Can a Sole Proprietor Deduct Attorney's Fees Related to Starting a Business?

By Jeff Franco J.D./M.A./M.B.A.

When operating a sole proprietorship, your business and personal assets and liabilities are one in the same. As a result, you report all business income on your personal tax return using a Schedule C. You can, however, report the same deductions that other business structures can, which may include attorney fees you pay during the startup phase of the business.

When operating a sole proprietorship, your business and personal assets and liabilities are one in the same. As a result, you report all business income on your personal tax return using a Schedule C. You can, however, report the same deductions that other business structures can, which may include attorney fees you pay during the startup phase of the business.

Startup or Operating Cost?

Before you deduct any attorney fees, you’ll need to classify the expense as either a startup cost or an operating cost. Startup costs cover all expenses you incur prior to the first day you’re up and running and open for business, whereas operating costs are the ordinary expenses you incur as of the first day of business operations. However, to be considered a startup cost, the expense must relate to creating a business or acquiring an active one. For example, if you hire an attorney to provide you with legal information about the types of licenses you need to acquire before opening a catering business, the attorney fee is a startup cost. But once you commence catering operations, all legal fees you incur from that day forward are treated as operating costs.

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Are Attorneys Fees Deductible?

In order for an expense to be deductible as a startup cost -- meaning it reduces your taxable sole proprietor earnings -- it must be of the type that’s deductible on Schedule C if it were an operating expense. Under the tax code, operating expenses must be “ordinary and necessary” before a deduction can be taken. If you determine that attorney fees are customarily deducted by other businesses and the legal information was helpful to your operations, it satisfies the “ordinary and necessary” requirement.

Capital Expenditure Treatment

When you invest money and property into a business idea, regardless of whether you plan on operating as a sole proprietor or under a legal business entity, the tax law treats your investment as a capital expenditure. Except for assets you acquire for the business that are deductible through annual depreciation, startup expenses ordinarily are not deductible. Instead, the costs you incur, such as attorney fees, increase your tax basis in the business. Normally, you can recover these startup costs only when the business is sold. However, there is an exception to this capital expenditure rule that may provide you with some tax savings for your startup costs.

Current Deduction & Amortization

The Internal Revenue Service allows sole proprietors to take an immediate deduction for up to $5,000 in startup costs on their tax returns that cover the first year of business operations. One limitation, however, is that the $5,000 must be reduced by the total amount of startup expenses, including attorney fees, in excess of $50,000. For example, if you incur $52,000 of startup costs, you need to reduce your first-year deduction by $2,000 to $3,000. The remaining $49,000 is deductible through annual amortization deductions, which can only be taken if you make an election by filing Form 4562 with your return. If your total startup expenses total $55,000 or more, you can still deduct those costs -- but only through amortization.

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References

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