Section 162 allows a deduction for ordinary and necessary business expenses paid or incurred during the year in carrying on any trade or business. Section 212 allows a deduction for ordinary and necessary expenses paid or incurred during the year for the production or collection of income and for the management, conservation, and maintenance of property held for the production of income. Section 262 provides that no deduction shall be allowed for personal, living, or family expenses and section 263 provides no deduction shall be allowed for capital expenditures. Among these potentially applicable sections there was much debate over whether attorney’s fees and other litigation costs would be deductible or nondeductible.
For legal fees to be deductible under section 212, they must relate to the production or collection of taxable income—amount includible in gross income. For example, damages received on account of non-physical injury are includible in gross income; as a result, attorney’s fees to recover such damages are deductible under §212 as expenses for the production of income. Conversely, legal fees paid in connection with the production or collection of tax-exempt income is generally not deductible in order to prevent double benefit i.e. exclusion and a deduction. To illustrate, attorney’s fees paid in connection with the receipt of damages on account of person physical injury are nondeductible since such damages are excludable from gross income under section 104.
If a legal fee is partially deductible and partially nondeductible, the taxpayer must allocate the fee between the deductible and nondeductible portions. Lawyer fee statement that make a reasonable and good faith allocation are typically respected.