Legal Expenses: Capital Expenditure or Business Expense?

Here is an interesting excerpt from a CFO magazine article on CFO.com. The article, When Are Legal Costs Nondeductible by Robert Willens discusses a specific court case. However, the decisions provided by the court (and later supported on appeal) to clarify nondeductible legal fees are applicable to many businesses. See the excerpt below. The emphasis is provided by me.

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In its analysis, the appeals court explained the difference between a capital expenditure and an ordinary and necessary business expense via examples. The cost of buying a building, for instance, is a capital expenditure because a building has “a useful life substantially beyond the taxable year,” which is the legal definition of “capital expenditure.”

A capital expenditure isn’t deductible as a business expense in the year in which it’s made. Instead it must be depreciated over its useful life, and the amount of depreciation each year is all that’s deductible that year, according to the appeals court. Thus, as required by tax law, cost is matched temporally with revenue.

In contrast, the court reasoned, business expenses incurred in the course of day-to-day operations are ordinary business expenses. If they’re also “necessary” (meaning “appropriate and helpful”), they’re deductible from the business’s taxable income in the year in which they’re incurred.

Thus, in the court’s example, repairs to a building that preserve but do not enhance the building’s value can be expensed. On the other hand, improvements intended to boost the building’s value must be capitalized.

Like repairs that prevent a building from collapsing, expenses paid out to defend title to the building are incurred to protect the building against what, from the owner’s standpoint, might be a loss equivalent to its collapsing. “But such expenditures, because incurred to defend (or assert) the ownership of a capital asset, cannot be expensed,” the court stated in its decision.

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What this means is that the origin of the legal claim being defended against is important, as is the intent behind that legal claim. If you incur legal fees in the daily operation of your business, those fees can be expensed. Defending your company against an employee wrongful termination suit or against the city in which you operate who sues you for unpaid taxes or against a customer or supplier for contractual non-performance are all deductible business expenses. However, if you incur legal fees to defend the company against another shareholder who disputes the business’ valuation or you are sued for contractual non-performance on the sale of a significant company asset such as land, real estate, or manufacturing equipment, then those are nondeductible legal fees. Instead they must be treated as a capitalized expense, added to the balance sheet, then depreciated over its useful life. The depreciation amount is all that can be expensed on a yearly basis.

What’s the underlying difference? What determines whether or not your legal costs are nondeductible? If the intent behind the suit or legal expenses is to maintain or increase the value of a major asset, then the legal expense is a capital expenditure (and thus nondeductible legal fees). For all other legal expenses incurred to keep your business humming along and operating smoothly, those legal expenses are operating expenses and fully deductible in the year incurred.

One caveat: All the legal fees eventually flow through the income statement. The timing of that flow is the issue here. Whether all the legal fees can be expensed in one year or depreciated (and that depreciation amount expensed) over ten or 15 years…or more.

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About Tiffany C. Wright - The Resourceful CEO

Tiffany C. Wright is the author of “The Funding Is Out There! Access the Cash You Need to Impact Your Business” and “Solving the Capital Equation: Financing Solutions for Small Businesses.” She is the founder of The Resourceful CEO, which helps owners of small/medium-sized businesses prepare their businesses for sale. Tiffany has an MBA from the Wharton School of Business, sits on non-profit boards and serves as a business mentor with the Cherie Blair Foundation.
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