Deducting Legal Fees For Contract Review

Article Summary

Deducting legal fees for contract review directly impacts businesses, independent contractors, and investors who routinely negotiate binding agreements. In the U.S., improper classification of these expenses can trigger IRS audits, resulting in back taxes plus penalties up to 20% of disallowed amounts. Small businesses (LLCs, S-Corps) face specific challenges under IRC §162(a) when distinguishing between deductible operational expenses vs. capital expenditures. State-level variations further complicate compliance—for example, California requires strict apportionment for multi-purpose contracts under Cal. Rev. & Tax Code §17201. Proactive documentation determines whether legal fees reduce taxable income or become non-recoverable costs.

What This Means for You:

• Immediate Action: Annotate invoices from attorneys to specify the business purpose of each contract review session.
• Financial Risks: IRS may reclassify deducted fees as non-deductible capital expenditures if linked to asset acquisition.
• Costs Involved: Hourly rates range from $150–$650; complex agreements may require 5–20 hours of legal review.
• Long-Term Strategy: Implement separate accounting buckets for operational legal fees vs. capitalization-required fees.

Explained: Deducting Legal Fees For Contract Review

Under IRC §162(a), legal fees for contract review qualify as deductible ordinary and necessary business expenses if they meet three criteria: (1) directly related to income-producing activities, (2) not capitalizable under IRC §263, and (3) adequately documented. Federal law prohibits deductions for personal legal services (IRC §262), creating complexity for mixed-use contracts (e.g., a business lease with personal storage space). The Tax Cuts and Jobs Act (TCJA §11045) further restricts employees from deducting unreimbursed job-related legal fees through 2025.

At the state level, 13 states including New York and California follow federal deduction rules with modifications. California’s Franchise Tax Board (FTB Pub. 1131) requires legal fees to be “directly allocable” to business income, prohibiting blanket deductions for general contract templates. Conversely, Texas (Tex. Tax Code §171.1011) allows full deduction of legal fees as operational expenses without apportionment.

”Deducting Legal Fees For Contract Review” Principles:

The IRS applies the “ordinary and necessary” test (Reg. §1.162-1(a)), requiring legal fees to be customary in your industry and helpful for business operations. For example, freelance software developers may deduct fees for reviewing client service agreements, but not personal rental contracts. Mixed-use expenses require strict allocation: If 60% of a trademark license agreement pertains to business use, only 60% of legal review costs are deductible. Apportionment must be calculated using contractual clauses or revenue projections, not square footage or time estimates.

Capitalization triggers occur when contract review relates to acquiring long-term assets (e.g., real estate purchase agreements). Under IRC §263A, these fees must be capitalized and depreciated over the asset’s useful life rather than expensed immediately. Courts have enforced this in cases like INDOPCO, Inc. v. Commissioner (1992), where legal fees for merger contracts were ruled capitalizable.

Standard Deduction vs. Itemized Deductions:

Businesses report deductible legal fees differently than individuals:

• C-Corps/S-Corps/LLCs: Deduct fees directly on Form 1120 (Line 12), 1120-S (Line 7), or Schedule C (Line 17) without itemizing
• Employees/Individuals: TCJA suspended miscellaneous itemized deductions until 2026; legal fees are only deductible if categorized as:
• Whistleblower awards (IRC §62(a)(21))
• Damages from physical injury (IRC §104(a)(2))

California maintains pre-TCJA rules through 2025 for state returns (Cal. FTB Notice 2023-01), allowing employees to deduct unreimbursed job-related legal fees via Schedule CA (540), Line 21. Contrastingly, Pennsylvania fully conforms to federal law, requiring businesses to adjust deductions on PA Corporate Tax Report Line 5.

Types of Categories for Individuals:

Investors (not traders) may deduct legal fees for reviewing contracts tied to taxable investments under IRC §212(1), such as stock purchase agreements or partnership interest acquisitions. Documentation must prove the expense’s direct relationship to income generation. Landlords can include legal fees for lease reviews in Schedule E expenses, provided they don’t capitalize improvements (Reg. §1.212-1(k)).

Freelancers/QBIs qualify under IRC §199A to deduct 20% of legal fees from qualified business income if structured as pass-through entities. However, the deduction phases out for service businesses (e.g., lawyers) at $170k+ single/$340k+ MFJ income.

