by Robert W. Wood

Clients always prefer to deduct legal fees rather than to achieve a less immediate tax effect. Unfortunately, in most real estate transactions, and even real estate disputes, legal fees must be capitalized. Much of this follows from the origin of the claims doctrine, and important underlying rule that we’ll address below. If a payment pursuant to a settlement or judgment is required to be capitalized, the legal fees should follow the same character.

But if the payment of a settlement or judgment does not occur, then some other index must be used to determine the tax treatment of the legal fees. If a plaintiff brings suit and is unsuccessful in obtaining either a settlement or a judgment, the legal expenses may still have to be capitalized. Indeed, the legal expenses may be outside the litigation context entirely, and may relate to ongoing operations or to a transaction. The question in each case will be whether the action related to the preservation, maintenance or purchase of a capital asset.

The classic example of legal fees that must be capitalized rather than deducted is where the legal fees are paid or incurred to preserve or protect title to property. For example, if a taxpayer acquires a piece of real property for $1 million and subsequently brings suit to remove a cloud on title, the legal fees cannot be deducted but must be capitalized as a part of the acquisition cost of the property. This is so even if the holding of the real property constitutes a trade or business or investment activity. Even though there is a business nexus between the taxpayer and the property, that nexus does not convert the expense either into a trade or business expense deductible under Section 162, nor even into an investment expense deductible under Section 212. Although the standards are often confused, the question here is whether the legal fees relate to the preservation, maintenance or purchase of a capital asset.

Fact patterns in the case law are extremely varied, and a review of some of the cases is therefore appropriate. In Jack L. Baylin v. United States, the court held that legal expenses that were incurred in a state condemnation proceeding were capital expenditures and therefore nondeductible. The taxpayer had argued that the legal fees were properly deductible under Section 212 as an expense of producing income. Similarly, in Ivan A. Jasko v. Commissioner, the Tax Court held that legal fees paid to recover insurance proceeds for the destruction of a principal residence were not deductible. The taxpayer argued that the residence in effect represented an investment, so that Section 212 should apply. The Tax Court disagreed.

In Lin v. Commissioner, the taxpayer incurred legal expenses in pursuing two actions, one to determine the taxpayer’s 50% ownership interest in a corporation, and the other to set aside a deed. The deed in the second action purported to convey the taxpayer’s 50% interest in rental property, and the taxpayer sought to set the deed aside as fraudulent and to obtain an accounting of rents and profits. The taxpayer’s deductions for the legal fees were considered capital expenditures by the IRS, and the Tax Court agreed. In both suits the origin of the claim was to protect, defend, or restore the taxpayer’s interest in property.

Occasionally a legal proceeding or matter may relate to the conservation, collection or production of income as well as to a capital asset. If the legal expenses can be allocated, the legal expenses incurred in pursuing the former would be deductible, while those expenses related to the latter would not.

Of course, the mere fact that the legal expenses in some way relate to property does not convert them into a capital expenditure. Many legal fees paid by those in the real property management business or in the conduct of some other real property development activity are legitimately deductible. For example, if a real property lessor or property developer has a dispute with employees and incurs legal expenses pursuing the defense of union organizing activity, wrongful termination or discrimination lawsuits or the like, such legal expenses are merely a cost of doing business. They are therefore deductible under Section 162.

Income-Producing Activity.  Even where the lawsuit relates rather clearly to income-producing activity, the capitalization of the legal expenses may be required. For example, in James J. Freeland v. Commissioner, the taxpayers incurred legal expenses in resisting a legal action filed for the purposes of preventing them from foreclosing their purchase money mortgage against certain property. The taxpayers claimed legal expenses as deductions in connection with the lawsuit. The court, however, held that the lawsuit related not to the collection of income, but to the defense or protection of the title to the property.

Accordingly, the Tax Court required the expenses to be capitalized as part of the cost of the property. The IRS argued persuasively—and the Tax Court agreed—that the origin of the litigation was the original sale of the capital asset, and accordingly that the expenses all had to be capitalized. Unfortunately, the analysis of the court in the Freeland decision is quite complex. Indeed, the court noted that in determining the origin of a claim:

“The search for the origin of the claim is not limited to a simple determination of the first event in a chain which led to the litigation but, instead is “an examination of all the facts...to ascertain the kind of transaction out of which the litigation arose.”

In Jean W. Lang, et ux. v. Commissioner, T.C. Memo 1998-161, Tax Notes Doc. No. 98-14273 (1998), legal fee deductions were denied for Jean Lang, a minority shareholder in a family-owned company. Jean Lang and his brother Elmer had an arrangement that they were equal partners in Madison Holding Company, although Elmer technically owned more shares than Jean. Upon Elmer’s death, Jean sought to equalize the stock held by the two sides of the family. Elmer’s heirs filed suit to block Jean, and the legal fees in this dispute were significant.

