If a taxpayer incurs legal expenses in connection with a business transaction or primarily to preserve an existing business, its reputation, or its goodwill, then the legal expenses are generally deductible. The Internal Revenue Service will use the same tests for deductibility as for other business deductions, which precludes a current deduction for a legal expense incurred in the acquisition of goodwill or any other capital asset. In order for legal fees to be deductible, there does not have to be litigation, and the success of the taxpayer does not affect the deductibility of legal expenses.

In examining legal fees, the IRS will first make a determination as to whether the expenses were "personal" or "business" by applying the "origin of claim" test. Under that doctrine, the origin and character of the claim giving rise to the legal expenses, not the results, determine whether the expenses were for a personal or business reason.

The origin of claim test also governs whether legal expenses are deductible in the current period or subject to capitalization. If the legal services were rendered to protect property or to produce long-term benefits, then they cannot be deducted and must be capitalized. This issue most frequently arises in cases involving the ownership of property or changes in corporate structure.

Attorney's fees are not the only type of deductible legal expense. Deductible legal expenses may include fees or expenses of accountants and expert witnesses as well as the costs of a court stenographer and various printing charges.

Settlement payments made to avoid litigation may be deductible as ordinary and necessary business expenses if, under the origin of claim doctrine, the origin and character of the dispute indicated that the cause of action arose from a business activity. When a taxpayer enters into a settlement agreement, he may also deduct any related attorney's fees and court costs if the origin of claim requirements were met.

When a settlement is made that was not ordered by a court, the Tax Court has established a test to determine whether the expense paid to settle the lawsuit was necessary. The first part of the test asks if the taxpayer was entirely confident that any action which the plaintiff might bring would not succeed. Second, did the taxpayer make the payment just to avoid damage to his credit, reputation and business? Finally, did the taxpayer have a reasonably justifiable fear that damage from litigation would exceed the settlement amount?

Legal and related expenses incurred in defending a business against charges of illegal acts or practices are generally deductible even if the defense is unsuccessful. Legal expense deductions have been allowed where the taxpayer was unsuccessful in defending against charges of violations of state and federal antitrust laws, price-ceiling violations, and certain penalties under federal employment laws.

However, the IRS has not allowed deductions for legal expenses incurred to defend a taxpayer against criminal charges if expenses for the type of activity involved would not be deductible. Thus, a taxpayer who was charged with buying votes was not entitled to deduct his legal expenses because his actions arose from a political campaign and political campaign expenses are not deductible.

If a taxpayer incurs legal expenses in connection with a tax determination and litigation, they are deductible legal expenses if they were connected with the taxpayer's trade or business.

Copyright 2009 LexisNexis, a division of Reed Elsevier Inc.