Legal Fees for Estate Planning for Clients
Lawyers typically advise people regarding wills, powers of attorney and advance health directives. Some advisers may also provide advice regarding guardianship matters, which is critical in the event a person were to lose capacity as a result of an accident or illness.
Wills enable a person to determine who receives their estate after their death. These documents also deal with appointing an executor, who is responsible for distributing the deceased person’s estate. Many people also prepare enduring powers of attorney to give effect to the wishes of a person regarding matters that need to be dealt with if they lose capacity .
While many people prepare wills and powers attorney on an ‘one off’ basis, many lawyers find themselves providing ongoing advice in relation to wills and estate planning. These services may also involve advising clients regarding a person’s incapacity and general guardianship matters.
Given the complex nature of these types of legal work, and the regularity with which law firms provide advice in this area of law, many firms take the view that these legal expenses are deductible.
Legal Fees Deductibility and Requirements
In general, the IRS allows taxpayers to deduct "ordinary and necessary expenses" incurred in the course of conducting a trade or business, a requirement that is applied in determining if legal fees are deductible on tax returns. The determination of what is ordinary and necessary requires facts and circumstances analysis. Personal legal fees, on the other hand, are not deductible. For example, you wouldn’t be able to deduct the cost of a divorce or an adoption on your income tax return.
So, does this mean paying an estate planning attorney to draft your will, power of attorney or trust is not deductible? It typically does not—unless the attorney’s services help you establish or maintain an investment or trade or business.
The IRS distinguishes between tax expenses incurred "for the production or collection of income or for the management, conservation or maintenance of property held for the production of income" and those incurred for individual or personal purposes. Estate planning legal fees frequently pass the ordinary and necessary test for income producing property.
While it may seem non-intuitive, an estate planning attorney’s fees will likely not be deductible if the planning involves taxes on an estate administered to benefit the taxpayer’s heirs. For tax purposes, the taxpayer will likely be considered to have economic outlays equal to any taxes paid, which will offset the value of the assets passing to his or her beneficiaries. Thus, if to support his or her own heirs an estate planning taxpayer uses his or her assets to pay an estate tax, that payment is not deductible.
When is Legal Fees Tax Deductible?
There are some estate tax planning circumstances where legal fees incurred in connection with estate planning may be able to be deducted on an income tax return or be claimed as a miscellaneous itemized deduction. If the legal services of the attorney can be shown to be for the production; management or conservation of taxable income; a deductible ordinary and necessary business expense; or in connection with a claim for refund, then the fees for the legal services may in fact be deductible.
If legal fees are incurred solely for collection of rents or rental income, it has been argued that the taxpayer could not deduct such fees because the property was not held primarily for production of income. However, the requirement that the property be held for a profit is relaxed if the taxpayer can show that deductibility of the fees serves to reduce the estate tax that would otherwise be owed by the taxpayer.
If, however, the legal fees are incurred in connection with the negotiation of a lease, however, the expenditure is not deductible. In the cases where these expenses were accepted as being deductible, all or part of the legal expense can arguably be deductible under Section 212. For example, in Cook v. Commissioner, a case involving the pro rata allocation of legal fees for contested and uncontested claims, both were considered deductible because the expenses were incurred to converse the corpus of the estate or to produce income.
In the case of Estate of Blessing, a husband and wife who both owned one-half of two vacant lots in a neighborhood zoned for apartment buildings, the Court of Claims held that the expenditures were deductible under Section 212(1). Similarly, in Estate of Crespo, the same situation also took place where the legal fees were deducted for efforts to secure a zoning change from single family to residential-2 family which would enhance the value of the assets in the Estate.
In Urquhart v. Commissioner, the court allowed deductions for legal fees incurred to conserve the assets of an estate where the legal services were directly related to the collection of income and management of two corporations owned 50% by the decedent. In Estate of Rothko, the executor argued that legal fees incurred in an attempt to secure a larger inheritance for his wife constituted a deductible ordinary and necessary business expense under Section 212. However, the court refused to allow the deduction because the legal services were "neither for the production of income nor connected with the management or conservation of property held for the production of income."