Seeking to rule on the origin of the legal claims, the Tax Court considered the matter to involve the protection, defense and acquisition of Mr. Lang’s ownership interest in the Madison stock. Although the Tax Court considered the taxpayers purpose in undertaking litigation on this subject might have included protecting his job, the Tax Court did not find this determinative under the origin-of-the-claim test. The taxpayer here sought to establish his ownership of the additional Madison shares. Consequently, the court ruled that the legal fees were nondeductible capital expenditures.

Effect of Form of Suit.  In some cases, the form of a lawsuit may significantly influence the manner in which the origin of the claims test is applied, and consequently may influence whether the legal fees are deductible or must be capitalized. One of the most interesting cases is Mosby v. Commissioner, where the taxpayer was a lessee of mineral rights from the government who was refused access to the property. The taxpayer made a claim under the Federal Tort Claims Act and, when it was rejected, sued in the Court of Claims for damages arising because his right to extract the minerals had been taken without due compensation.

The Court of Claims in Mosby ruled in the taxpayer’s favor, holding that there had been an inverse condemnation. The taxpayer deducted the legal fees incurred in the suit, and the IRS disallowed them. The IRS’ theory was that the award was a condemnation award and that the legal costs therefore resulted from the disposition of a capital asset.

The taxpayer’s counter-argument was that he was merely trying to engage in his regular business of quarrying minerals, and that his suit to gain access to the property was therefore an ordinary and necessary business expense. The Tax Court, however, denied the deduction because of the specific nature of the remedy the taxpayer requested, which was granted by the Court of Claims. The taxpayer’s claim was for the taking of property, regardless of his motives for bringing the suit. According to the Tax Court, the expenses had to be capitalized under the origin of the claims doctrine.

The Mosby case suggests that if the taxpayer had sued for damages he had suffered as a result of not being allowed access, as opposed to suing in the nature of an inverse condemnation action, his legal fees would have been deductible! It may be extreme to suggest that the tax consequences down the road should control the manner in which the lawsuit is framed. Nevertheless, Mosby seems to suggest such an approach.

If nothing else, the case dramatically points out that the origin of the claims test can be applied variously. The court in Mosby presumably could have held that the origin of the claim was the taxpayer’s right to enter the property to engage in his usual business of mining. The form of the complaint, therefore, seems to be given controlling weight. It is often easy to distinguish between an expenditure that is clearly capital, such as the cost of defending or perfecting title to property, and one that is clearly ordinary. As in Mosby, however, where the suit relates to the ownership or operation of the property and income derived from it, it may be unclear whether capital or ordinary treatment should result.

Under the origin of the claims test, the background of the controversy should be examined. Despite the decision in Mosby, where a suit seeks to recover income or profits flowing from the ownership of property, the legal expenses should be deductible. However, if the action attempts to recover income or profits and also to establish ownership of the underlying property, the entire legal fees may have to be capitalized.

Abandoned Transactions.  Ironically, one of the best ways to insure that a deduction for legal fees is available in the real property context, is to abandon the transaction. For example, if a taxpayer incurs legal fees pursuing the purchase of real estate the taxpayer intends to use in a trade or business or to hold for investment, those legal fees would clearly have to be capitalized if the real property transaction closes. What happens, however, if the deal is never closed? Here, there is no capital asset to which the legal fees can be appended and capitalized. As a result, legal fees for the abandoned transaction will be deductible. Whether they would be deductible as a business expense under Section 162 or as an investment expense under Section 212 will be controlled by the character of the transaction and the property. The good news, however, is that these legal fees would clearly not be subject to capitalization requirements.

Where a transaction is abandoned, even if it is of a capital nature, the legal expenses incurred in pursuing the transaction until it is abandoned will be deductible as long as the expenses were directly related to a transaction entered into for profit.

Trustee Costs.  Advisors may focus on deductibility of fees in the litigation context, occasionally overlooking the fact that the deductibility of fees in other contexts can also present a problem. In Ruby Jean Stevens v. Commissioner, T.C. Memo 1999-259 (1999), the Tax Court recently held professional fees an individual incurred in connection with litigation involving a trust (of which she was a trustee and beneficiary) were nondeductible capital expenditures under Section 263. The case is interesting, and potentially troubling inasmuch as trustee litigation is increasingly common. One would have thought that the individual legal fees by the trustee would have been deductible.

The facts in this case arose out of irrevocable grantor trust established by Red Stevens in 1990. The income was either distributed to Red or added to principal during his lifetime. He died in 1991, at which time the trust became irrevocable and his spouse Ruby became successor trustee. She made two required distributions to the Stevens’ daughter, Sedra, and to Red’s son, Garland, from a prior marriage. The remaining trust property was distributed to Ruby as trustee of a marital trust for her benefit.

