitalized, but that legal costs incurred by the taxpayer in the defence against patent infringement actions are deductible.