Understanding Legal Fees During Estate Planning
The legal fees incurred in connection with estate planning are legal fees an individual or surviving spouse can deduct under I.R.C. § 671(c), whether the estate plan includes a trust or a will. Examples of legal fees which can be deducted as part of an estate plan are preparation of a will, establishment of inter vivos or revocable trusts, and preparation of durable powers of attorney. Legal fees related to charitable giving or to the sale or transfer of property are not considered deductible legal expenses for estate planning purposes.
An individual is not entitled to deduct legal fees (plus other expenses related to administration of the estate) that exceed 2% of his or her adjusted gross income. However , married individuals filing a joint return are entitled to deduct the legal fees related to the administration of estates, if each of the individuals’ share of 2% (or the combined share of 4%) would exceed the amount of that threshold. The deduction of these fees may still be limited by other provisions of the tax code, so it is always advisable to consult with a CPA regarding the financial impact of this portion of the estate plan.
IRS Rules Regarding Deductible Legal Expenses
IRS rules on deductibility of legal fees are found in sections 212 and 262 of the Internal Revenue Code and in various Treasury regulations. IRS code section 212 allows tax deductions for expenses which are ordinary and necessary for the production or collection of income, or the management, conservation, or maintenance of property held for the production of income. For example, deductibility may be allowed for legal costs incurred as part of an investment, like real estate.
On the other hand, IRS code section 262 disallows deductions for personal expenditures. IRS regulations state that "A taxpayer must take his expenses ‘as expenses relate to his total adjusted gross income rather than the separate items of income which generated them.’" In other words, there must be a connection between the fees paid and the kind of income or property from which the fee arises. If the expense cannot be directly associated with a particular item of income, it is not deductible.
IRS revenue rulings and publications as well as private letter rulings also provide guidance on whether legal fees may be deducted. IRS revenue ruling 76-310 states that filing expenses are directly related to regularly scheduled income tax liability, and that legal fees paid to organize a business are directly related to the apparently taxable business income and are therefore deductible. IRS revenue ruling 81-186 states that legal fees incurred in establishing and maintaining a trust may be deductible as a miscellaneous itemized deduction as long as the fees relate to the production or collection of income or the management of property held for the production of income.
When Estate Planning Fees are Not Deductible
Unfortunately, there are certain circumstances where legal fees for estate planning are not deductible. Here are some common situations:
- Personal Expense – A tax savings that does not relate directly to business or future business is generally considered a personal expense, which is not an allowable deduction for federal income tax purposes. In other words, even though you may enjoy the fact that you did some estate planning that saved you some money later on, the IRS does not consider that a business deduction.
- Hobby Activity – Similarly, if the estate planning activity involves something for business purposes but is more like a hobby, the deduction may not be available. If you can demonstrate that even though the activity involved some other element of expense, the primary focus was business, it may still qualify. You should discuss this with a tax advisor in the event you are uncertain.
- Creating a Joint Trust – If you have an existing trust in place and create a new trust in order to create a joint trust, there will be no tax deduction for the cost of doing so. Since you already had an estate plan, these legal fees were considered for creating a new trust, not planning ahead to save tax.
Legally Deductible Estate Planning Legal Fees
In some instances, legal fees related to an estate plan may be deductible. While the Internal Revenue Code does not carve out specific fees for deduction consideration, the IRS allows deduction of fees provided that they are incurred in order to produce income. A deduction, however, is not available for fees "allocable to production of tax-exempt income or relating to a claim of a type which could have been handled on a purely personal level." However, if a professional service can be separated into its law and non-law components, the latter may allocate the fee away from the former and possibly qualify for a deduction. Thus, fees to create wills, trusts and other estate planning instruments typically are not deductible, but fees paid to producing income might be. For instance, in regard to trust income, if a client’s revocable trust generates interest or dividends that otherwise would be attributable to the settlor, a deduction is permitted as long as the fees relate to income-producing interests . Also, deductions might be available for fees paid for investment and tax advice. However, legal fees for property purchase negotiations would not be deductible because the property involved was not held for the production of income. Separately, fees for creating or defending a will, trust or similar instrument generally are deductible on the estate’s Income Tax Return (Form 1041), and the cost of administering an estate also may be deductible on the Form 1041. In addition, fees incurred within the initial three months of an estate’s creation, for instance through settlement of a decedent’s final tax return, may be deductible on the decedent’s final Income Tax Return (Form 1040). Such deductible fees otherwise will reduce taxable income for the year, effectively passing on savings to the client.
Documenting Legal Fees for the IRS
When it comes to tax reporting, the person receiving a tax benefit is typically required to maintain documentation sufficient to satisfy IRS requirements. Taxpayers, therefore, should retain all invoices, receipts and documentation from legal professionals concerning legal services relating to estate planning and distribution.
A good policy is to work with your legal professional to ensure that the invoices and/or receipts clearly detail: All invoices and receipts should be itemized and describe the dates of services, hours spent and rates charged. You should also keep copies of relevant correspondence, pleadings and other court documents, and any receipts for client costs and disbursements. In some cases, related invoices may be combined or summarized in one invoice. In this case, you should ask that the attorneys notate the timekeeper’s name next to the timekeeper’s billing on the invoice.
You should also provide your attorney with information about potential deductions prior to incurring any legal fees and expenses so that the attorney may detail how certain expenses may be deductible. Your attorney may be able to draft a letter or include a statement on the final invoice.
Consulting a Tax Expert
The situations discussed in the prior sections are complex and the laws surrounding them may have changed or are subject to interpretation. To get a through understanding of whether legal fees from Estate or Trust Planning are deductible under current tax laws , we recommend consulting a CPA or tax advisor to get the most up-to-date guidance related to tax compliance.
Consulting a CPA or tax advisor is important for a few reasons: