This is the first contributor who contacted you. I was hoping that I could clarify whether or not you were seeking to deduct your legal expenses from your taxable income, or whether you were seeking to recover those expenses as counsel fees from your employer as part of the legal action.
Apparently, the other contributor appears to have determined that your question relates to your desire to deduct your legal expenses from your taxable income, and she has answered you accordingly.
Assuming that this is in fact what you are attempting to determine, then I believe that the other contributor's answer is far too conclusory to provide you with an answer that will permit you to determine your tax liability, if any -- so, I will attempt to thoroughly explain this issue, so that you can know where you stand.
In United States v. Gilmore, 372 U.S. 39, 48 (1963), the U.S. Supreme Court held that the test as to whether legal fees are business or personal expenses depends upon whether the claim arises in connection with the taxpayer's profit-seeking activities or his personal activities. For example, under this "origin of the claim" test, the Supreme Court held that legal expenses incurred to defeat claims arising from a marital relationship were personal and nondeductible. Id. at 51. The Court noted that it is irrelevant whether the taxpayer's income-producing property would be affected by the outcome of the divorce proceeding. See id. at 48.
Similarly, in McKeague v. U.S., 12 Cl.Ct. 671 (U.S. Ct. Claims July 01, 1987), the U.S. Court of Claims writes (paraphrasing) that:
- Legal expenses incurred in counts involving ordinary income items, including lost compensation, punitive damages and attorney fees, all of which originated from parties' employment dispute, were deductible as ordinary expenses. 26 U.S.C.A. §§ 162, 212...As the origin of this claim related to the protection of plaintiff's business interest, the legal expenses incurred for Count V should allow ordinary expense deductions...Legal expenses incurred by taxpayer in seeking access to management information were deductible as ordinary expense related to protection of existing income or continuation of existing business. 26 U.S.C.A. §§ 162, 212...In determining the origin and nature of the various counts, legal expenses are deductible as business expenses if they are directly related with, or connected to taxpayers' trade or business.
See also, Treas. Reg. 1.212-1(d):" Expenses, to be deductible under section 212, must be “ordinary and necessary”. Thus, such expenses must be reasonable in amount and must bear a reasonable and proximate relation to the production or collection of taxable income or to the management, conservation, or maintenance of property held for the production of income."
Your dispute appears to involve an employment contract. An employment contract is a property right -- therefore counsel/attorney's fees incurred as part of the "management, conservation, or maintenance" of that property right, are deductible as Miscellaneous Itemized Expenses, on Schedule A, subject to the 2% adjusted gross income (AGI) floor.
The fact that your case was dismissed while you were defending your interest in the employment contract is irrelevant. If the "origin of the claim" is related to a contract of employment and the alleged breach thereof, and to the maintenance or protection of your right to income under the contract, then the legal expenses are deductible.
Finally, the other contributor refers to IRC 265(a) as authority for her answer. I believe that the correct IRC Sections are 162 and 212.
(edited by moderator)
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