Buckingham, Doolittle and Burroughs
United States: Is your lawsuit tax deductible? How to know when it is, and is not, deductible
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Any lawsuit that a business faces is disruptive to business. The costs associated with hiring lawyers, defending a case, and paying damages or settlements can be prohibitive and affect a company’s bottom line. The good news is that these payments are generally tax-deductible business expenses. In order to maximize this deduction, however, businesses must be aware of its limitations.
Like the cost of office equipment and rent, 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 fees are treated the same. Court cases and legislation have restricted the scope of what is, and what is not, a legitimate business expense qualifying for the deduction.
While every business owner knows that personal expenses are not tax deductible, what is considered a personal expense versus litigation costs is not that straightforward. A recent case found that paying a company to settle a lawsuit in which it was the named defendant is not deductible when the lawsuit arose out of an incident that occurred during personal vacation taken by the CEO and other employees . In order for the settlement costs to be deductible business expenses, the origin of the claim must result from a for-profit business activity. If the CEO and employees had been absent for a board meeting, the outcome might have been different. This decision reminds companies that it is not enough to be a named defendant; if a legal action does not arise from a commercial activity, legal fees and settlement costs will not be deductible.
Know your limits
As long as there is no doubt that a lawsuit arises from a gainful 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 costs of resolving the dispute, whether the company pays damages to the plaintiff or agrees to settle the dispute. In addition, if a company defends itself against the government, any damage qualified as remedial or compensatory is deductible. The qualification of such damages in the settlement agreement is essential. Punitive and criminal fines and damages are
do not deductible. Consult with a tax attorney when it comes to negotiating a settlement agreement to ensure that the desired tax treatment of costs is built into the agreement.
Under the Tax Cuts and Jobs Act, companies are now prohibited from writing off litigation costs paid or incurred after December 22, 2017 in cases of harassment or sexual abuse subject to harassment. non-disclosure agreements. The excluded deduction applies to all legal fees, payments or settlements related to the case. While businesses are generally inclined to cover up 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 fixed asset are not immediately deductible, the costs associated with litigation concerning the acquisition of a fixed asset (or the defense of title to a fixed asset) can be characterized as capital expenditures. . Whether these costs are considered capital expenditure is determined by the activity that gives rise to the dispute. For example, if a lawsuit arises because a claimant disputes the validity of a merger transaction, the expenses incurred to defend the lawsuit should be capitalized because the claim is based on the acquisition of a fixed asset. . If, however, the plaintiffs allege that violations of securities law by the board of directors adversely affected the value of the plaintiffs’ shares after the merger, these defense costs will not be capitalized expenses because the claim is not. not related to the merger itself. .
Timing is everything
As with any deductible business expense, the timing of the write-off of expenses incurred in litigation depends entirely on the company’s accounting policy. For businesses that operate on cash, the deduction of eligible costs associated with litigation must be made in the year in which attorney fees, damages or settlement amounts are actually paid. For businesses that operate on the accrual basis of accounting, litigation costs are deductible in the year they are incurred. For example, an accrual-based business will deduct legal fees in the year the lawyer provides the legal services agreed to in the terms of engagement and the cost to the business of the services is known with certainty. In terms of settlement, an accrual-based taxpayer would deduct this cost once the settlement agreement is executed and the company’s payment amount is established. The deduction rules for taxpayers on an accrual basis in this context are fact-specific and complex, and a business should rely on its accountants to determine when these expenses are deductible.
No business welcomes a lawsuit with open arms, but knowing that related expenses are generally deductible can be comforting as the legal bills start to mount. Businesses should be aware of the limits on amortization of legal fees, damages, and settlements so that they can take full advantage of the deduction on their next tax return. To properly assess your situation, it is always best to consult a professional regarding the tax deductions available for costs incurred in the context of a dispute.
The content of this article is intended to provide a general guide on the subject. Specialist advice should be sought regarding your particular situation.
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