Key Business and Small Business Provisions:

Startup expenses (IRC §195): Legal fees for initial contracts (e.g., incorporation documents, founder agreements) are deductible up to $5,000 in the first year, amortized over 180 months thereafter. Ongoing businesses deduct fees for employment contracts, vendor agreements, and licensing deals in full during the tax year incurred. Retainer fees require proportional deduction—only portions actually used for contract review during the year.

Contingency fee agreements face strict deduction limits. In Commissioner v. Banks (2005), the Supreme Court ruled plaintiffs cannot deduct contingency legal fees pre-verdict; deductions apply only after award finalization.

Record-Keeping and Substantiation Requirements:

The IRS requires contemporaneous records showing: (1) attorney name/EIN, (2) dates of service, (3) hourly breakdown, (4) business purpose of each contract reviewed, and (5) payment receipts (Rev. Proc. 2022-25). Digital copies suffice if they contain metadata proving authenticity. Retention periods:

• Federal: 3 years from filing date (6 years if income understated by 25%+)
• California: 4 years (Cal. Rev. & Tax Code §19057)
• New York: 3 years for corporations, unlimited for suspected fraud (NY Tax Law §1135)

Audit Process:

IRS audits targeting legal fee deductions typically begin with a Letter 566(D) requesting:

1. Original invoices
2. Annotated contracts showing reviewed sections
3. Proof of payment (canceled checks/bank statements)

If records lack specificity, the IRS applies the capitalization presumption rule (Reg. §1.263(a)-2). Burden of proof shifts to the taxpayer per IRC §7491(a). Common dispute resolutions involve negotiated allocations (60% business/40% personal) or withdrawal through Form 843.

Choosing a Tax Professional:

Select CPAs or Enrolled Agents (EAs) with proven experience in legal fee substantiation. Verify credentials using the IRS PTIN Lookup. Specialists should provide audit defense clauses in engagement letters and know state-specific thresholds (e.g., California’s 50% business-use requirement for mixed contracts).

Laws and Regulations Relating To Deducting Legal Fees For Contract Review:

Federal:
– IRC §162(a): Ordinary/necessary business expense deduction
– IRC §263(a)(1)(N): Capitalization of fees related to intangible assets
– TCJA §11045: Suspension of employee deductions (2018-2025)

California:
– Cal. Rev. & Tax Code §17201: Conformity to federal rules with active/passive activity differentiation
– FTB Legal Ruling 2021-01: Documentation standards for apportioned legal fees

New York:
– NY TSB-M-18(3)I: Post-TCJA treatment aligning business deductions but disallowing employee write-offs

People Also Ask:

“Can I deduct legal fees for reviewing employment contracts as an employee?”
No, under TCJA §11045, employee expenses are non-deductible until 2026 unless reimbursed by your employer via an accountable plan (Rev. Rul. 2020-27). Exceptions exist for fees related to whistleblower awards or discrimination claims under IRC §62(a)(20-21).

“Are contract review fees deductible for startups?”
Yes, but subject to IRC §195 limits. The first $5,000 is immediately deductible if total startup costs are ≤$50,000. Beyond that, fees are amortized over 180 months starting when active business begins (Reg. §1.195-1(b)).

“Does an LLC or Corp get better deductions for legal fees?”
Both entity types deduct fees equally under IRC §162. However, C-Corps face stricter capitalization rules under IRC §263A for contracts related to asset acquisitions or mergers. LLCs may qualify for the 20% QBI deduction on retained legal fees (IRC §199A(b)).

“Can I deduct legal fees for reviewing personal service contracts?”
No, per IRC §262. Exception: Contracts with partial business use (e.g., home office leases) allow proportional deductions—document the business-use percentage with square footage measurements or time logs.

Extra Information:

• IRS Publication 535 (Business Expenses): Details capitalization vs. deduction rules for legal fees (irs.gov/pub535)
• California FTB Publication 1131: Apportionment guidelines for multi-state businesses (ftb.ca.gov/pub1131)

Expert Opinion:

Legal fee deductions require proactive categorization at the time of payment—retrofitting justification during an audit significantly increases disallowance risks. Businesses must implement a three-step process: (1) Tag each invoice with the applicable IRC section, (2) Segregate capitalizable fees into dedicated accounts, and (3) Conduct quarterly reviews using IRS cost segregation guidelines.

Key Terms:

• IRC Section 162 ordinary and necessary business expense deductions
• Contract review legal fees capitalization rules
• Mixed-use legal expense apportionment strategies
• California FTB legal fee substantiation requirements
• TCJA employee legal deduction suspension impact

*featured image sourced by DallE-3