Is Your Lawsuit Tax Deductible? | How to know when it is, and isn’t, deductible
Any lawsuit a company faces is disruptive to business. The costs associated with hiring attorneys, defending a case, and paying for damages or a settlement can be exorbitant, and damage a company’s profitability. The good news is these payments are generally tax deductible business expenses. In order to maximize this deduction, however, companies must be aware of its limitations.
Like the cost of office equipment and rent, the costs associated with defending a lawsuit are generally considered costs incurred in the ordinary course of business and are, therefore, tax deductible. Not all lawsuits and legal costs are treated equally. Court cases and legislation have narrowed the scope of what is, and what is not, considered a legitimate business expense entitled to the deduction.
While every business owner knows that personal expenses are not tax deductible, what is considered a personal expense in relation to litigation costs is not so cut and dry. A recent case found that a company’s payment to settle a lawsuit in which it was the named defendant is not deductible when the lawsuit stemmed from an incident that occurred during a personal vacation taken by the CEO and other employees. In order for settlement costs to be deductible business expenses, the origin of the claim must arise from a profit-seeking business activity. Had the CEO and employees been away for a board meeting, the outcome may have been different. This decision serves as a reminder to businesses that being a named defendant alone is not enough; if a lawsuit does not stem from a business activity, the legal fees and settlement expenses will not be deductible.
Know Your Limits
So long as there is no question that a lawsuit stems from profit-seeking activity, the costs of defending and resolving it will generally be deductible. Any legal fees or court costs incurred will be deductible as well as the cost of resolving the suit, whether the company pays damages to the plaintiff or agrees to settle the dispute. Moreover, if a company is defending itself against the government, any damages characterized as remedial or compensatory are deductible. The characterization of such damages in the settlement agreement is critical. Fines and punitive and penal damages are not deductible. Consult a tax attorney when it comes to negotiating any settlement agreement to ensure that the desired tax treatment of costs is baked into the agreement.
As part of the Tax Cuts and Jobs Act, companies are now precluded from writing off litigation expenses paid or incurred after December 22, 2017 in harassment or sexual abuse cases subject to non-disclosure agreements. The precluded deduction applies to any attorneys’ fees, payment, or settlement related to the case. While companies are generally inclined to conceal these types of lawsuits with confidentiality agreements, the new law creates a tax consequence for doing so.
To Capitalize or Not to Capitalize
Just as the costs incurred to create, acquire, or protect a capital asset are not immediately deductible, the costs associated with litigation regarding the acquisition of a capital asset (or defense of title to a capital asset) may be characterized as capital expenditures. Whether such costs are considered capital expenditures is determined by the activity from which the litigation arises. For example, if a lawsuit arises because a plaintiff challenges the validity of a merger transaction, such expenses incurred in defending the lawsuit must be capitalized because the claim is rooted in the acquisition of a capital asset. If, however, the plaintiffs allege that securities law violations by the board of directors harmed the value of the plaintiffs’ stock after the merger occurred, such costs in defending the lawsuit will not be capitalized expenses because the claim is not rooted in the merger itself.
Timing is Everything
Like with any deductible business expense, the timing for writing off expenses incurred in litigation is entirely dependent on a company’s accounting method. For those companies that operate on a cash basis, the deduction for qualifying costs associated with litigation must be taken in the year in which attorneys’ fees, damages, or settlement amounts are actually paid. For companies that operate on an accrual basis, the costs associated with litigation are deductible in the year they are incurred. For example, an accrual-based company would deduct legal fees in the year the attorney provides the legal services that were agreed to under the terms of engagement and the cost to the company for the services is known with certainty. In terms of settlement, an accrual-based taxpayer would deduct such cost once the settlement agreement is executed and the company’s payment amount is established. The deduction rules for accrual-based taxpayers in this context are fact-specific and complex, and a company should rely on its accountants for making the determination of when such expenses are deductible.
No company welcomes a lawsuit with open arms, but knowing that related expenses are generally deductible can be comforting as legal bills start to multiply. Companies must be aware of the limitations of writing off legal expenses, damages, and settlements so that they can take full advantage of the deduction on their next tax return. To fully assess your situation, it is always best to consult a professional regarding available tax deductions for costs incurred in litigation.
Anna M. Luczkow is an associate in the Business and Mergers & Acquisitions practice groups. She practices in the Akron office of Buckingham Doolittle & Burroughs, LLC. Anna helps clients navigate the complex laws that govern these transactions as well as the area of taxation. She drafts comprehensive and strategic agreements that protect her clients’ best interests and mitigates future risks. She can be reached at [email protected] or 330.258.6510.
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