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Lessons from the Courts: Make noise about legal fees

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in Small Business Tax,Small Business Tax Deduction Strategies

As a general rule, legal fees incurred by a business are deductible when they arise in the context of a business activity. This is based on the origin and character of the claim.

New decision: Ms. McMillan operated an information technology (IT) business as a self-employed taxpayer. (McMillan also ran a self-employed equine business, which was considered by the Tax Court on another issue.) She received $65,000 of revenue from the IT business and had net income of $15,000 in 2009.

McMillan resided in a condominium unit where she maintained a home office. She deducted 50% of various condominium costs as home office expenses.

In 2005, McMillan sued the condo association and several of her neighbors, seeking injunctive and declaratory relief. The lawsuit was based on damages for claims of

  (1) dogs running wild, barking and defecating around the property

  (2) construction defects related to the presence of mold in her bathroom

  (3) construction defects causing noise problems.

She was involved in a separate legal action in 2009 concerning misdemeanor criminal charges in connection with her attempts to gather evidence for the litigation.

On her Schedule C for 2009, McMillan deducted 50% of her legal expenses of $26,000, comprised of $5,000 paid to one attorney for legal representation in the separate action and $21,000 paid to another attorney for both the condo litigation and the separate action.

The IRS challenged the deduction for the legal fees. It said that they were personal expenses unrelated to her IT business.

Tax verdict: In a case where the IRS had the burden of proof, the Tax Court said that the dispute giving rise to the legal expenses arose mainly due to McMillan’s claims of noise and other factors interfering with her use and enjoyment of her property. Because she reported 50% business use of the condo and the IRS failed to prove a lesser business percentage or that the noise and other factors didn’t affect her business use of the unit, the deduction was allowed. (McMillan, TC Memo 2015-109)

Tip: There was no mention of the fact that some fees involved criminal charges.

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