IRS Legal Fees Audit

by Chris Moss CPA

Welcome to TaxView with Chris Moss CPA Tax Attorney

If any of you have incurred legal fees in 2015 perhaps you should consider a Legal Fees Tax Deduction?  You are entitled to deduct civil or even criminal legal fees under Section 162(a) paid to an attorney in connection with your business. You can also deduct legal fees paid to an attorney as a miscellaneous itemized deduction under Section 67 if you bring legal action against your employer. Finally, you can deduct legal fees under Section 212 if you paid an attorney in connection with the production or collection of income or the maintenance of property held for the production of income. But the Government is aggressively reviewing your legal fee deductions in many cases years later during an IRS Legal Fees Audit, hoping to disallow much of your legal fees deductions.  So stay with us here on TaxView with Chris Moss CPA Tax Attorney where you will learn how to deduct legal fees in 2015 by protecting those deductions with bullet proof evidence you will need years later to successfully defend your deductions during an IRS Legal Fees Audit.

The first and most important evidence you need is contemporaneously prepared legal invoices by your attorney detailing the kind of legal work you paid for as Parker Company found out in Parker v IRS US Tax Court (2012). The Parker business claimed $630,000 in legal fees paid to attorneys in 2003 in relation to the arbitration and the shareholder derivative suit. The IRS audited six years later in 2009 and disallowed all legal fees. Parker appealed to US Tax Court in Parker v IRS US Tax Court (2012) arguing the legal fees were ordinary and necessary trade or business expenses to defend shareholder derivative suits. However, the Court concluded that Parker could not substantiate most of the claimed legal fees. A ledger and two cancelled checks provided by Parker was not good enough.  The Court allowed only $55K and disallowed $575,000.  IRS Wins Parker Loses.

In addition to having the proper contemporaneously prepared legal invoices, make sure you know what IRS Code Section you are able to legally deduct your legal fees as Gary Lee Colvin found out in Colvin v US Tax Court (2004).  Colvin paid an attorney in connection with State Court litigation against his primary residence homeowners association and paid the same attorney to sue his former employer to recover lost wages, however the attorney he paid never provided detailed invoices showing the kind of legal work he was paid for. Colvin deducted one total legal fee on his Schedule C business in 1997 and 1998. The IRS audited and disallowed all legal fees arguing that the legal fees were not ordinary and necessary business expenses and there was insufficient legal invoices to sustain the deduction. Colvin appealed to US Tax Court in Colvin v IRS US Tax Court (2004) arguing the legal fees were deductible under Section 212 to protect the production and collection of income. Special Trial Judge Dean easily finds for the Government noting that Colvin may not under Section 212 deduct legal fees that are personal expenses to protect his primary home as per Section 1.212-1(h). The Court concedes that legal fees to sue his former employer for lost wages would have been deductible but because there were no contemporaneously prepared legal invoices documented the nature of the legal work performed no deduction could be allowed.  IRS wins Colvin loses.

Our next case Chaplin v IRS US Tax Court (2007), involves a professional fiduciary Philip Chaplin who worked for Rice Heard & Bigelow Inc (Rice) and was elected to the Board of Directors of Rice in 1987.  Chaplin acted as a fiduciary for clients from 1988-1994, was provided a Rice credit card and was paid as an employee of Rice as per his employment agreement. Unfortunately Rice terminated Chaplin in 1994 and eventually in 1997 Chaplin filed suit against Rice alleging breach of contract and wrongful termination.  The case settled in 2002 and Chaplin was paid $1.5M.  Chaplin deducted legal fees on his 2001 tax return as an offset to the $1.5M.  In 2005 the IRS audited Chaplin’s 2001 tax return and denied his legal fee deduction claiming that the legal fees were not deductible from adjusted gross income as business legal fees but rather unreimbursed employee expense legal fees under Code Section 67 to be deducted as miscellaneous itemized deductions subject to the 2% floor limitation.  Chaplin appealed to US Tax Court in Chaplin v IRS US Tax Court (2007)Judge Haines easily finds for the Government concluding that Chaplin was clearly an employee not an independent contractor.  IRS Wins Chaplin loses.

Our next case Brenner v IRS US Tax Court (2001) introduces us to Andrew Brenner employee of Nomura Securities from 1987 to his termination in May of 1996.  Brenner sued Nomura and eventually settled in 1998 for $1.9M. In 1997, Brenner deducted $215,354 worth of legal fees as a miscellaneous itemized deduction under Section 67. But in 1999 he filed an amended return  on advice of his accountants claiming his legal fees were part of his company corporate plan under IRS Section 62 and Regulations 1.62, which allowed that his legal fees be directly deducted as an offset to his $1.9 settlement income.  The IRS audited and disallowed the adjusted the legal fees back to what they were on his original return claiming that Nomura was Brenner’s employer.  Brenner appealed to US Tax Court in Brenner v IRS US Tax Court (2001)and Judge Halpern easily found for the Government because no lawyer’s bill was ever submitted to Nomura, and no itemization of specific bills or invoices was ever substantiated under Section 162-2(e)(3). Because Brenner did not provide the required documents  to comply with Section 1.62-(2)(e)(3), Brenner’s only recourse was to deduct the legal fees under Section 67 as a miscellaneous itemized unreimbursed employee business expense on Schedule A of the original return as filed.  IRS Wins Brenner Loses.

Our final case is Butler v IRS US Tax Court (1997).  The facts are simple.  Butler purchased a farm in California and became involved with various law suits over water rights to protect and defend the title to his farm.  Butler deducted his legal fees in 1991 1992 and 1993 under Section 162.  The IRS audited disallowing all legal fees claiming the farm was not engaged in for profit within the meaning of Section 183, and therefore not deductible or in the alternative under Section 263 the legal fees were capital in nature to protect the title to the property and were also not deductible.  Butler appealed to US Tax Court in Butler v IRS US Tax Court (1997).  Butler claimed that at the legal fees where business expenses under Section 162 or in the alternative itemized deductions under Section 212 to protect is investment in the farm.   Judge Gerger finds easily for the Government because Butler did not work the farm full time and that Butler lacked a profit motive.  Therefore under Section 183 no legal fees could be deducted either under Section 162 or in the alternativeSection 212.  IRS Wins Butler loses.

As you can see, the US Tax Court does not allow legal fees to be deducted on your tax return unless you have well document legal invoices, a business connection under Section 162, unreimbursed employer expense under Section 67, or a clearly set up contemporaneous set of facts and evidence to prove the legal fees you paid  to an attorney protected  your income producing investment under Section 212.  So how can you win an IRS Legal Fee Audit?  First make sure you legal invoices are all specific enough to connect the legal service provided to the appropriate Code Section eitherCode Section 162, Section 67 or Section 212.  Second make sure you retain a tax attorney to create contemporaneous documentation to insert into your tax return before you file to make sure the Government has disclosure of under what Section of the IRS Code you are claiming your legal fee deduction. Finally obtain from your trial attorney before you pay them their opinion on whether or not their legal fee is tax deductible.  If they don’t know, perhaps they can retain a tax attorney to give her opinion prior to commencing litigation.  You will be glad you did years later when the Government comes knocking on your door to commence an IRS Legal Fee Audit.

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Chris Moss CPA Tax Attorney