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The Professor Nedley Series

Deductibility of Attorney & Accounting Fees in Dissolution

By

Hon. Edward B. Huntington (Ret.)

June 1, 2010

 

    Any area of family law that specifically deals with "taxation" seems to leave both attorneys and their clients in the dark.  Attorneys because it is complex area with a different lingo and clients simply because they are unaware of the very fact that there are consequences in each and every act of a dissolution that may or may not affect the taxes that they may or may not pay.  A husband of the client of the Professor's (back in the good ol' days) simply filed an extension each and every year, but never filed the actual tax return.  It didn't occur to either party nor to the opposing lawyer that were serious and significant tax issues, along with enormous penalties that would likely consume their entire estate.  The well-informed lawyer can aid his/her client considerably by advising them of the parts of their legal efforts deal with tax advice and their pursuit of income.  This article will provide both the lawyer and the client with basic information about what is and what is not deductible on their personal income tax return.

          Basic Premise of Non-Deductibility:  Start with the basic proposition that fees in dissolution are personal expenses and are therefore not deductible for tax purposes.  Income, adjusted gross income (AGI) and taxable income (TI) are defined in Internal Revenue Code §§61, 62 & 63.  Permissible deductions from taxable income are defined in §§211 et. seq..  If deductions are not so defined then they simply don’t exist.

             Alimony as an example is defined in §215 and it is defined with six very specific elements.  If all of those elements don’t exist alimony becomes non-includible to the recipient and non-deductible to the payor, if the tests are met then alimony is a specifically authorized deductible item.  Likewise, where there is no definition that permits the routine deduction of professional expenses for accountants and lawyers then they are not routinely deductible from taxable income. As an example, the wife, a lawyer, cannot deduct the attorney fees for fighting over the value of her law firm share, that is a personal expense and not specifically deductible, therefore not deductible no matter how businesslike the litigation would appear.

             Sections 261 et. seq. go on to define items that are not deductible and §262 clearly states that no deduction shall be allowed for personal, living, or family expenses.  The Regs (1.262-1(b)(7)) state that the fees incurred for marriage dissolution, child custody and similar family law disputes are defined as of a personal in nature and are therefore not deductible.

            Some Principles of Deductibility:  On the other hand §212 provides that for an individual there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred for (1) the production or collection of income; (2) for the management, conservation or maintenance of property held for the production of income; or (3) in the determination, collection or refund of any tax.  This definition clearly opens the door to some permissible deductibility.

            First Some Housekeeping Rules about Status:  Remember some basics.  If the parties file a joint tax return, none of this stuff applies. 

            If this is the first year of separation, be very careful to follow the rules of tax returns.  Is there a Head of Household filing taking place?  Is the party eligible for a Separate Return (as opposed to Married Filing Separately) A person is entitled to file a Separate Return if that individual is unmarried at the close of the taxable year, but as all good Family Law attorneys know it takes six months to get a decree of dissolution in California.   Note that an individual is considered unmarried if they legally separated under a decree of Legal Separation or if there has been a judgment of nullity rendered.

            Status  matters.   The tax amount for $100,000 of taxable income is (1) $17,363 for Joint Filers; (2) $22,122 for Separate Returns (MFS); (3) $21,709 for Single Taxpayers and (4) $19,848 for Heads of Households – a range of almost $5000.

 

            Remember that these expenses when determined are reported as miscellaneous itemized deductions and are subject to the 2% floor that applies to all such miscellaneous itemized deductions.  They must exceed 2% of the taxpayer’s adjusted gross income (AGI) before they are deductible.  Virtually all divorcing taxpayers are cash basis taxpayers, meaning simply that the deductions for professional fees are only deductible in the tax year in which they’re actually paid in real hard cash dollars.  Toward the end of the year, the taxpayer may wish to defer or accelerate the payment of accounting or legal fees in order to build up enough fees to exceed the 2% floor.  Consider – if the taxpayer’s income AGI is $100k, the fees have to exceed $2000 before the taxpayer can even start deducting them, so if he pays some fees at the end of the year and some fees next year, he or she will have to have exceeded $4000 in total deduction instead of just $2000.   In other words it is best to group the fees paid into a single tax year whether the fees are deferred or accelerated.

             A person filing as Head of Household may also take these deductions.  To be a Head of Household you cannot be married at the end of the tax year and you must maintain a household which constitutes, for more than one-half of the tax year the principle place of abode of a qualifying child of the taxpayer or the Mother or Father of the taxpayer. (§ 2 (b))

            It should be noted that family law judges, as well as attorneys perennially mis-define Head of Household when calculating support on the computer programs approved by the Judicial Council.  By law, if the dissolution is filed anytime after July 1st, the taxpayer cannot be “not married at the close of the taxable year” as defined in §2.  Therefore, when they observe that the person has custody and assign Head of Household status to the custodial parent – they are wrong and they have placed that person in an incorrect filing status, which will lower the child support that they receive.  The irony is that if you spend extra time pursuing that issue either by appeal or additional motions it would all be deductible as the pursuit of additional taxable income.

