Deductible? Maybe not.

The Internal Revenue Code does not specifically allow deductions for legal and accounting fees. In seeking to deduct such expenses, taxpayers must use the rationale in IRC sections 162, 165 and 212. The Internal Revenue Service, however, has erected numerous obstacles to deducting these fees. This article reviews some of the difficulties taxpayers may face.

Obstacle: The IRS may argue the taxpayer who received the service did not pay the fees.

A husband could not deduct his wife's legal expenses for tax advice on a property settlement agreement in a divorce. A corporation that paid legal fees for its sole shareholder's defense against tax evasion charges was held to have paid a nondeductible constructive dividend.

The IRS also may argue an owner's payment for legal and accounting fees actually was an expense of the entity. A general partner could not deduct payments to an adviser for services to his limited partnership. Even though the partnership agreement allowed the general partner to incur such expenses, the Tax Court observed the partners were not notified of the payments.

Obstacle: The IRS may argue a payment originates from a motive to protect property or title to property, rather than from a motive to produce or collect income.

This distinction is clearly seen in a Fifth Circuit Court of Appeals decision in which both the taxpayer and the State of Louisiana claimed royalties from certain oil wells. The court held the royalties while the parties litigated title to the land. The taxpayer won and was paid the royalties. Later, Louisiana contested royalties from other wells on the same property. The Fifth Circuit said legal fees incurred in the first suit were not deductible because title was at issue. However, legal fees in the second suit were deductible because royalties were contested and tide had been settled.

In another case, a remainder beneficiary of a trust agreed to pay an attorney 25% of the value of the trust's assets to redraft the trust instrument and manage it. After his mother's death, the taxpayer sued to remove the trustee and reduce his fee. An out-of-court settlement resulted in the taxpayer's paying the attorney $185,000, as well as $80,000 to another attorney for handling the case. The Second Circuit Court of Appeals allowed a deduction of $185,000 under IPC, section 212(2) for management of property for the production of income. However, the $80,000 fee was not deductible because the suit concerned title to part of the trust's assets.

Fees paid to prevent foreclosure of property held as an investment were held nondeductible because the suit's primary purpose was to defend legal title. However, just because title is acquired as a result of a suit does not mean fees are nondeductible. In a case that also involved removal of a trustee, the Tax Court allowed a deduction because the primary issue was recovery of lost income, not title.

Obstacle: The IRS may argue part of a fee is not for tax advice.

Section 212(3) allows individuals to deduct fees incurred in the determination, collection or refund of any tax. This usually is interpreted to include planning for future transactions, such as divorce. But the cost of advice that has future tax ramifications may have to be capitalized. In one case, the IRS succeeded in distinguishing between advice on the tax consequences of a stock exchange (deductible) and determination of the basis of stock received in a reorganization (capitalized) because calculating the stock's tax basis was for the taxpayer's possible future use. The IRS also may distinguish between tax advice for an investment already selected by the taxpayer and payment of a fee to locate or select an asset.

Obstacle: The IRS may argue legal and accounting fees arise from personal or family matters.

The U.S. Supreme Court denied a deduction for attorney fees to maintain control over income-producing property a spouse demanded in a divorce. The Court said the fees were nondeductible personal expenses despite the taxpayer's contention he was trying to conserve certain income-producing assets. However, if the divorce proceedings disrupt a business, the taxpayer's chances of securing a deduction may improve. A taxpayer's corporation was permitted to deduct legal fees when it was restrained from taking certain actions without the divorce court's permission. If a company's assets are directly threatened by a claim, the costs of settling the litigation may be deductible--as in the case of a company that incurred expenses to settle litigation arising from personal use of one of its automobiles by the son of its sole shareholder.

Obstacle: The IRS generally disallows legal expenses in a reorganization or takeover

The IRS argues such changes create a new asset in the form of a new or surviving corporation. Although a recent Supreme Court decision in Indopco was for a friendly takeover, the IRS quickly acted to put taxpayers on notice that capitalization could also be required in defending against a hostile takeover. However, if the reorganization or takeover plan is abandoned, the legal fees should be deductible.

