Divorce Attorney Fees

More frequently than not, the divorce attorney will receive a call from the client who has paid his or her bill, inquiring as to what portion of attorney's fees paid can be deductible for income tax purposes. The client's accountant advised that he/she needed an opinion from his/her attorney and a letter allocating the deductible portion of what was paid for income tax purposes. The client may have paid a princely sum and will want to deduct as much as possible.

Unless the attorney is one who limits his or her practice to tax matters and gave advice solely concerning the tax consequences of a proposed marital settlement agreement, the portion of fees that can be tax deductible will be severely limited. The client will be in for a surprise because attorneys' fees for the services of the divorce lawyer are deductible only for services attributable to tax advice, and which were incurred for the production of taxable income; to-wit: alimony that meets the provisions of I.R.C. ' 71.

Furthermore, even for fees that are attributed to services that are in fact deductible, they are such only as part of the miscellaneous itemized deductions. These miscellaneous itemized deductions can only be deducted to the extent that, in the aggregate, they exceed 2% of the taxpayer's adjusted gross income. Taxpayers whose miscellaneous itemized deductions do not total more than 2% of adjusted gross income will not be able to deduct any amount of attorneys' fees.

Fees Related to Tax Advice

It will not help a client who wants to deduct a portion of fees paid to the divorce attorney if the attorney specifically excludes the giving of the tax advice. Too often, attorneys insert in the marital settlement agreement a clause that provides: “Each of the parties acknowledges that they have received no tax advice in connection with this Agreement from the aforementioned attorneys and each has been advised to seek independent tax advice from accountants or tax attorneys of their own individual choosing.”

If such language is included in the agreement, most certainly the client will be precluded from deducting any portion of fees paid unless they are attributed to the production of taxable income. One wonders why such a clause is inserted and just who is being protected by it?

There are many areas about which the divorce attorney can and should give advice having tax implications. They include, but certainly are not limited to, the following:

• The tax implications of the form of alimony that is provided.
• The possibility and avoidance of creating recapture under the rule for recomputation of front-loaded alimony payments in the first 3 post-separation years.
• The tax effect of unallocated alimony and child support.
• The tax impact of child support and its involvement with alimony.
• The proper structure of temporary (pendente lite) alimony.
• Tax deductibility of a property payout.
• The tax effect of the distribution of property, including qualified retirement plans and IRAs.
• Taxability or deductibility of interest payments on installments to equalize distribution of property.
• The tax implication of the sale of a principal residence.
• The deductibility of interest payments on the mortgage encumbering the marital residence.
• The transfer or award of stock options.
• The allocation of the dependency exemption and child tax credit.
• The execution or refusal to sign a joint tax return.
• The deductibility of attorneys' fees.

The Production of Taxable Income

Fees attributable to obtaining a dissolution of marriage are not deductible to the taxpayer who pays. Consequently, the professional services and the costs related to the preparation of pleadings, court appearances and negotiations for the dissolution are viewed as personal and are not allowable as a deduction. Likewise, notwithstanding that considerable fees are generated in custody, visitation and child support controversies, because they do not involve the production of taxable income, such fees are not deductible. Moreover, fees incurred to obtain spousal support that is designated as nontaxable do not qualify as deductible.

Only fees attributable to obtaining alimony that is taxable to the recipient qualify for the production of taxable income. Alimony that can be taxable to the recipient, and thus deductible to the payor: 1) must be paid in cash; 2) must be to, or on behalf of, the recipient; 3) must be pursuant to a divorce or separation instrument; 4) must be payments that are not designated as nontaxable/nondeductible; 5) must be for parties whose status of marriage changes and who live in separate households; 6) must be the liability for payment of which ceases on the death of the payee; 7) must be payments that are not fixed as child support; 8) must be for parties who file separate returns.

Fees for collecting taxable spousal support in arrears are deductible. A distinction must be drawn between includible spousal support, on the one hand, and child support which is not includible as taxable income. Fees for the collection of child support will not be deductible.

Fees in connection with securing an increase in taxable alimony will be deductible. Legal fees incurred in an unsuccessful attempt to secure alimony or other taxable income should be deductible. However, legal fees paid to resist the collection of taxable alimony by the other spouse are not deductible; nor are fees for a successful attempt to reduce his (or her) alimony obligation.

Fees for Obtaining or Protecting Income-Producing Property

Fees for obtaining or protecting income-producing property are not deductible. The fees can, however, be added to the tax basis of the property. There is a problem, however, in the area of basis adjustment. If a number of assets are received and the fees are not specifically allocated among the various assets, the IRS may successfully argue for a pro rata allocation of fees.

