Under Reg. 1.262-1(b)(7) attorney and professional fees paid in securing a divorce, separate maintenance agreement, or decree for child support are generally nondeductible by either spouse. However, the exact tax treatment certain expenditures receive is contingent upon the nature of the professional services sought.
Collection or Production of Income Related to a Divorce
Under IRC sec. 212(1) Fees paid related to securing the production or collection of income are deductible and this is equally true where related to a divorce. Legal fees paid in a divorce to secure a right to receive items of taxable income as part of the marital dissolution and martial property settlement are deductible. For example, legal fees incurred in a legal effort to regain or possess a marital profit seeking business entity are deductible. Legal fees incurred to secure a right to receive or increase alimony are deductible as Schedule A miscellaneous itemized deductions subject to the 2%-of-AGI limitation. HOWEVER, legal fees paid in an effort to resist or reduce paying alimony are nondeductible as they are not legally considered related to the production or collection of income. Along the same lines of logic, since child support payments are not includible in the recipient’s income, legal fees paid to secure child support are nondeductible.
Tax Advice Sought in the Course of a Divorce
Separately stated fees by an attorney, CPA or other tax professional related to the providing of federal, state, local, estate, and property tax advice related to a divorce, separation or spousal support action are arguably related to the production or collection of income are therefore potentially deductible. Where these expenses are deductible, they are 2%-of-AGI miscellaneous itemized deductions, and thus subject to a potential haircut. AMT is also an issue.
However, a taxpayer is only allowed to deduct legal and professional fees paid for tax advice regarding his or her own taxes. Where the taxpayer was required by a court to pay the legal expenses of his or her spouse, he or she is prohibited from deducting these costs even where they directly relate to tax counsel provided to their ex-spouse.
Legal and Professional Fees as an Increase to Basis
Where tax advice fees are of no immediate benefit, the tax professional should consider capitalizing the tax advice expenses and adding them ratably to the basis of property a party receives in a martial property settlement agreement.
An argument can be made for a taxpayer to add to his or her closely held stock basis the allocable portion of the legal and professional fees they paid in order to retain the ownership their corporation that was at issue during divorce litigation. As a general rule, where legal and professional fees in a divorce relate to assets received via a marital property settlement, the taxpayer is justified in allocating the cost in a prorata fashion among the assets received in the divorce.
Billing for Tax Advice, Collection and Production of Income and Defense of Title Services
To help a client fully benefit from a tax perspective and determine the proper tax treatment and potential deductibility, or basis increase related to legal and professional fees expended during a divorce, the attorneys and professional should be requested to cull out and specify services related to tax advice, the collection or production of income, or services related to the defense of title to property.
Partnership and a Partner’s Divorce Litigation
A partnership is prohibited from deducting, and thus the partners will not be allocated a related deduction on their individual K-1s, settlement expenses related to litigation that is brought against an individual partner in that partner’s capacity as an individual. This legal principle has been applied to deny a partnership a deduction for amounts the partnership paid to ward off financial damage the partnership where a partner’s spouse made demands against a partnership in a divorce action.