Often, I receive questions from clients regarding whether they can deduct their tax preparation fees or the legal fees associated with my tax controversy work. Generally, the answer depends on the facts and circumstances of the particular case and whether the fees at issue sufficiently relate to a trade or business expense.
Above-the-Line vs. Below-the-Line Deductions.
The Code segregates certain deductions into either miscellaneous itemized deductions or above-the-line deductions. Compare Section 62 (above-the-line deductions) with Section 67 (below-the-line deductions or miscellaneous itemized deductions). Above-the-line deductions include those attributable to a trade or business (other than itemized deductions) carried on by the taxpayer, if the trade or business does not consist of the performance of services by the taxpayer as an employee. Section 62(a)(1); see also Section 162 (trade or business expenses). Conversely, miscellaneous itemized deductions include, for example, unreimbursed employee expenses and expenses for the determination, collection, or refund of any tax. Temp. Treas. Reg. § 1.67-1T(a); Section 212(3).
Schedule C Deductions for Tax Preparation Fees and Tax Legal Fees.
The IRS has provided some helpful guidance for taxpayers with Schedule C businesses. In Rev. Rul. 92-29, the IRS concluded that Schedule C taxpayers may claim an above-the-line deduction under Section 62(a)(1) for trade or business expenses associated with: (1) expenses incurred by the taxpayer in preparing that portion of the taxpayer’s return that relates to the Schedule C business; and (2) expenses incurred in resolving asserted tax deficiencies related to the taxpayer’s Schedule C business. See also PLR 9234009. However, the Revenue Ruling cautions that fees not associated with the Schedule C business should generally be characterized as miscellaneous itemized deductions. For tax years 2008 through 2025, these deductions are currently not permitted. Section 67(g).
With the above guidance in mind, can a Schedule C taxpayer claim a deduction for legal and accounting fees associated with tax controversy work? Maybe, depending on the facts and circumstances. In Int’l Trading Co. v. Comm’r, T.C. Memo. 1958-104, the taxpayers had a sole proprietorship business which they reported on their income tax returns. After examination, the taxpayers filed a petition with the United States Tax Court challenging the IRS’ audit determinations. Later, the taxpayers were also indicted on criminal tax charges for filing false and fraudulent tax returns. In connection with the civil and criminal tax litigation, the taxpayers hired attorneys and accountants to assist in their representation against the Government. On these facts, the Tax Court concluded that the legal fees were deductible as above-the-line deductions. Notably, the Tax Court rejected the Government’s argument that the deductions should be below-the-line because they related to the taxpayers’ personal income tax returns. Specifically, the Tax Court stated:
The [IRS] also contends that the litigation arose over the filing of personal income tax returns and hence the fees could not be regarded as business expenses. But the evidence shows that the income reported on the returns or involved in the dispute came from a business operated as a sole proprietorship. Necessarily the profits of such a business had to be reported on individual returns or joint returns of husband and wife. The litigation concerned business income and the costs of such litigation are business expenses.
See also Casper v. Comm’r, 44 T.C. 411 (1965) (relying on Int’l Trading Co. decision to conclude that legal fees related to business income were deductible under Section 162(a)); Standing v. Comm’r, 259 F.2d 450 (4th Cir. 1958), aff’g, 28 T.C. 789 (1957).
Thus, there is federal tax authority to support a claim of Schedule C business deductions for expenses associated with tax preparation and tax controversy work for the business. As with other claimed deductions, it is important to properly identify and substantiate only those deductions related to the Schedule C business. In addition, Schedule C business owners should be wary of their potential reporting obligations for such expenses under Section 6041A, which requires Forms 1099-MISC (and Forms 1099-NEC for 2020 and later tax years) for service-recipients engaged in a trade or business who make payments of $600 or more to a service provider during the course of their trade or business. See 2019 Instructions for Form 1099-MISC; see also 2020 Instructions for Forms 1099-MISC and 1099-NEC.
To discuss these issues more, Mr. Roberts may be reached by telephone at 214.308.2864 or by email at email@example.com.