Fees Paid By One Spouse to the Attorney of the Other Spouse

Only fees paid to a spouse's own attorney will qualify under any of the above-mentioned rules. However, the fees of the other party may be deducted, if paid as alimony. Prior to the 1984 amendment to the alimony provision of the Code, I.R.C. ' 71, this method was frequently negotiated. However, now it could violate the anti-front loading rule, resulting in recapture, unless timed properly.

If fees can be paid out over a period of time so as not to violate the anti-front loading rule, the Code allows payments to be deductible if they are received by the spouse or on behalf of the spouse. Therefore, payments to a third party (ie, the spouse's attorney) could be deductible. The divorce instrument should make it clear that it is the payee's obligation that the payor is satisfying, not an obligation of the payor. Caution is advised in that there must be specific language that the liability for payments ceases on death of the payee.

Temporary (Pendente Lite) Attorneys' Fees Awarded for Adverse Party

The payment of an award of attorneys' fees in a temporary order for support may be taxable/deductible as alimony if it meets the criteria of the Code; the most significant requirement for a temporary order is that there may be no liability to make such payment after the death of the spouse who is benefited. Thus, if the order specifically provides for cessation of liability for the payment of fees or if the liability ceases by virtue of state law, the cessation on death requirement would be met. Since the anti-front-loading rule does not apply to orders for temporary support, this is a fertile area for deducting fees as alimony. Of course, the sums paid will be taxable alimony to the payee.

Fees Paid Out of Spouse's Business Entity

Fees paid by a business entity for the client's divorce proceeding would not ordinarily be a deductible business expense to the business, and would be deemed taxable income to the person for whom it was paid. However, if the business entity is joined as a party to the action, an argument can possibly be made that a good portion of the fees are attributable to protection of that business and will, therefore, be allowed by the IRS.

Allocation of Fees

Attorneys should be prepared to allocate all fees charged by deductible and nondeductible services. If no specific dollar amount is allocated to each deductible service, the deduction may be disallowed by the IRS. As stated by Thomas S. Forkin, Esq. of Cherry Hill, NJ (Divorce Law Education Institute, Vail, CO, January, 1985):

“The recommended and generally accepted procedure is to code the time sheets as '212(1) or '12(3) services and itemize what was done on that particular day the time entry was made. Detailed itemization and segregation of tax-deductible services from non-tax services is absolutely critical and essential. Automatic percentage allocation of fees is unacceptable and should not be engaged in by counsel.”

Factors in arriving at allocated fee include:

• Time: The most conservative app- roach is to specify in each billing the number of hours spent on tax matters and the dollar total of the fees allocated to tax matters.
• Complexity: The amount of time is not the only criterion. The complex nature of tax law usually justifies greater fees attributable for such matters.
• Legal issues involved.
• Fees customarily charged in the locality for similar services.
• The results obtained.

The better practice is for the attorney to allocate fees on each invoice sent to the client in the following manner:

• Non-deductible Fees. These are fees relating to securing the divorce, custody, child support, etc.
• Deductible Fees. These are fees relating to the production of taxable income, ie, securing the taxable alimony and for the determination, collection or refund of any tax, ie, for tax advice.
• Fees that are not deductible for the management, conservation or maintenance of income-producing property, but which may be added to the basis of the property to which they relate. Thus, fees relating to the acquisition of income-producing real estate, stocks, bonds, or other income-producing property should be specified.

If it is not possible for the attorney to allocate fees on each invoice, an allocation should be made and transmitted to the client before the end of each calendar year during which services are rendered.

Further Limitation on Deductibility of Fees

In addition to the limitation for the miscellaneous itemized deduction referred to at the beginning of this article, for individuals whose adjusted gross income exceeds a particular threshold (which is adjusted annually for inflation), the amount of itemized deductions otherwise allowable shall be reduced by the lesser of:

• Three percent of the excess of adjudged gross income over the threshold, or
• Eighty percent of the amount of the itemized deductions otherwise allowable for such tax year.
• The threshold for 2004 is $142,700 ($71,350 if married filing separately).

Caveat

An attorney should not give tax advice unless he or she is knowledgeable about such matters. If the attorney is not current on these matters, he or she should seek the advice of competent tax counsel or a CPA who is experienced in evaluating and calculating the tax consequences of divorce settlements. The attorney must have on hand one of several divorce tax texts (one of which is written by this author and published by James Publishing, Inc., 3505 Cadillac Avenue, Suite H, Costa Mesa, CA. Phone: 1-800-394-2626, Web site: http://www.jamespublishing.com/).

A penalty could be applied to an attorney who misallocates the deductibility of the fee in such a manner as to aid the client in understating the client's tax liability.