            A married person who files a separate return is in the category of MFS – Married Filing Separately. § 1(d).  Married persons who elect to file a single return jointly fall into the category of a Joint Return. §6013 (a).  Therefore, if two people are going their separate ways in filing their returns at the end of the year, the likelihood is that they are probably going to be required to consider Married Filing Separately.  That is for sure, if the case was filed after the 1st of July and it would seem highly likely if it was filed between Jan 1st to June 30th unless someone was moving right along in getting the dissolution concluded in timely fashion.  A well organized dissolution should be concluded in about a year on average.

            One last slick little tip, a person married at the conclusion of his/her tax year may file a Separate Return (as opposed to Married Filing Separately) under §7703 (b) IF that person maintains as his home a household which constitutes for more than one-half of the taxable year the principle place of abode of a child (as defined in §152(f)(1)) with respect ton whom such individual is entitled to a deduction for the taxable year under §151 (or would be if it weren’t for §152(e) Special Rules for Divorced Parents).  This is the Poor Man’s Head of Household deduction – in other words you get a better rate schedule even though the taxpayer is not truly unmarried at the end of the year – the taxpayer is simply deemed by law to be “unmarried”.

            Why do we care about all of this accountant stuff?  Because our client’s may want to deduct some or all of their fees and they may or may not be deductible depending on how their divorce lawyer resolved matters.  End of Housekeeping Matters.

            Fees for Production or Collection of Income (§212(1)) – Under the code definition and the regs, fees for obtaining or collecting spousal support are fees for the production of taxable income and are therefore deductible.  Fees for obtaining or collecting child support are NOT deductible.  The difference? One is taxable income (spousal support/alimony) and the other is not (child support).  If the Spousal support were designated to be non-taxable to the recipient then the fees surrounding it would not be deductible.  Note that although the fees for negotiating the spousal support agreement, setting it up and preparing it or even litigating the entire issue of achieving spousal support for one’s client, this is strictly a one-sided deal.  None of the payor’s fees are deductible.  Why?  There is no obtaining or collecting taxable income.  The defense of alimony is simply not deductible, it is a purely personal expense.

            Does it even need to be said parenthetically that issues of custody or visitation are never, never deductible, they are purely personal expenses.  In litigation, if the lawyer doesn’t break the fees down and show specifically what it is that relates to the production of taxable income, then all of the fees will be deemed to be personal.

            A very subtle distinction must be noted.  Even if the payee is legitimately pursuing alimony, but the parties file a joint return – nothing’s deductible.  No fees – No Alimony.  The key is production or collection of taxable income.  Alimony – even if it’s actually paid pursuant to a court order is NOT deductible on a joint tax return, therefore neither are any of the fees to set it up or collect it.

            The attorney doing the work has a very specific obligation for the benefit of his client to be very specific in his/her billing process to clearly identify the work being done as definable, deductible legal work – “Prepared specific provisions in the MSA for the determination and payment collection of taxable alimony” (correction intentional to better comply with the code).  Footnote:  Don’t forget, there is no tax distinction between “alimony” as used in IRC §§71/215, “spousal support” as defined in Fam.C. §§4300 et. seq. and “family support” as defined in §4066.  When done properly and in compliance with the Internal Revenue Code they each define taxable/deductible support of the spouse.

            One other example of pursuing taxable income is the attempt to recover or secure an interest in the pension or profit-sharing plan of the other party.  The rationale is simple enough, the right to pension income is the right to taxable income when received.  (TC Memo 1997-497)  The warning sign for the divorce lawyer is anytime you are advising or litigating over income for your client that is taxable, you must make clear both in your advising and in your billing that you are dealing with the production or collection of income that is taxable.  Remember, you don’t have to actually understand tax law and it is always wise to bring in someone who does, but you darn well need to know when you’re fighting over it.  IRC 212(1).

             Fees in Connection with the Determination or Refund of any Tax:  Accounting or legal fees regarding the preparation and/or the understanding of income tax returns (state or federal) are deductible.  This would include CPA’s preparing or lawyers reviewing such returns.  Any plain and simple tax advice given regarding the tax impact on a property division or an alimony consequence given to either party would be deductible.  Even the discussion of the tax impact of various custody arrangements would be deductible.  As an example, the explanation of the dependency exemptions and the effect of various child sharing arrangements would clearly be a discussion of tax impact.  This isn’t an invitation to be cute and try and lump all discussions into something tax deductible.  Clearly the lawyers or accountants billing must be precise and on point, so that the tax preparer can properly allocate the costs.  But how often have we as lawyers not been precise in identifying truly deductible time and advice  in our billing.

