Small businesses often incur legal expenses in their dealings with attorneys and other legal professionals as part of their everyday operations. It is possible for these businesses to deduct a broad range of legal fees that are crucial for their ordinary and necessary operations.
This article aims to inform you about the specific types of legal fees that are tax-deductible, as well as provide guidance on how and when to claim these deductions on your business tax return.
When Can Small Businesses Deduct Legal Fees from Their Taxes?
Legal fees can be tax-deductible for small businesses, but they must meet specific criteria to qualify. Firstly, these expenses should be categorized as “ordinary and necessary,” directly associated with the operation of your business. “Ordinary” refers to those expenses that are commonly accepted within your business realm, while “necessary” expenses might not be indispensable but should be relevant and beneficial for your business.
Examples of deductible legal services typically encompass:
- Services related to tax matters, such as advice, tax form preparation, and handling of tax audits
- Fees to corporate lawyers for litigation and business transactions
- Legal services concerning property matters like buying or selling business premises
- Fees pertaining to employment issues, such as policies and lawsuits
- Intellectual property matters, like obtaining a copyright, trademark, or patent
- Legal expenses related to finance and securities for corporations with stock shares
- Entertainment-related issues, such as royalties and contracts
Legal Fees That Do Not Qualify for Tax Deductions
However, not all legal fees are deductible. Fees related to maintaining or performing your job, such as defending against criminal charges stemming from your business, are non-deductible.
Also, payments to attorneys regarding sexual harassment suits or settlements, especially cases involving a non-disclosure agreement, are not deductible.
Legal Fees of a Personal Nature
Personal legal fees also cannot be deducted. If a bill from a lawyer includes both personal and business expenses, these costs should be separated, and only the business-related part can be deducted.
It’s worth noting that some personal legal expenses may be deducted on Schedule A of your personal tax return as a miscellaneous deduction, but recent changes in tax law have affected the deductibility of miscellaneous expenses on personal tax returns, including personal legal fees.
Legal Fees for Business Start-Up
Legal expenses incurred during a business start-up differ from those of an existing business and are deducted differently. These costs may arise from engaging an attorney to assist with start-up or organizational expenses.
Start-up attorney fees may encompass costs for:
- Drafting articles of incorporation and setting up a founders’ agreement
- Creating contracts with key employees
- Assisting in negotiations during the acquisition of an existing business
Organizational attorney fees might include expenses for:
- Preparing a partnership contract, formulating corporation regulations, or establishing an operating agreement for a Limited Liability Company (LLC).
- Preparing state-mandated applications for business formation
These fees contribute to the value of your business and are subject to amortization, deducted over a 15-year period. Each year, the business is allowed to deduct one-fifteenth of the total cost on its business tax return.
How to Claim Legal Fee Deductions
To correctly claim legal fee deductions for your business, you need to include all legal expenses paid by your business under the “Legal and Professional Fees” category on your business tax return form. Calculating your business’s taxable income requires the completion of this form and the inclusion of all relevant tax deductions for your business. The proportion of taxable income from the business is then reported on your Form 1040.
Navigating the intricacies of deducting legal fees and other business tax deductions can pose a formidable challenge, given the numerous constraints and conditions involved. Oftentimes, it is prudent to enlist the services of a certified tax specialist or utilize business tax preparation applications to ensure the precision of your deductions. Keep in mind that the software versions for partnerships, LLCs, corporations, and S corporations may not be identical to the version for Form 1040.
Maintaining Records of Legal Fee Deductions for Taxes
Maintaining comprehensive records is pivotal when claiming deductions for legal and other expenses. It’s crucial that all documentation reflects that these payments were strictly for business purposes. For these deductions, preserve all records, including not only law firm bills but also payments made to them.
Supporting documentation that you might consider retaining includes:
- Canceled checks or proof of electronic payment
- Account statements or invoices from attorneys
- Credit card receipts and statements
Ensure you retain all these documents and your tax returns even after your annual tax return has been filed, particularly if an audit situation arises. As a general guideline, it’s recommended to save everything for up to three years from the date you filed the return or two years after you paid the tax, whichever is later.
Remember that the tax invoice format for these documents should be in accordance with the standard business format. This includes details of the service provided, the cost, the date, and the details of both parties involved.
Other Business Expenses Eligible for Tax Deductions
Tax Preparation Fees
Regardless of who prepares your business tax returns – be it a tax attorney, an accountant, an enrolled agent, or a tax preparation service – the costs incurred for these services are tax-deductible. It’s essential to note that the individual or agency preparing your tax return should have an IRS-approved Preparer Tax Identification Number (PTIN).
License, Permit, and Regulatory Fees
Businesses are allowed to deduct the costs of various federal, state, and local agency fees as long as they are necessary for business operations. These fees often include licenses, document filings, and other regulatory fees. For instance, a business serving alcohol may need to pay for a state liquor license, which is a deductible expense.
Other deductible fees include annual report fees, annual licenses, and fees for making amendments to business documents. Fees paid to federal agencies for applications related to copyrights, patents, and trademarks are also deductible, as they contribute to the business’s income generation.