January 24, 2017
Section 212(3) of the Internal Revenue Code [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 (“IRS”), a State, a Municipality or a foreign country. The language “any tax” is all encompassing and includes; income, estate, gift, excise, property, sales and use, and any other taxes that are attempted to be levied. See Treas. Reg. § 1.212(l). 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.” For example, such expenses or professional fees might include, among others, the preparation costs in connection with 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 liability situation to qualify – it 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 husband incurred legal expenses in ascertaining that substantial support payments to his former wife constituted taxable alimony to her and therefore, was deductible by him). Also, it does not matter if the taxpayer is successful in contesting the purported tax liability; he can lose the controversy with the taxing authority and the deduction is still available.
Unfortunately, under Section 212(3) these expenses of an individual are designated as “nontrade or nonbusiness” and therefore, are deductible as miscellaneous itemized deductions subject to the 2% 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 that portion of the taxpayer’s return that relates to the taxpayer’s business as a sole proprietorship, and expenses incurred in resolving asserted tax deficiencies relating to that business, are deductible as trade or business expenses under Code § 162 with respect to that business in ultimately determining the taxpayer’s adjusted gross income under Code § 62(a)(1) and thus are 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) or farm income and expenses (Schedule F) are deductible as trade or business expenses under Code § 162 in determining the net income of those businesses and thus, the taxpayer’s adjusted gross income is reduced in a corresponding manner. See Rev. Rul. 92-29, 1992-1 C.B. 20; Code § 62(a)(1). This helps explain 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, where applicable. 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 would be a proper measure for allocating the costs involved. Thus, 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, respectively, whereas the remainder of the fee is a miscellaneous deduction subject to the 2% floor for AGI.
Note, however, that legal fees paid or incurred to defend or protect title, acquire or dispose, or develop or improve rental property are not to be deducted on Schedule E. Rather, these expenses must be capitalized and added to the property’s basis. Section 263 of the Code 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 on Schedule A to the extent that the legal fees are attributable to tax advice. Since estate planning is generally not concerned solely with tax matters, the portion of the fees which are allocable to tax planning should be separated from the portion allocable to other estate planning work. Only the portion which is related to tax advice and planning can be properly deducted on Schedule A as a miscellaneous deduction.
It is important to note that 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 by a taxing authority are not miscellaneous itemized deductions of the partners or shareholders. These fees are the entity’s business expenses [Code § 162] which are reflected in the partners’ or shareholders’ distributive share of income or loss.
The client-taxpayer should work closely with his/her accountant or lawyer in determining what fees are deductible in the context of Code §§ 162 and 212(3) and have adequate substantiation reflecting a reasonable allocation of such expenses as previously mentioned. Any time where professional fees are being paid or incurred in connection with tax matters, one should be asking these questions: Am I entitled to a deduction under the Internal Revenue Code and if so, how much?
Paul Topolka is Special Counsel at Nexsen Pruet in Greensboro. He is a former District Counsel of the IRS for North-South Carolina who guides business leaders and professionals on how to pay only the proper amount of taxes.