Legal Fees that Are Not Deductible in an Estate Plan
There are some situations in which most taxpayers would not be able to deduct any portion of their legal fees for estate planning purposes. For example, in Gottschalk v. Commr., TC Memo 2006-75 (4/25/06), a couple that planned to donate farmland and interested in obtaining a deduction for the donation hired legal counsel to prepare the documents conveying the property as well as the related paperwork needed to substantiate the donation with the IRS. Unfortunately, the couple decided against making the donation after the attorneys prepared the relevant documents because they estimated that they would receive only a small deduction for the donation, which they felt was not worth the effort. As a result, the taxpayers asked the attorneys to revise the documents that had been prepared by their original attorneys so that they could retain the property. Further, the taxpayers’ tax advisor advised that they should not make a gift until sometime in the future, at which point, they could decide whether to make the gift or retain the property. Although the forms had already been prepared and all that was needed was to sign the documents, the taxpayers’ attorneys charged them $10,500 for the work done and the time spent on the prior transaction, the "no-gift" advise, and a conference with the taxpayers .
The Tax Court reviewed the provisions of Code §67(a), which limits the amount a taxpayer can deduct in a given year for miscellaneous itemized deductions, such as investment or legal fees, to the extent that the aggregate of the deductions exceed 2% of the taxpayer’s adjusted gross income for the year. As a result, since taxpayers generally do not spend 2% of their adjusted gross income on legal fees and because "gift planning" is not a type of law that the IRS has determined to be deductible, the taxpayers were required to capitalize the legal fees onto the basis of the real estate (unless the property is later sold or exchanged) because the legal fees were not deductible in the first place, much less subject to capitalization rules. Accordingly, the taxpayers were entitled to no deduction for the legal fees. See also McLallen v. Commr., TC Memo 2011-174 (6/20/11) (taxpayer not entitled to deduct fee for assistance in creating irrevocable trust because it did not produce income) and Meyer v. Commr., TC Memo 2010-303 (11/22/10)(taxpayer not entitled to deduct fee for will contest suit paid by the estate).
Important Considerations and IRS Guidelines
The IRS allows taxpayers to deduct some legal fees paid in connection with estate planning provided the tax benefits of the deduction outweigh any harm to the taxpayer. Further, business expenses incurred by an estate may be deductible if carrying out the purposes for which the estate was entered into would otherwise cause the estate to owe more federal income tax.
Practitioners should be aware that legal fees associated with the establishment of an irrevocable trust, powers of attorney, living wills, etc., are not deductible by the taxpayer, even though this is generally the most sophisticated work performed by an attorney in the estate planning arena. Instead, these fees are viewed as related to nondeductible personal activities of the taxpayers, and the cost associated with these types of documents is a matter of personal concern to the taxpayer and not a concern of the taxpayer’s trade or business.
As an example, a taxpayer might pay a local attorney $2,000 to prepare an estate plan that includes a revocable living trust, powers of attorney, and a living will. In contrast, an irrevocable trust, business succession plan or high net worth tax sensitive estate plan might add to the complexity of the plan and make a successful argument for tax deductibility. A common example of tax deductibility might exist if an irrevocable trust was set up prior to establishing a closely-held corporation and the tax implications and mechanics of transferring the closely-held corporation into the irrevocable trust were properly addressed.
If a taxpayer maintains investments in a brokerage account and retains legal counsel to provide services on behalf of the taxpayer against the brokerage firm and/or the investment company holding the account, a portion of the fee might be deductible. The taxpayer cannot deduct the entire legal fee but only the portion attributable to the recovery of taxable income and/or interest or dividends. To this end, the taxpayer should not only request an unallocated invoice from the attorney but also maintain a contemporaneous record of the time spent on each service. For example, if an attorney spent 6 hours on a matter related to taxable income and 2 hours on a matter related to tax exempt income, the taxpayer may only deduct 75% of the legal charges.
Documentation and substantiation of the deductions is required. In the event of an audit, the taxpayer may be required to provide information regarding the particulars of the deduction, including the nature of the item, the amount involved and the business purpose. If documentation and substantiation are not provided, the IRS may challenge the deduction and impose penalties and interest.
Professional Help for Tax Advice
In the realm of estate planning, the interaction of legal fees and tax regulations can be complex. Estate planning can overlap with a variety of areas of law, and the fees accrued in the process can sometimes be deductible. However, whether the fees are deductible is a question only a tax professional, whether it be a CPA or an attorney with taxation experience, can definitively answer. Further , this determination may change based on such factors as whether the payment is for solely estate planning or whether the payment relates to other matters with separate locales and choices.
Consulting with a tax professional when meeting with an estate planner, before making any payments, generally results in a more seamless estate administration that complies with all laws. The professional will be able to use his or her expertise to determine the best manner to structure the payments.