Introduction

Legal fees are one of the most misunderstood areas in federal income taxation. Many taxpayers assume that if they pay an attorney, the cost is deductible. That used to be partially true—but after the Tax Cuts and Jobs Act (TCJA), the rules changed dramatically.

This article explains when legal fees are deductible, when they are not, and the narrow but powerful exceptions that still exist under the Internal Revenue Code.

The General Rule: Legal Fees Are NOT Deductible (For Most Individuals)

Before 2018, many individuals could deduct legal fees as miscellaneous itemized deductions. That changed with the TCJA.

Under IRC § 67(g):

“Notwithstanding subsection (a), no miscellaneous itemized deduction shall be allowed for any taxable year beginning after December 31, 2017, and before January 1, 2026.”

This provision effectively eliminated deductions for most personal legal fees, including:

• Divorce legal fees (except limited tax planning portions)
• Employment disputes (in many cases)
• Contract disputes unrelated to business
• Personal injury matters (unless tied to taxable recovery)

The Key Exception: “Above-the-Line” Legal Fee Deductions

Not all hope is lost. Some legal fees remain deductible above the line, meaning they reduce adjusted gross income (AGI) directly.

1. Employment and Civil Rights Claims (IRC § 62(a)(20))

Under IRC § 62(a)(20):

Taxpayers may deduct attorney’s fees and court costs “in connection with any action involving a claim of unlawful discrimination.”

This includes:

• Employment discrimination claims
• Whistleblower actions
• Certain civil rights claims

💡 Why this matters:
Even if a taxpayer receives a large settlement (which is taxable), they can deduct the legal fees—avoiding tax on money they never actually keep.

2. Whistleblower Awards (IRC § 62(a)(21))

Similarly, IRC § 62(a)(21) allows deductions for:

“Attorney’s fees and court costs paid… in connection with any action involving a claim under section 7623(b).”

This applies to IRS whistleblower awards.

Business-Related Legal Fees: Still Deductible

If the legal fees are tied to a trade or business, they are generally deductible under:

IRC § 162(a)

“There shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred… in carrying on any trade or business.”

Examples include:

• Contract disputes for a business
• Defense of business-related lawsuits
• Legal fees for collections or enforcement
• Drafting operating agreements or leases

💡 Key distinction:
The expense must be directly connected to the business, not personal in nature.

Capital vs. Deductible Legal Fees

Not all business legal fees are immediately deductible.

Under general tax principles:

• Deductible: Routine legal expenses (e.g., litigation, collections)
• Capitalized: Legal fees tied to acquiring or improving an asset

For example:

• Legal fees to purchase real estate → capitalized into basis
• Legal fees to defend title → capitalized

This follows long-standing capitalization principles under IRC § 263(a).

The Hidden Trap: Contingency Fees Are Still Income

Even when legal fees are deducted, taxpayers must often include the gross recovery in income.

The U.S. Supreme Court confirmed this in Commissioner v. Banks, 543 U.S. 426 (2005), holding that:

• Plaintiffs must include the full settlement amount, including the portion paid to attorneys.

💡 This is why IRC § 62(a)(20) is so critical—it prevents “phantom income” taxation in qualifying cases.

Special Case: Personal Injury Recoveries (IRC § 104)

Legal fees may be irrelevant in some cases.

Under IRC § 104(a)(2):

“Gross income does not include… damages… on account of personal physical injuries or physical sickness.”

If the recovery is tax-free, then:

• Legal fees are not deductible
• But also not needed, since the income isn’t taxed

Practical Examples

✅ Deductible

• Business owner pays $15,000 to defend a contract dispute → deductible under § 162
• Employee wins discrimination claim and pays attorney 40% → deductible under § 62(a)(20)

❌ Not Deductible

• Divorce attorney fees (except limited tax advice portions)
• Personal lawsuit unrelated to income or business
• General legal advice for personal matters

Planning Insight: Structuring Matters

For high-dollar cases, structuring can be critical:

• Allocate claims to qualify under § 62(a)(20) where possible
• Separate taxable vs. non-taxable damages
• Carefully draft settlement agreements

This is where legal and tax strategy intersect—and where real savings happen.

Conclusion

The TCJA fundamentally changed how legal fees are treated:

• Most personal legal fees are no longer deductible
• Business legal fees remain deductible under § 162
• Certain claims (like employment discrimination) still qualify for powerful above-the-line deductions

Understanding these distinctions can mean the difference between paying tax on net income vs. gross recovery—a massive financial impact.

At Dino Tax Co, we help clients navigate tax matters ranging from unfiled returns to IRS letters and levies and everything in between with clarity and confidence. If you’d like guidance on your situation, schedule a consultation today. Call or text (713) 397-4678 or email davie@dinotaxco.com. We’re here to help you take the next step.