Taxpayers often come to advisers seeking a way to claim a deduction for legal fees. As we are aware, the IRC doesn’t provide a provision that broadly allows a deduction for legal fees. Rather, taxpayers must find a provision in the IRC that allows a deduction for expenses of a type in which the current legal fees can be categorized.

The search for a provision under which to claim a deduction for legal fees was undertaken recently by the taxpayer in the case of Barry v. Commissioner, TC Memo 2017-237. In this case the taxpayer had incurred over $25,000 of legal fees in an unsuccessful attempt to recover what he claimed was alimony which he had paid to his wife in excess of what was allowed under their agreement.

Mr. Barry’s attempt to obtain the overpaid alimony from his ex-spouse eventually failed when the court in which he had filed suit dismissed the case due to it being filed after the statute of limitations for such a claim had expired.

The general rule for determining whether legal fees are deductible by a taxpayer is referred to as the “origin of the claim” test. Under this test, established in the U.S. Supreme Court case of United States v. Gilmore, 372 U.S. 39 (1963) the taxpayer attempting to claim a deduction for legal fees must show that origin of the claim in question arose from a profit making, rather than personal, activity even if the result of the legal case might have various consequences on the financial condition of the taxpayer.

If the origin of the claim is a personal issue, then the deduction is barred under IRC §262(a). However, if the claim originates in, say, the production or collection of income or the management conservation or maintenance of property held for the production of income, then the expenses would be deductible under IRC §212. Specifically, in a divorce related case, the origin of the claim would generally be regarded as personal (and therefore the expenses nondeductible) if the claim would not have arisen but for the marriage.

That would appear to create a major barrier for the taxpayer in this case, but the taxpayer argued that his case was different from the situation in Gilmore. As the Court explained the taxpayer’s rationale:

They contend, however, that Gilmore and Patrick are distinguishable as involving taxpayers whose claimed deductions were based on specific language of the Code, now found in section 212(2), allowing a deduction for expenses paid or incurred “for the * * * conservation * * * of property held for the production of income”. By contrast, petitioners rely upon section 212(1), which allows a deduction for expenses paid or incurred “for the production * * * of income”. Because Mr. Barry’s lawsuit was for the purpose of recovering allegedly overpaid alimony, which petitioners equate with “the production * * * of income”, they say the deduction of the associated legal expenses is not barred by the origin-of-the-claim test.

However, the Court found that this distinction did not make a difference, and that the general origin of the claim test would still apply to an attempt to recoup overpaid alimony deducted in a prior year.

The Court pointed to a prior District Court case that specifically disallowed a deduction for legal expenses related to overpaid alimony, noting:

And in a case presenting the very question presented to us today--the deductibility under section 212(1) of legal expenses incurred in an attempt to recoup allegedly wrongfully paid alimony--a District Court disallowed the claimed deduction, relying upon Sunderland and its application of the Gilmore origin-of- the-claim test. Favrot v. United States, 550 F. Supp. 809 (E.D. La. 1982).

But the taxpayer protested that legal fees paid by a potential recipient of alimony to attempt to obtain or increase such payment has been held to be deductible, so he should get the same treatment since, had he been successful, the repayment of the alimony would have includable in gross income under the tax benefit rule.

While agreeing any recovery would have been taxable, the Court found that the cases dealing with deducting legal fees to obtain alimony did not base their rulings on the question of whether the payment in question would have been includable in the taxpayer’s income had he/she been successful.

Contrary to the teaching of Gilmore, petitioners’ argument focuses improperly on the potential consequences of Mr. Barry’s lawsuit--the putative inclusion of the recovered proceeds in petitioners’ gross income under the tax benefit rule--rather than upon the origin and character of his claim. Moreover, the holding in Wild does not turn, as petitioners seem to suggest, simply on the question of whether the amounts sought to be recovered in the legal proceedings would have been includible in gross or taxable income. Rather, Wild relied on regulations which contain an exception to the general rule that was applied in Gilmore and Patrick. Sec. 1.262-1(b)(7), Income Tax Regs. That regulatory exception “relates solely to expenses incurred by the wife for the production or collection of amounts ‘includible in gross income under section 71,’ which deals with the taxability of alimony and similar amounts received by a wife as separate maintenance or support in connection with the marital relationship.” Wolfson v. Commissioner, 47 T.C. 290, 294 (1966).6 Petitioners do not contend that this regulatory exception applies to Mr. Barry’s claimed legal expenses, and the record does not support any such contention.

The Court expanded on why this regulation would not help Mr. Barry in a footnote to the above analysis, pointing out:

Although the amount Mr. Barry sought to recover from Ms. Barry was attributable to allegedly overpaid alimony, any amount he recovered as a result of his legal action would not have been includable in income as alimony under sec. 71. In order to qualify as alimony, a cash payment must satisfy four requirements, including that “such payment is received by (or on behalf of) a spouse under a divorce or separation instrument”. Sec. 71(b)(1)(A). Because Mr. Barry’s claim against Ms. Barry was for breach of contract and sought to recover alimony allegedly overpaid, any amount recovered would not be “under a divorce or separation instrument.” Therefore, any recovery on that cause of action would not be alimony under sec. 71, and the associated legal fees would not come within the ambit of the second sentence of sec. 1.262-1(b)(7), Income Tax Regs.