Are Criminal Defendants Permitted a Deduction of Legal Fees Relating to Criminal Activity?

Often criminal defendants ask if they are permitted a deduction of legal fees relating to criminal defense. As a general rule, criminal attorney fees are not tax-deductible. The Internal Revenue Code considers them personal in nature. However, in some cases, the crime which is alleged to have been committed arises in the context of the defendant’s profession or business. In order for legal fees relating to criminal activity to be deductible, they must be characterized as an “ordinary and necessary” of a trade or business. Section 162(a) of the Internal Revenue Code allows a deduction for all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. An ordinary and necessary expense is one which is appropriate and helpful to the taxpayer’s business and results from an activity that is common and accepted in the business. Amdahl Corp. & Consol.Subs. v. Commissioner, 108 T.C. 507, 523 (1997). Business expenses deductible from gross income include the ordinary and necessary expenditures directly connected with or pertaining to a taxpayer’s trade or business. Treas. Reg. Section 1.162-1(a). A taxpayer claiming a deduction must show that a reported business expense was incurred for business rather than personal reasons and that there was a proximate relationship between the expense and the business. See Walliser v. Commissioner, 72 T.C. 433, 437 (1979).

Origin and Character Test

The deductibility of legal fees also depends on the origin and character of the claim for which the expenses were incurred and whether the claim bears a sufficient nexus to the taxpayer’s business or income producing activity. See United States v. Gilmore, 372 U.S. 39, 48-49 (1963). The Supreme Court has stated that “the origin and character of the claim with respect to which an expense was incurred, rather than its potential consequences upon the fortunes of the taxpayer, is the controlling basic test. Id. at 49. If the claim arises “in connection with the taxpayer’s profit-seeking activities,” the fees are deductible; if not, they are not deductible. Id. at 48. Public policy does not prohibit the deduction of legal fees relating to criminal activity so long as the legal fees are an ordinary and necessary expense of a trade or business. See Commissioner v. Tellier, 687, 694-95 (1966).

Thus, for legal fees incurred in the defense of criminal cases to be deductible, there must be a nexus between the crime which was alleged to have been committed and the defendant’s business. For example, a management consultant cannot deduct legal expenses incurred in defending a charge against him for fraudulently selling securities because he was not in the business of selling securities. See Daniel Price v. Commissioner, T.C. 1973-65 T.C.M. (1973). With that said, in Tellier, the U.S. Supreme Court allowed a deduction for the unsuccessful defense of a criminal prosecution by a securities dealer convicted of violating the 1933 Securities Act and mail fraud statutes in conducting his business. The Tellier decision was noteworthy not only in the fact that it overturned several lower court cases, but also in fact that it made irrelevant the success or failure of the defense of the criminal charges.

It should be understood that if the nexus between the trade or business and the alleged crime is not particularly strong, the deduction will probably be denied by the Internal Revenue Service (“IRS”). For example, the fact that a defendant’s business will be destroyed if he or she is convicted of a crime does not provide adequate nexus to claim legal fees as a deduction. See Hylton v. Commissioner, T.C. Memo 1973-262 (1973). Further, even if a conviction may disqualify a defendant from engaging in a business or profession, if the claim does not arise out of the business or profession to begin with, the legal fees will not be deductible. See Patch v. Commissioner, T.C. Memo. 1980-11 (1980).

Conclusion

As discussed above, although seemingly against public policy, legal fees relating to criminal activity may be deducted as an ordinary and necessary expense of a trade or business. However, the ultimate deductibility of criminal legal fees will depend on the origin and character of the claim for the expense and whether the legal fees bear a sufficient nexus to the defendant’s business or income producing activity.

Anthony Diosdi is a tax attorney at Diosdi & Liu, LLP. Anthony frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.

This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.