More frequently than not, the divorce attorney will receive a call from the client who has paid his or her bill, inquiring as to what portion of attorney's fees paid can be deductible for income tax purposes. The client's accountant advised that he/she needed an opinion from his/her attorney and a letter allocating the deductible portion of what was paid for income tax purposes. The client may have paid a princely sum and will want to deduct as much as possible.

Unless the attorney is one who limits his or her practice to tax matters and gave advice solely concerning the tax consequences of a proposed marital settlement agreement, the portion of fees that can be tax deductible will be severely limited. The client will be in for a surprise because attorneys' fees for the services of the divorce lawyer are deductible only for services attributable to tax advice, and which were incurred for the production of taxable income; to-wit: alimony that meets the provisions of I.R.C. ' 71.

Furthermore, even for fees that are attributed to services that are in fact deductible, they are such only as part of the miscellaneous itemized deductions. These miscellaneous itemized deductions can only be deducted to the extent that, in the aggregate, they exceed 2% of the taxpayer's adjusted gross income. Taxpayers whose miscellaneous itemized deductions do not total more than 2% of adjusted gross income will not be able to deduct any amount of attorneys' fees.

Fees Related to Tax Advice

It will not help a client who wants to deduct a portion of fees paid to the divorce attorney if the attorney specifically excludes the giving of the tax advice. Too often, attorneys insert in the marital settlement agreement a clause that provides: “Each of the parties acknowledges that they have received no tax advice in connection with this Agreement from the aforementioned attorneys and each has been advised to seek independent tax advice from accountants or tax attorneys of their own individual choosing.”

If such language is included in the agreement, most certainly the client will be precluded from deducting any portion of fees paid unless they are attributed to the production of taxable income. One wonders why such a clause is inserted and just who is being protected by it?

There are many areas about which the divorce attorney can and should give advice having tax implications. They include, but certainly are not limited to, the following:

• The tax implications of the form of alimony that is provided.
• The possibility and avoidance of creating recapture under the rule for recomputation of front-loaded alimony payments in the first 3 post-separation years.
• The tax effect of unallocated alimony and child support.
• The tax impact of child support and its involvement with alimony.
• The proper structure of temporary (pendente lite) alimony.
• Tax deductibility of a property payout.
• The tax effect of the distribution of property, including qualified retirement plans and IRAs.
• Taxability or deductibility of interest payments on installments to equalize distribution of property.
• The tax implication of the sale of a principal residence.
• The deductibility of interest payments on the mortgage encumbering the marital residence.
• The transfer or award of stock options.
• The allocation of the dependency exemption and child tax credit.
• The execution or refusal to sign a joint tax return.
• The deductibility of attorneys' fees.

The Production of Taxable Income

Fees attributable to obtaining a dissolution of marriage are not deductible to the taxpayer who pays. Consequently, the professional services and the costs related to the preparation of pleadings, court appearances and negotiations for the dissolution are viewed as personal and are not allowable as a deduction. Likewise, notwithstanding that considerable fees are generated in custody, visitation and child support controversies, because they do not involve the production of taxable income, such fees are not deductible. Moreover, fees incurred to obtain spousal support that is designated as nontaxable do not qualify as deductible.

Only fees attributable to obtaining alimony that is taxable to the recipient qualify for the production of taxable income. Alimony that can be taxable to the recipient, and thus deductible to the payor: 1) must be paid in cash; 2) must be to, or on behalf of, the recipient; 3) must be pursuant to a divorce or separation instrument; 4) must be payments that are not designated as nontaxable/nondeductible; 5) must be for parties whose status of marriage changes and who live in separate households; 6) must be the liability for payment of which ceases on the death of the payee; 7) must be payments that are not fixed as child support; 8) must be for parties who file separate returns.

Fees for collecting taxable spousal support in arrears are deductible. A distinction must be drawn between includible spousal support, on the one hand, and child support which is not includible as taxable income. Fees for the collection of child support will not be deductible.

Fees in connection with securing an increase in taxable alimony will be deductible. Legal fees incurred in an unsuccessful attempt to secure alimony or other taxable income should be deductible. However, legal fees paid to resist the collection of taxable alimony by the other spouse are not deductible; nor are fees for a successful attempt to reduce his (or her) alimony obligation.

Fees for Obtaining or Protecting Income-Producing Property

Fees for obtaining or protecting income-producing property are not deductible. The fees can, however, be added to the tax basis of the property. There is a problem, however, in the area of basis adjustment. If a number of assets are received and the fees are not specifically allocated among the various assets, the IRS may successfully argue for a pro rata allocation of fees.

