Generally, individuals, as cash basis taxpayers, may deduct attorneys’ fees in the year they are
paid, assuming the attorneys’ fees otherwise qualify as deductible. In the majority of such cases,
the attorneys’ fees are paid pursuant to a contingent fee arrangement once damages have been
recovered. Where the ultimate recovery is excludable from gross income, either in whole or in
part, the payment of contingent attorneys’ fees allocable to exempt income are not deductible.
IRC § 265(a)(1). The question of the timing and deductibility of attorneys’ fees paid prior to
resolution of the lawsuit on a noncontingent fee basis requires additional analysis that is not
practical to provide in this guide. Examiners should consult with the appropriate Technical
Advisor.
Numerous sections of the Code govern the deduction of attorney’s fees. The most relevant of
which are IRC sections 62(a)(relating to the definition of adjusted gross income), 162 (relating to
trade or business expenses), 212 (relating to expenses for production of income), 262 (relating to
the non-deductibility of personal, living, and family expenses), and 263 (relating to capital
expenditures). Generally, one must look to the underlying lawsuit to determine which Code
section applies. Except in rare cases, such as a compensatory recovery of self-employment
income (for example, commissions that are reported on Schedule C) or recovery of capital gain
income, legal fees will be a Schedule A miscellaneous itemized deduction, subject to the 2
percent floor and AMT. (This, of course, assumes that the lawsuit proceeds have been taxed at
gross in the taxpayer’s income.) Nevertheless, the Tax Court has ruled adversely to the
Commissioner that a self-employed individual could deduct legal fees allocable to the recovery
of punitive damages on Schedule C, rather than as a miscellaneous itemized deduction on
Schedule A. Guill v Commissioner, 112 T.C. 325 (1999) (court held that the punitive damages
recovered by the taxpayer were Schedule C income).
Review Church v. Commissioner, 80 T.C. 1104, 1110 (1983)(fees allocated to exempt income
not deductible), a pre 1996 Amendment case, for an illustration of the need to allocate attorney
fees to the various components of the award to determine their deductibility. See also Alexander
v. Commissioner, T.C. Memo. 1995-51, aff’d, 72 F.3d 938 (1st Cir. 1995); IRC § 212.
