Attorney's fees incurred in connection with a divorce are deductible in a few circumstances. When deductible, attorney's fees are treated as "miscellaneous itemized deductions." They are deductible only to the extent they exceed 2% of the taxpayer's adjusted gross income and they are subject to a phase out when the adjusted gross income exceeds a certain amount. They cannot be taken into account in computing the alternate minimum tax. In order to take advantage of the 2% rule, the client should pay all deductible legal fees in one year.
Attorney's fees and other litigation costs are deductible to the extent they are incurred to produce income that is includable in the recipient's gross income. Because spousal support is includable in gross income, the fees incurred in obtaining the spousal support or in collecting delinquent spousal support are deductible (IRC § 212(1); Regs. § 1.262-1(b)(7); Wild v. Commissioner, 42 TC 706 (1964)). An accountant's fees may be tax deductible to the extent their work involved obtaining spousal support such as work involved in determining the parties' actual cash flow. The fees incurred to hire an expert such as a vocational counselor may also be deductible to the extent they were used to obtain an order for spousal support.
Fees and costs in connection with a application for a modification of spousal support by the payee are also tax deductible. Attorney's fees incurred for obtaining an interest in the employee spouse's retirement plan are also be deductible. Attorney's fees incurred in obtaining royalties, residuals, and other income taxable to the client may also be tax deductible.
Fees are also deductible to the extent they are paid for tax planning advice (IRC § 212(3); Carpenter v. United States, 338 F.2d 366 (Ct.Cl.1964); Rev. Rul. 72-545, 1972-2 CB 179). The following advice may be allocated to tax planning or production of income:
- Costs of structuring a property division to produce desired tax effects, i.e., advice re: rollover of residence, the one-time tax exclusion of capital gain for taxpayers 55 and over, etc.
- Costs of determining the adjusted basis of assets in the property settlement.
- Costs of planning an alimony trust or annuity agreement to avoid some of the restrictions on deductible spousal support.
- Costs of estate planning that assure proper estate and gift tax consequences for the payment or receipt of support or property divisions.
- Costs of preparing a settlement agreement to assure deductible support payments during the separation period.
- Costs of maximizing the deductible portion of spousal support or of minimizing the taxable portion of spousal support.
- Costs of allocating dependency exemptions.
- Costs of obtaining advice regarding the tax consequences of divorce or separation instrument; or of gathering information for actual preparation of tax returns.
- Costs of drafting a QDRO and submitting it to the plan administrator for approval.
Fees incurred in establishing or defending title to property may be capitalized and added to the basis of property (Serianni v. Commissioner, 80 TC 1090, 1103 (1983), aff'd on appeal without discussion on this issue, 765 F.2d 1051 (11 Cir. 1985); Gilmore v. United States, 245 F. Supp. 383, 386 (ND CA 1965)).
The best way to handle the deductibility of attorney's fees is by separately itemizing the services that involved tax advice and the "production or collection of income." The attorney, with the advice of an accountant, should send the client a letter at the conclusion of the case that expressly identifies the deductible vs. non deductible services rendered. In the event the client's deductions are disputed, the IRS must receive such allocation letter in evidence (Goldaper v. Commr., TC Memo. 1977-34). A sample letter is appended to this article.
By tax planning, parties can use the tax deductibility of attorney's fees to allocate fees between the spouses. If, for example, Husband pays to Wife $10,000 as temporary spousal support (to avoid recapture rules) and Wife pays her attorney's fees from this money and she is able to deduct a significant portion of her fees, the transaction benefits both parties. It gives incentive for Husband to pay Wife's attorney's fees by making them tax deductible as spousal support and gives Wife the partial tax deduction for attorney's fees when incurred for production of income or for tax advice.
Law Offices of
PETER M. WALZER
23975 Park Sorrento, Suite 250
Calabasas, CA 91302
Tel: (818) 591-3700
Fax: (818) 591-3774
Re: Marriage of____________
You have asked for our opinion regarding the deductibility of the legal fees you incurred in 2001 in connection with the above-captioned matter. Of the $________________ in legal fees paid by you to us in 199_, __________ percent (__%) was for tax advice and __________ percent (__%) was in connection with the production of spousal support income.
You may deduct that portion of our fee which is attributable to tax advice, i.e., (__%), including advice given for tax planning in connection with the division of your community property. I.R.C. section 212(3); Regs. section 1,212-1(1); Rev. Rul. 72-545. Generally, non-business attorney's fees are only deductible to the extent they and your other "Miscellaneous Deductions" exceed 2% of your adjusted gross income.
You may deduct that portion of our fee allocable to the production or enforcement of spousal support, i.e., __%. Spousal support is taxable income to you (I.R.C. section 71), and an attorney's fees incurred in its production are therefore expenses made for the production of income. See I.R.C. section 212(1); Reg. section 1.262-1(b)(7). Wild, 42 T.C. 706 (1964). This rule does not extend to child support, however, because child support is not taxable income. I.R.C. sections 71(b) and 265(1).
That portion of our fee attributable to getting you divorced and dividing your community property is not deductible. In the case of United States v. Gilmore, 372 U.S. 39 (1963), the United States Supreme Court held that because the marital status and property division expenses were "personal" rather than "business" in origin, no deduction would be allowed. I.R.C. section 262; Reg. section 1.262-1(b)(7).
Fees paid in successfully defending separate property claims may be capitalized on the basis of those assets successfully defended. Although this will not save you taxes immediately, it would lower the capital gains tax when you later sell those assets. See Gilmore v. United States, 245 F. Supp. 383 (1965) (on remand).
If there is anything else you wish to know, please do not hesitate to call me.
Yours very truly,
Peter M. Walzer