This sounds like a fairly typical estate plan. However, as Ruby received the net income plus discretionary distributions of corpus, she also had a general testamentary power of appointment that, if not exercised, all remaining income in corpus would be distributed to Sedra after Ruby died. In 1993, Garland sued Ruby individually and as beneficiary and trustee. He also named Sedra as a defendant. Garland alleged that his father lacked mental capacity, that the defendants misled or unduly influenced him into signing the documents, etc. Ruby’s attorneys advised her that it was her duty as trustee to defend the lawsuit, which she successfully did.

On her 1993-1994 tax returns, Ruby deducted professional fees she incurred in connection with the lawsuit. The IRS disallowed them, determining that they were capital expenditures. Judge L. Paige Marvel agreed with the IRS that the fees were not deductible because Ruby’s defense of the lawsuit was to protect the trust’s title to the trust property—not to protect, safeguard or maintain physical assets. A fine distinction perhaps, but one that the court was willing to make.

Ruby asserted that none of Garland’s claims for relief related to the acquisition or defense of title to property and she insisted that she defended the lawsuit in her capacity as income beneficiary (in other words, to prevent the impairment of the production and collection of trust income). The latter would sound very much like a Section 212 expense. Nonetheless, the court applied the origin of the claim test here finding that the lawsuit did not allege abuses in the administration of the trust, but rather the validity of the trust.

Allocating Attorneys’ Fees Between Deductible and Capital. Perhaps the most interesting aspect of the Ruby Jean Stevens case was the manner in which attorneys’ fees were allocated—or assertedly allocated. The normal method (and the presumptive method as far as the IRS is concerned) of allocating attorneys’ fees and costs between those which go to produce taxable income and a suit for excludable damage awards is a pro rata approach. Thus, if one recovers $100 as a plaintiff and $50 of it is taxable and the other $50 is excludable under Section 104, the way to allocate the attorneys’ fees (presumptively) would be to deduct that portion of the attorneys’ fees (50%) related to the portion of the recovery that was taxable. This has long been the Service’s position, and is the position adopted by most taxpayers.

It is, however, possible to argue that one portion of the case (say the portion that produced the excludable income) actually took less time and was simpler for the attorney than the balance of the case. Provided that time records can support this notion, or some other good evidence (perhaps affidavits from the attorneys involved?), this kind of argument can work.

In Stevens, the taxpayer’s attorneys testified that 75% of the fees were allocated to the first, second and fourth claims (that not surprisingly produced taxable income), while only 25% of the fees were allocated to the third claim for relief (which alleged tortious interference). The attorneys who testified confirmed that the allocation of fees was not based on precise recordkeeping, but rather was an estimate.

The Tax Court found this allocation not controlling for several reasons. First, the court said the allocation was made among claims for relief which suffer from the same infirmity (each one grounded in an attempt to invalidate the trust). Furthermore, regardless of whether an allocation was made, none of the costs so allocated were deductible because, said the court, they did not satisfy the standard for deductibility under Section 212.

The second reason is that petitioner failed to prove that the allocation was “anything more than a guess made to salvage some part of a deduction out of that which is simply not deductible.”

Taxpayers are often successful in allocating fees, legal fees and costs. A good example would be in the divorce context, where it is very common for divorce attorneys to allocate a portion of the fees to “tax advice.”  The same theory can be applied to deductible vs. capitalized fees, as long as careful records are kept supporting such a bifurcation.

In Jean W. Lange, et ux. v. Commissioner, T.C. Memo 1998-161 (1998), the Tax Court held that a shareholder of a closely held bank holding company was required to capitalize the attorneys’ fees he expended during litigation over his ownership interest. Jean Lange and his deceased brother, Elmer, had owned the stock of Madison Holding Company, which in turn owned the Union State Bank. The court found that the litigation between Jean and Elmer’s heirs related to Jean’s ownership interest in Madison Holding Company, rather than in his employment position at the bank. Jean had tried to enforce a buy-sell agreement that he and Elmer had executed to provide for the disposition of the Madison stock on either of their deaths.

The litigation also related to Jean’s attempt to increase his ownership interest in order to reflect his and Elmer’s understanding that they were equal partners. Faced with litigation over such matters, the Tax Court denied deductions for legal fees, and found that they had to be capitalized as related to protecting the stock interest in the corporation. Had different planning been done, perhaps some fees would have been held deductible.

Capitalizing Legal Fees in Real Estate Deals, Vol. 20, No. 9, Real Estate Tax Digest (November 2002), p. 3.