Tax laws have changed recently, and there have also been changes to what counts as deductible, so you may be wondering if you can deduct attorney fees from a car accident settlement.
Deductible legal fees
The enactment of the 2017 Tax Cuts and Jobs Act saw sweeping changes to tax laws impacting most taxpayers.
One of the most pivotal changes involved the elimination of miscellaneous itemized deductions.
Traditionally, many taxpayers claimed itemized deduction, whether for unreimbursed employee expenses or legal fees. Post-TCJA, though, you may only deduct the following types of personal legal fees:
- Fees representing ordinary, necessary expenses directly linked to operating your business (complete Schedule C of Form 1040).
- Fees related to an unlawful discrimination claim (include on Form 1040).
- Fees associated with whistleblower claims (include on Form 1040).
- Fees levied for advice and preparation of tax forms directly related to your business, as well as fees for resolving tax issues (complete Schedule C of Form 1040).
- Rental fees or fees for royalties on properties that generate income (complete Schedule E of Form 1040).
- Fees associated with farm expenses and income and expenses (complete Schedule F of Form 1040).
Most legal fees that are directly related to your business can be deductions. This includes rental properties, and it is also applied even if you lost the legal case attracting the legal fees in question.
You may also deduct legal fees related to the adoption of a child, assuming you qualify for the federal adoption tax credit (include on Form 8839).
Current tax laws allow taxpayers far less latitude when it comes to deductible legal fees.
Non-deductible legal fees
Under current tax law, you are not permitted to include any legal fees related to personal issues when making itemized deductions.
IRS regulations allow for the inclusion of the following fees:
- Fees related to nonbusiness tax advice or tax issues
- Fees associated with the refund or collection of any taxes
- Child custody legal expenses
- Breaching promise to marry
- Purchasing real estate
- Civil or criminal charges concerned with personal relationships
- Title preparation
- Personal injury
- Property claims and settlements
- Estate planning (will preparation)
- Fees for defending charges arising from participation in a political campaign
Not all kinds of legal fees can be deducted, and those eligible for deduction must be itemized.
What does itemizing your deductions entail?
When you file your taxes, you can typically choose between taking the standard deduction and itemizing deductions. The purpose of both options is to legally reduce your taxable income, meaning you’ll pay correspondingly less taxes.
In the case of deducting legal fees, you must itemize deductions instead of taking the standard deduction for that tax year.
From 2018, not only did the new law limit the number of itemized deductions taxpayers can claim, but the new tax law also raises the standard deduction. What this means is that some itemized deductions you may have habitually taken over the years are now no longer applicable.
As an example, you are no longer permitted to include any of the following in your miscellaneous deductions:
- Investment expenses
- Tax preparation fees
- Hobby expenses
- Work clothes
- Union dues
What is the 2% rule?
Before the enactment of the TCJA, the 2% rule was applied. This rule allowed taxpayers unable to write off certain job-related expenses to deduct an amount of those itemized expenses exceeding 2% of their AGI (adjusted gross income).
Since 2018, the new tax laws mean deductions linked to the 2% rule are suspended.
Despite this, it is still possible to deduct some legal fees, as long as they relate to your work.
As of 2018, deductions related to this 2% rule have been suspended. However, some legal fees can still be deducted if they relate to your work.
Awards from cases and legal settlements
If you are awarded compensation from a legal case or settlement, it is liable that this award will be taxable. You should include the award amount in the gross income you report to the IRS.
The exception to this rule is when compensation is awarded following a personal injury or sickness lawsuit. Even when this applies, other rules and exemptions may still also apply. You will not usually be permitted to deduct attorney fees from these cases from your taxes, though.
Record-keeping tips to streamline taxes
Check that the invoices you receive from your attorney clearly specify the nature of any services provided. If you have already received an invoice and it does not specify the nature of legal counsel, ask your lawyer to amend the invoice to include this information. This will make it easier for you to substantiate the legal fees you deduct from your taxes.
If you ask your attorney in advance, it is possible to have separate bills for deductible and nondeductible services.
There are many virtual accounting solutions you can leverage at home to keep track of deductions you are eligible for, and to manage your billing and expenses. With bookkeeping software, you can also streamline tracking and classifying your expenses.
Bottom line, taxpayers no longer enjoy the same latitude when it comes to the deduction of legal fees for personal reasons, including car settlements. The TCJA is due to expire in 2025, so unless the act is overturned before then, you should get accustomed to making fewer deductions for legal fees.
There is no substitute for seeking advice from an accountant or attorney if you are in any doubt about what fees you can deduct from your taxes.