If you enter taxes before 2018, you may remember hearing about the “2% rule.” This rule meant that taxpayers who could not write off certain work-related expenses were allowed to deduct a portion of these disaggregated miscellaneous expenses that exceeded 2% of their adjusted gross income (AGI). When you file your tax returns, you can usually make the standard deduction or list the deductions. Both options generally reduce your taxable income, which means you`ll pay less tax. If your attorney`s fees are deducted, you will need to list your deductions instead of taking the standard deduction for the tax year. Not only was there no proper line for expense deductions on IRS forms, but you also had to provide a specific code next to your letter. If your case was an employment case, the code to enter was “UDC” for unlawful discrimination. The instructions stated: If attorneys` fees are incurred and damages are excluded from income (e.g. because of the application of section 104), the fees are not deductible. Paragraph 265 does not allow deductions for items that can be attributed to exempt income. If legal fees generate both tax-free and taxable income, the costs can be split between the two types of income.
The taxpayers claimed that they are not employees because they were no longer employees during the period in which the legal fees were incurred, even though the fees were related to previous employment. Taxpayers also argued that an employer`s payments were part of a recoverable plan, allowing IAG`s attorneys` fees to be deducted under section 62(a)(2)(A). 17 Chaplin, TC Memorandum 2007-58. The Court applied the common law rules to establish that the taxpayer was an employee and not an independent contractor. Thus, IAG`s legal fees were deductible and not AGI`s fees. Section 62 (e) lists 18 types of complaints of “unlawful discrimination”. These include certain violations of the Civil Rights Act of 1991, the National Labor Relations Act, the Fair Labor Standards Act of 1938, the Family and Medical Leave Act of 1993, and several others. Section 62(a)(20) applies to attorneys` fees paid after October 22, 2004 for judgments or settlements rendered after that date.
The purpose of the investigation is to establish the “nature of the transaction” at the origin of the dispute. It is necessary to consider the issues at stake, the nature and objectives of the litigation, the defences invoked, the purpose for which the deductions claimed were used, the context of the litigation, and any facts related to the controversy.6 When the IRS updated Form 1040, it also updated its instructions for Form 1040, who now have the codes (“UDC” and “EAER”, for example) that were needed to identify the deduction on the old forms. This makes sense for UDC printouts of Article 62(a)(20) as they now have their own line and do not need to be identified by a code. The benchmark for classifying expenses as business or personal (as well as deductible from capitalizable expenses3) is the Supreme Court`s decision in Gilmore.4 This case examined the tax treatment of attorneys` fees to defend a divorce action and to protect the husband`s business assets from the wife`s claims. The husband argued that the expenses were deductible because they were incurred to obtain property (shares) held to generate income, something the lower court accepted. The court set aside the lower court and held that the characterization of lawyers` fees as business or personal depended on whether the origin and nature of the action were the taxpayer`s gainful activities. The qualification did not depend on the consequences that might arise if a claim or legal claim was not defended or rejected. The Court found that this approach is related to the wording of the Code`s provisions allowing deductions for commercial and for-profit activities. The court also concluded that this was the just outcome likely intended by Congress. For example, if two people involved in car accidents while driving for personal pleasure could only deduct the corresponding attorney`s fees if the damages were to be paid from income-generating assets (rather than income), the law would unfairly favor the driver with fixed assets. The origin of rights test meets certain fundamental principles of good tax policy. As the Court stated in Gilmore, “if the relative impact of a claim on a taxpayer`s income-generating resources were to determine deductibility, the rule would contain significant uncertainty and unfairness.” 29 The classification of lawyers` fees on the basis of the origin of a claim, rather than on the basis of the assets which must be protected, tends to lead to taxpayers being treated in a similar manner and to increase the objectivity of the law.