Fees Paid By One Spouse to the Attorney of the Other Spouse

Only fees paid to a spouse's own attorney will qualify under any of the above-mentioned rules. However, the fees of the other party may be deducted, if paid as alimony. Prior to the 1984 amendment to the alimony provision of the Code, I.R.C. ' 71, this method was frequently negotiated. However, now it could violate the anti-front loading rule, resulting in recapture, unless timed properly.

If fees can be paid out over a period of time so as not to violate the anti-front loading rule, the Code allows payments to be deductible if they are received by the spouse or on behalf of the spouse. Therefore, payments to a third party (ie, the spouse's attorney) could be deductible. The divorce instrument should make it clear that it is the payee's obligation that the payor is satisfying, not an obligation of the payor. Caution is advised in that there must be specific language that the liability for payments ceases on death of the payee.

Temporary (Pendente Lite) Attorneys' Fees Awarded for Adverse Party

The payment of an award of attorneys' fees in a temporary order for support may be taxable/deductible as alimony if it meets the criteria of the Code; the most significant requirement for a temporary order is that there may be no liability to make such payment after the death of the spouse who is benefited. Thus, if the order specifically provides for cessation of liability for the payment of fees or if the liability ceases by virtue of state law, the cessation on death requirement would be met. Since the anti-front-loading rule does not apply to orders for temporary support, this is a fertile area for deducting fees as alimony. Of course, the sums paid will be taxable alimony to the payee.

Fees Paid Out of Spouse's Business Entity

Fees paid by a business entity for the client's divorce proceeding would not ordinarily be a deductible business expense to the business, and would be deemed taxable income to the person for whom it was paid. However, if the business entity is joined as a party to the action, an argument can possibly be made that a good portion of the fees are attributable to protection of that business and will, therefore, be allowed by the IRS.

Allocation of Fees

Attorneys should be prepared to allocate all fees charged by deductible and nondeductible services. If no specific dollar amount is allocated to each deductible service, the deduction may be disallowed by the IRS. As stated by Thomas S. Forkin, Esq. of Cherry Hill, NJ (Divorce Law Education Institute, Vail, CO, January, 1985):

“The recommended and generally accepted procedure is to code the time sheets as '212(1) or '12(3) services and itemize what was done on that particular day the time entry was made. Detailed itemization and segregation of tax-deductible services from non-tax services is absolutely critical and essential. Automatic percentage allocation of fees is unacceptable and should not be engaged in by counsel.”

Factors in arriving at allocated fee include:

• Time: The most conservative app- roach is to specify in each billing the number of hours spent on tax matters and the dollar total of the fees allocated to tax matters.
• Complexity: The amount of time is not the only criterion. The complex nature of tax law usually justifies greater fees attributable for such matters.
• Legal issues involved.
• Fees customarily charged in the locality for similar services.
• The results obtained.

The better practice is for the attorney to allocate fees on each invoice sent to the client in the following manner:

• Non-deductible Fees. These are fees relating to securing the divorce, custody, child support, etc.
• Deductible Fees. These are fees relating to the production of taxable income, ie, securing the taxable alimony and for the determination, collection or refund of any tax, ie, for tax advice.
• Fees that are not deductible for the management, conservation or maintenance of income-producing property, but which may be added to the basis of the property to which they relate. Thus, fees relating to the acquisition of income-producing real estate, stocks, bonds, or other income-producing property should be specified.

If it is not possible for the attorney to allocate fees on each invoice, an allocation should be made and transmitted to the client before the end of each calendar year during which services are rendered.

Further Limitation on Deductibility of Fees

In addition to the limitation for the miscellaneous itemized deduction referred to at the beginning of this article, for individuals whose adjusted gross income exceeds a particular threshold (which is adjusted annually for inflation), the amount of itemized deductions otherwise allowable shall be reduced by the lesser of:

• Three percent of the excess of adjudged gross income over the threshold, or
• Eighty percent of the amount of the itemized deductions otherwise allowable for such tax year.
• The threshold for 2004 is $142,700 ($71,350 if married filing separately).

Caveat

An attorney should not give tax advice unless he or she is knowledgeable about such matters. If the attorney is not current on these matters, he or she should seek the advice of competent tax counsel or a CPA who is experienced in evaluating and calculating the tax consequences of divorce settlements. The attorney must have on hand one of several divorce tax texts (one of which is written by this author and published by James Publishing, Inc., 3505 Cadillac Avenue, Suite H, Costa Mesa, CA. Phone: 1-800-394-2626, Web site: http://www.jamespublishing.com/).

A penalty could be applied to an attorney who misallocates the deductibility of the fee in such a manner as to aid the client in understating the client's tax liability.