            The types of billable time would include consultations with your client specifically on the issue of taxes, billing would include prepared opinions on taxation, as well as advice and planning both before and after a settlement or decree has rendered.  The term “determination” can be quite broad in a divorce case.

            Added to Basis – Even where the advice doesn’t fall into the production or collection of taxable income or into the determination of current taxation, it may still fall into the broader area of business costs.  An example would be where the parties litigate or negotiate the title to income property, as in a dispute over separate vs. community property.  The cost of this litigation could be added to the cost basis of the property to the extent that property title is the issue rather than simply the usual fight over who gets what.  (Remember the law firm value discussed earlier).

            When the cost is added to the basis for IRC §§1245 & 1250 (depreciable) properties, the cost of the litigation can be recovered the same as any other part of the recoverable cost basis of the property – typically by depreciating it.  To the extent that it hasn’t been recovered at the time of a sale through depreciation, then you will have an increased basis which will reduce the taxable gain upon sale of the property.  Notice that when you avoid taxable income in this manner, there is no 2% floor involved – whatever gain you avoid in this manner, you get all of the savings.

            When this is the type of planning that you’re doing, be specific as to the property in preparing your billing.  Absent clear billing and property identification the IRS may and likely will, allocate your litigation costs among all of the property being litigated and that may not be the result you wanted.

            Ordinary and Necessary Business Expense:  We’ve all heard stories about “other” professionals (ie. doctors and dentists, of course) running a lot of stuff through their corporations, as if somehow this filters and cleanses the expenses and makes them deductible.  But, divorce expenses paid through the business are still personal expenses and the mere scrubbing them through the business will probably do only one thing and that’s to create dividends where dividends aren’t wanted.  Remember the corporation cannot deduct a dividend where it CAN deduct a salary or a bonus and the IRS would like nothing better than to turn a business profit into a dividend. 

            Summary:  Attorney fees in dissolution litigation are generally non-deductible, personal expenses, unless specifically authorized as deductible by the Internal Revenue Code.  Litigation over the value of the property is a personal expense and not deductible.  Litigation over custody and visitation is always a personal expense for either party and is not deductible.  Litigation over who gets what property is not deductible.  Litigation to establish or collect alimony IS deductible (subject to the 2% of AGI limitation).  Defending against alimony is NOT a deductible, expense, it is a personal expense.  Collection of the right to pension or profit sharing income is deductible because it is the pursuit of taxable income.  Certain expenses such as title litigation may be capitalizable when appropriate.   Plain old legal advice regarding the tax consequences and the tax planning of any part of the litigation is certainly deductible since it involves the determination of taxes or refunds.

            For any of this to work, the lawyer’s bill must be detailed and specific and none of it can be reported on a joint tax return. It is the client’s ultimate call as to what to deduct on his/her return.  The lawyer bills and the client deducts – those are two separate steps.  Neither the lawyer nor the client should play tax games with the IRS and the deductions based upon the billings must be reasonable and defensible and the billings must be detailed and specific as well as supportable in the lawyer’s file.

            When all is said and done the lawyer or accountant needs to save the records pursuant to the dictates of the profession and his or her own good judgment.  The client at the least must save the records for a period of three years from the actual date of the filing of the return.  If the client defers the 2010 return to October 15th of 2011 (which is permissible as long as the taxes are paid), then the records in support of that return must be kept until at least October 15th of 2014.  The point in this last exercise is to show that decisions to defer or accelerate income made clear back in 2009 may have consequences as far in the future as late 2014.  Divorce lawyers that are used to computing alimony years from the date that alimony starts, need to remember that the IRS and all tax professionals think in calendar years only, so over in our state court three years of deductible alimony lasts three years from the month it starts until 36 months later when it actually ends, but in Tax Court, a three year statute of limitations on a tax return may last forever.

 

 

 

Hon. Edward B. (Ned) Huntington is a retired Superior Court Judge who has reactivated his legal specializations in Family Law and in Taxation.  He served most of his tenure on the bench in Family Law.  He was President of the San Diego County Bar Association and Vice-President of the State Bar Board of Governors.  He holds an LL.M. in Taxation from University of San Diego’s Graduate Tax Program. Judge Huntington also operates a not for profit website for the benefit of other judges and family law attorneys.  That is www.professornedley.com. Its “Buzzwords” page has long been used in judicial college for the assistance of newly assigned judges in family law.