By Paul Topolka
Section 212(3) of the Code provides in pertinent part: “In case of an individual, there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in connection with the determination, collection, or refund of any tax.”
The reach of the above provision is very broad. The deduction is available whether the taxing authority is the United States, a state, a municipality or a foreign country. “Any tax” is all encompassing and includes income, estate, gift, excise, property, sales and use, and any other taxes. As stated in Treas. Reg. § 1.212(l): “Thus, expenses paid or incurred by a taxpayer for tax counsel or expenses paid or incurred in connection with the preparation of his tax returns or in connection with any proceedings involved in determining the extent of tax liability or in contesting his tax liability are deductible.” Such expenses or professional fees include, among others, the preparation costs of a request for a private letter ruling or appraisal fees to determine the amount of a casualty loss deduction or a charitable contribution deduction. Thus, it does not have to be a contested tax situation to qualify – the expense only needs to arise “in connection with the determination of any tax.” See Carpenter v. United States, 338 F.2d 366 (Ct. Cl. 1964) (where taxpayer incurred legal expenses in ascertaining that substantial support payments to his former wife constituted taxable alimony to her and therefore were deductible by him). Also, it does not matter whether the taxpayer is successful in contesting the purported tax liability; he can lose the controversy with the taxing authority and still deduct the related expenses.
Unfortunately, under Section 212(3) these expenses of an individual are designated as nontrade or nonbusiness and therefore are miscellaneous itemized deductions subject to the 2 percent floor for adjusted gross income. Code § 67(b); Lines 22 & 23 of Schedule A. However, the same or similar expenses incurred by an individual taxpayer in preparing the portion of his or her return that relates to the taxpayer’s business as a sole proprietorship, and expenses incurred in resolving tax deficiencies relating to that business, are trade or business expenses under Section 162 and thus deductible on Schedule C.
In other words, expenses incurred in preparing schedules or resolving asserted tax deficiencies relating to profit or loss from business (Schedule C), income or loss from rentals or royalties (Part 1 of Schedule E), and farm income and expenses (Schedule F) are deductible as trade or business expenses under Section 162 in determining the net income of those businesses. See Rev. Rul. 92-29, 1992-1 C.B. 20; Code § 62(a)(1). That explains why there is no separate line item on Page 1 of Form 1040 for this deduction from gross income in determining adjusted gross income – those items have already been captured (or should have been) in the net income or loss from Schedules C, E or F. See generally Cutler v. Commissioner, T.C. Memo. 2015-73 for the distinction between “above the line” and “below the line” deductions with respect to the adjusted gross income (AGI).
Where an expense relates to both a trade or business and a nontrade or nonbusiness, it must be allocated on a reasonable basis. Generally, the amount of time the professional incurs in preparing that portion of the tax return or defending against asserted tax deficiencies is a proper measure for allocating the costs involved. Where a fee is paid for tax services defending against asserted tax deficiencies or tax return preparation, the portions of the expense allocable to the sole proprietorship or rental properties are fully deductible on Schedules C and E, while the remainder of the fee is a miscellaneous deduction subject to the 2 percent floor.
However, legal fees paid or incurred to defend or protect title, acquire or dispose, or develop or improve rental property are not deducted on Schedule E. Rather, these expenses must be capitalized and added to the property’s basis. Section 263 essentially modifies Section 212 by providing that no capital expenditure can be deducted. Instead, “such expenditures are added to the basis of the capital asset and are taken into account for tax purposes either through depreciation or by reducing the capital gain (or increasing the capital loss) when the asset is sold.” Woodward v. Commissioner, 397 U.S. 572 (1970).
Legal fees for estate planning purposes are commonly deducted as miscellaneous itemized deductions to the extent the legal fees are attributable to tax advice. Since estate planning is generally not concerned solely with tax matters, the portion of the fees allocable to tax planning should be separated from the portion allocable to other estate planning work. Only the portion related to tax advice and planning is deductible on Schedule A as a miscellaneous deduction.
Tax return preparation fees paid by a partnership or S corporation or fees incurred in contesting the income or loss reflected on those tax returns are not miscellaneous itemized deductions of the partners or shareholders. These fees are the entity’s business expenses that are reflected in the partners’ or shareholders’ distributive shares of income or loss.
A taxpayer should work closely with his/her accountant or lawyer in determining what fees are deductible in the context of Sections 162 and 212(3) and have adequate substantiation reflecting a reasonable allocation of such expenses. Any time professional fees are paid or incurred in connection with tax matters, we should ask: Is the client entitled to a deduction, and if so, how much?
Paul Topolka is an attorney with Nexsen Pruet, PLLC in Greensboro.