Whether a taxpayer can claim a deduction for legal expenses generally depends on the origin of the claim giving rise to the legal expense.  This means that even if the legal expense might arguably have an impact on one activity (say, a new trade or business the taxpayer is establishing) it will not be deductible as part of that activity if the claim originated elsewhere.  The case of Dulik v. Commissioner, TC Summ. Op. 2017-51 deals with this issue.

In this case the taxpayer was negotiating a separation agreement from his former employer.  In doing so he paid $26,781 in legal fees related to various issues in negotiating that agreement, specifically looking to get removed from the agreement a reference to a secrecy agreement he had signed with a predecessor of his current employer which contained a non-compete agreement.

The deduction was claimed on the tax return for an S corporation he had formed to start performing consulting services.  The IRS, while agreeing that the legal fees are deductible, took the position that the expenses were those of Mr. Dulik personally and that, rather than being deducted in computing adjusted gross income as part of an S corporation loss, they are only deductible as miscellaneous itemized deductions.

Per the Court, the taxpayer’s position was as follows:

Petitioners assert that after Nycomed terminated Mr. Dulik’s employment he was “pursuing his business” and seeking to work as an independent contractor consulting for the pharmaceutical industry; but because of the noncompete covenant of the secrecy agreement, no one would hire him. Mr. Dulik testified that he signed the severance agreement because he would have had to forgo his severance pay if he had not signed it. Mr. Dulik also testified that he did not incorporate AED until September 2010 because “[o]riginally when I started the business it was going to be a Schedule C proprietorship * * * later in 2010 I formed a subchapter S corporation fearing * * * legal issues could arise out of some of my activities.”

Petitioners do not assert that the claim against Nycomed was rooted in Mr. Dulik’s consulting business; instead they contend that the origin of the claim is Nycomed’s restriction on Mr. Dulik’s ability to work. Petitioners assert that Mr. Dulik hired counsel solely to renegotiate the terms of the severance agreement, so that he could operate a business as a consultant in the pharmaceutical industry. Mr. Dulik testified that but for his desire to work in the pharmaceutical industry he would have not hired counsel; for example, if he had wanted to work as a C.P.A. for an accounting firm, he would not have tried to negotiate the terms of the severance agreement.

The Tax Court did not find Mr. Dulik’s position to be correct.  Rather, the Court held:

Although the terms of the severance agreement may have prevented Mr. Dulik from operating a consulting business in the pharmaceutical industry, we look to the origin of the claim, not to the potential consequences of a win or loss in negotiating the terms of the severance agreement. Mr. Dulik’s claim arose from his status as a former employee of Nycomed, not from his consulting business. He hired attorneys because he was trying to negotiate the terms of the severance agreement proffered in connection with the termination of his employment at Nycomed. See Gilmore, 372 U.S. at 49; Kenton v. Commissioner, 2006 WL 237112, at *2-*3; Test v. Commissioner, 2000 WL 1738858, at *4. We conclude that petitioners are not permitted to deduct the legal fees as ordinary and necessary business expenses of Mr. Dulik’s consulting business as a flowthrough from AED. However, petitioners are entitled to $26,3256 as a miscellaneous itemized deduction on Schedule A, subject to the limitations set forth supra. See secs. 56(b)(1)(A)(i), 67(a) and (b), 68, 211, 212(1).