It’s that time of year again. Of course, the general rule is that lawyers’ fees and costs in connection with obtaining a divorce are not tax deductible. As with many general rules, there are exceptions:
1. Attorneys’ fees related to tax advice. I.R.C. §212(3). Areas having tax implications upon which an attorney may offer advice include the tax effect of the distribution of property, including retirement plans, tax deductibility of interest payments or installments to effectuate an equitable distribution of property, the allocation of the dependency exemption and child tax credit, whether a joint tax return should be filed, the tax effect of unallocated maintenance and child support, the tax implications of the form of alimony, and advice regarding the recapture of front end loaded maintenance in the first three years following separation.
Practice tip: it is not helpful for the client wishing to tax deduct some attorney fees to have a provision in the marital settlement agreement that no tax advice was given.
2. Attorneys’ fees related to the production or collection of taxable income may be deductible. I.R.C. §212(1). For example, the payee of taxable alimony may be entitled to a deduction for attorney fees in generating the production or collection of this taxable income and fees in connection with securing an increase in taxable alimony may also be deductible. Attorney fees for obtaining income producing property are not deductible, but could arguably be added to the tax basis of the property.
A taxpayer may deduct only fees paid to his or her own attorney, unless the fees of the other party are paid as alimony.
Any attorneys’ fees that are legitimate income tax deductions are deductible only to the extent that all of the miscellaneous deductions in the aggregate exceed 2% of the taxpayer’s adjusted gross income. There is also an “applicable amount” which may reduce the otherwise allowable deduction.
Lawyers must be very careful not to overstate the amount or portion of attorneys’ fees that relate to tax deductible advice or legal efforts. I.R.C. §6701, Penalties for Aiding and Abetting Understatement of Tax Liability.