I paid legal fees fighting for both damages from my company and to dissolve it entirely -- can I deduct all of those legal fees on my Virginia return?

Plain-English summary

A husband who was both a shareholder and an employee of a company got into a legal and arbitration battle with it, seeking two very different things: (1) damages for wrongful dismissal and breach of his employment contract, and (2) judicial dissolution of the company itself. The company counterclaimed for breach of his own employment contract and fiduciary duties. He ultimately lost both of his claims. He and his wife deducted the legal and accounting fees from this dispute as itemized deductions on their 2017 Virginia return; the Department's audit disallowed the whole thing, and the couple appealed.

The key legal concept here is the "origin of the claim" test, used to sort litigation expenses into two very different tax buckets. Under IRC § 212, expenses paid to produce or collect income are deductible -- but expenses that are essentially the cost of acquiring or disposing of a capital asset are treated as nondeductible capital expenditures instead, no matter how the underlying case was actually framed or worded. The test looks at what the lawsuit was really about, not just its label: if winning would have produced ordinary taxable income (like back pay or damages), the related legal fees are deductible; if winning would have resulted in disposing of a capital asset (like liquidating a company and cashing out shareholder equity), the related fees are a capital cost instead.

Applying that split here: the husband's wrongful-termination and breach-of-employment-contract claims, if he'd won, would have produced taxable damages -- so legal and arbitration fees tied to those claims were deductible under IRC § 212(1), even though he ultimately lost. But his judicial dissolution claim, if successful, would have resulted in the company being dissolved and liquidated -- meaning it was really about disposing of his shares, a capital asset -- so fees tied to that claim were nondeductible capital expenditures under the "origin of the claim" doctrine, regardless of outcome.

Because his lawyer's invoices covered both kinds of claims at different points in the litigation, the Department had to sort through them: all of the 2017 payments to the arbitrator, and most of the 2017 payments to legal counsel, related to the employment claims and were deductible. But some 2015-dated invoices from his legal counsel related in part to the dissolution claim, and that portion was a nondeductible capital expenditure. Separately, the couple couldn't provide any invoices to show that payments to their accountant qualified as a deductible expense at all -- and a cancelled check alone, without an invoice showing what the payment was actually for, isn't enough to prove a deduction. The case was sent back to the auditor to recompute the assessment, excluding only the dissolution-related legal fees and the undocumented accountant fees from the allowable deduction.

What this means for you

Anyone deducting legal fees from litigation involving a business you own or work for

Break your legal invoices down by which specific claim they relate to, not just by case name -- fees tied to claims that would produce ordinary income if won (like wrongful termination or breach of an employment contract) are deductible, while fees tied to claims that would result in disposing of a capital asset (like dissolving a company or a buy-sell dispute over your shares) are nondeductible capital expenditures, even within the exact same lawsuit.

Taxpayers who lost their underlying legal claim

Losing doesn't disqualify the deduction -- what matters is what you would have gotten if you'd WON, not the actual outcome. Fees for a claim that would have produced taxable income remain deductible even if you lost.

Anyone trying to substantiate a professional-fee deduction with only a cancelled check

A cancelled check by itself doesn't prove what the payment was for. Keep the actual invoice or engagement description showing the nature of the service, not just proof that money changed hands.

Common questions

Q: Does it matter whether I actually won my lawsuit for the legal fees to be deductible?
A: No -- the "origin of the claim" test looks at what kind of outcome the claim was seeking (ordinary income vs. disposing of a capital asset), not whether you actually won or lost.

Q: My lawsuit against my own company covered several different claims -- do all the legal fees get the same tax treatment?
A: Not necessarily. Different claims within the same case can have different origins -- here, employment-related claims and a company-dissolution claim were treated completely differently, and the invoices had to be split accordingly.

Q: Can I deduct professional fees if I only have a cancelled check, not an invoice?
A: Generally no -- a cancelled check alone shows a payment was made but not what it was for. You typically need an invoice or similar documentation describing the nature of the services to substantiate the deduction.

Citations and references

• Va. Code § 58.1-301 (Virginia conformity to the IRC)
• Va. Code § 58.1-322.03(1) (Virginia itemized deduction conformity)
• IRC § 212 (deduction for expenses to produce/collect income or manage income-producing property)
• Treas. Reg. § 1.212-1(e), (n) (capital expenditures and tax-exempt income expenses excluded)
• Woodward v. Commissioner, 397 U.S. 572 (1970) and United States v. Hilton Hotels Corp., 397 U.S. 580 (1970) (origin-of-the-claim test for characterizing litigation expenses as capital)
• Ralph K.B. Clay, TC Memo 1981-375 (applying the origin-of-the-claim test)
• P.D. 19-78 (7/29/2019) and P.D. 20-40 (3/13/2020) (a cancelled check alone doesn't substantiate a deduction without supporting invoices)

Subject

Deduction: Itemized - Legal Expenses

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 22-127

Original ruling text

August 10, 2022

Re: § 58.1-1821 Application: Individual Income Tax

Dear *:

This will respond to your letter in which you seek correction of the individual income tax assessment issued to * and *** (the “Taxpayers”) for the taxable year ended December 31, 2017. I apologize for the delay in responding to your letter.