A deduction may be permitted if the dominant aspect of a transaction is liquidation or partial liquidation. Legal and accounting fees were deductible when a bank holding company divested itself of nonbanking assets--despite the fact the transaction qualified as a "type D" reorganization. The Eighth Circuit Court of Appeals said the "substance" or the "dominant aspect" of the transaction was a partial liquidation. However, the IRS successfully contended in another court that even partial liquidation expenses were not deductible because they were incurred to change the corporate structure for the benefit of future operations. Obstacle: The IRS usually requires capitalization of fees incurred in connection with bankruptcy proceedings.

The IRS reasoning is simple: A bankruptcy proceeding also is a corporate reorganization with future benefits to the taxpayer. However, some of the expenses may be ordinary and necessary business expenses. In technical advice memorandum 9204001 the IRS allowed expenses related to the handling of tort claims in a bankruptcy proceeding to be separated from other legal costs and deducted. The IRS did not think the dominant aspect, or all-or-nothing approach, was proper in view of the dual character of the bankruptcy proceeding. It noted that utilizing a bankruptcy proceeding to resolve mass tort litigation is a recent phenomenon in which it is unclear whether the dominant aspect is the reorganization itself or resolving the tort claims.

Based on this situation, it appears the IRS will at least consider allowing a deduction for legal, consulting and other expenses incurred in a bankruptcy proceeding. However, the burden of proof is on the taxpayer to substantiate those expenditures that were ordinary and necessary business expenses. One approach a company can take is to determine the amount of expense that would have been incurred had the bankruptcy proceeding not been instituted.

Obstacle: Fees incurred in stock redemptions are nondeductible under IRC section 162 (K).

This provision was enacted in 1986 to clear up considerable confusion in the courts. Obstacle: The IRS may contend fees paid to defend against criminal charges are not business related.

The Supreme Court's Tellier decision stands for the proposition that even legal costs of an unsuccessful defense against criminal charges are deductible if related to the taxpayer's business. However, the argument that the taxpayer's business will be destroyed as a consequence of the litigation may not generate a deduction.

In a 1991 case, a taxpayer tried to deduct legal expenses incurred in a successful defense against racketeering charges. Since the indictment had sought forfeiture of certain assets, the taxpayer argued that his defense expenses were incurred for the conservation or maintenance of property held for the production of income. However, the courts found that forfeiture of assets would have been a consequence of failing to defeat the charges, which arose out of the taxpayer's alleged criminal activities, not out of his business activities.

Obstacle: A tax deduction may be denied for the costs of establishing a trust if the origin of the transaction is determined to be personal.

The Tax Court denied a deduction for the expense of setting up an irrevocable trust because it was viewed as a vehicle for the grantor to make gifts to trust beneficiaries. But the expense of creating a revocable trust, where the grantor remains taxable on the income, may be deductible under the theory that it is an arrangement for the management and conservation of property.

RELATED ARTICLE: EXECUTIVE SUMMARY

* SINCE THE INTERNAL REVENUE CODE does not specifically allow deductions for legal and accounting fees, taxpayers must use the reasoning in IRC sections 162, 165 and 212. However, the Internal Revenue Service has erected obstacles that make it difficult to deduct such expenses.

* THE TAXPAYER WHO RECEIVES THE service must pay the fees, not a corporation or other entity owned by the taxpayer. The fees may be for the production or collection of income, but not to obtain or protect title to property.

* FEES FOR PERSONAL OR FAMILY MATTERS are not deductible. For example, fees to retain control of income-producing property in a divorce are not deductible because the primary purpose is not production of income. Similarly, fees to set up a trust are deductible if the trust is used to manage and preserve property, but not if it is a vehicle to make gifts.

* FEES TO DEFEND AGAINST CRIMINAL charges are not deductible unless they are business related. Fees that have future benefits must be capitalized, not expensed.