FACTS

The Taxpayers, a husband and wife, filed a Virginia resident income tax return for the 2017 taxable year claiming itemized deductions. Under audit, the Department requested information to support the deductions. After reviewing the information provided by the Taxpayers, the Department disallowed the deductions for legal and accounting expenses attributable to litigation regarding the husband’s ownership of, and employment by * (the “Company”). The Department adjusted the return and issued an assessment. The Taxpayers appeal, contending the information provided was sufficient to support the deductions claimed.

DETERMINATION

Virginia Code § 58.1-301 provides, with certain exceptions, that terminology and references used in Title 58.1 of the Code of Virginia will have the same meaning as provided in the Internal Revenue Code (IRC) unless a different meaning is clearly required. Conformity does not extend to terms, concepts, or principles not specifically provided in the Code of Virginia . For individual income tax purposes, Virginia conforms to federal law, in that it starts the computation of Virginia taxable income with federal adjusted gross income (FAGI). Income properly included in the FAGI of a Virginia resident is subject to taxation by Virginia, unless it is specifically exempt as a Virginia modification pursuant to Chapter 3 of Title 58.1 of the Code of Virginia .

As a general rule, the Department relies on the accuracy of information and computations reflected on the federal income tax return when reviewing Virginia individual income tax returns. If the information provided on the federal return looks reasonable, there is generally no reason to look behind those computations. The Department, however, retains the authority to adjust the FAGI and itemized deductions where there is clear evidence that the amounts reported on the federal or Virginia income tax return are not consistent with the IRC. See Virginia Code § 58.1-219.

Virginia Code § 58.1-322.03 1 allows an individual to deduct from their Virginia adjusted gross income certain amounts allowed for itemized deductions for federal income tax purposes. These deductions include those for medical expenses, charitable contributions and other expenses provided they are claimed in accordance with the IRC and its related regulations.

IRC § 212 allows individuals a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year - (1) for the production or collection of income; [or] (2) for the management, conservation, or maintenance of property held for the production of income . . . .” [Insert added.] Expenses for the production of tax-exempt income and capital expenditures are not allowed. See Treas. Reg. § 1.212-1(e), (n). Where litigation expenses are at issue, the origin of the underlying claim determines the character of the expense. This test characterizes an expenditure as capital if it is incidental to either the acquisition or disposition of a capital asset. See, e.g., Woodward v. Commissioner , 397 U.S. 572 (1970), United States v. Hilton Hotels Corp ., 397 US 580 (1970), and Ralph K.B. Clay , TC Memo 1981-375.

The expenses at issue originated from litigation and arbitration concerning the husband’s relationship with the Company as a shareholder and an employee. He sought both the judicial dissolution of the Company and damages for wrongful dismissal and breach of his employment contract. The Company also counterclaimed for breach of the husband’s employment contract and fiduciary duties to the Company.

The court did not sustain either of the husband’s claims. Had he succeeded, any awards for wrongful termination or breach of employment contract would have produced taxable income and, accordingly, expenses associated with those claims were deductible under IRC § 212(1). The husband’s claim for judicial dissolution, however, if successful would have resulted in the dissolution and liquidation of the Company. Expenses related to the dissolution claim, accordingly, were not deductible under IRC § 212(2) because the origin of the claim involved the disposition of a capital asset, namely the husband’s shares in the Company.

The Taxpayers provided detailed invoices and cancelled checks to support the expenses paid to the husband’s legal counsel and the arbitrator. An examination of the invoices reveals that all payments made in the 2017 taxable year to the arbitrator and the majority of the payments to his legal counsel were related to the husband’s claims for which a deduction is allowable under IRC § 212. Invoices dated in 2015 from the husband’s legal counsel, however, relate in part to the husband’s claim for judicial dissolution and, to that extent, they are nondeductible capital expenditures. Further, the Taxpayers have indicated that they cannot provide invoices to confirm that the payments to their accountant qualify for deduction under IRC § 212. The cancelled checks standing alone cannot support the deductibility of those expenses. See, e.g., Public Document (P.D.) 19-78 (7/29/2019) and P.D. 20-40 (3/13/2020).

Because the Taxpayers have shown that a portion of the legal expenses were eligible to be reported as itemized deductions, the assessment will be adjusted. In order to compute the allowable deduction, the amount claimed on the Taxpayers’ 2017 income tax return as originally filed must be adjusted to exclude the deduction of * paid to the husband’s legal counsel that is determined to be a nondeductible capital expenditure related to the dissolution claim. The disallowance of the deduction for the payment to the Taxpayers’ accountant is upheld.

In accordance with this determination, this case will be returned to the auditor to adjust the amount of allowable deduction. The Taxpayers will receive a revised notice of return adjustments. Because the Taxpayers paid most of the outstanding assessment, an updated bill or refund will be issued as warranted. The Taxpayers should remit any balance due within 30 days of the bill date to avoid the accrual of additional interest and possible collection actions.

The Code of Virginia sections and public documents cited are available online at www.tax.virginia.gov in the Laws, Rules, & Decisions section of the Department’s website. If you have any questions regarding this determination, you may contact * in the Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/3859.X

Related Documents

19-78

20-40