Business Expenses for Law Firms: What Federal Tax Rules Allow?
Internal Revenue Code Section 162 generally permits a deduction for ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. For a law practice, that principle is the starting point for evaluating business expenses for law firms under federal tax law.
Two other rules limit the general principle. Personal, living, and family expenses are generally nondeductible under Internal Revenue Code Section 262, and certain capital expenditures must be treated differently from current business expenses. Paying an expense from a law firm bank account does not by itself make it deductible.
This article reviews common categories of deductible expenses for law firms and the facts that affect whether and when each may be deductible. It addresses federal tax rules only. The treatment of any particular expense depends on the firm's facts, accounting method, and applicable requirements.
The Basic Federal Rule for Ordinary and Necessary Business Expenses
Section 162(a) allows a deduction for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." Law firm tax deductions generally depend on whether an expense meets that standard.
An ordinary expense is one that is common and accepted in the trade or business. A necessary expense is one that is helpful and appropriate for the business. An expense also needs a business purpose and, when the requirements are satisfied, adequate records.
IRS Sources: Internal Revenue Code §162; IRS Publication 334, Tax Guide for Small Business
Employee Compensation
Section 162(a)(1) refers to "a reasonable allowance for salaries or other compensation for personal services actually rendered." Compensation paid to associates, paralegals, legal assistants, and administrative staff who are employees may therefore be deductible when it is reasonable and for services actually performed.
Employers also have federal payroll tax responsibilities described in IRS Publication 15, Employer's Tax Guide. Whether a worker is an employee or an independent contractor depends on the facts and circumstances of the working relationship, not on the title given to the worker.
IRS Sources: Internal Revenue Code §162(a)(1); IRS Publication 15
Office Rent
Section 162(a)(3) addresses rentals and other payments required to be made as a condition to the continued use or possession of property used in the trade or business, where the taxpayer has not taken title to the property and has no equity in it. Rent paid for a law office lease may therefore be deductible when these requirements are satisfied.
Improvements to leased office space are different from rent. Depending on the facts, they may need to be capitalized and recovered over time, as discussed below.
IRS Sources: Internal Revenue Code §162(a)(3); IRS Publication 334
Office Supplies
Supplies used in operating a law office, such as paper, printer materials, and similar items consumed in the business, may qualify as ordinary and necessary business expenses. Supplies used partly for personal purposes require an allocation between business and personal use.
IRS Sources: Internal Revenue Code §162; IRS Publication 334
Legal Research Tools and Practice-Management Software
Law firms commonly pay for legal research subscriptions, document management, billing, scheduling, and practice-management software. Payments for these services used for legitimate business purposes may qualify as business expenses.
The tax treatment can depend on whether a payment is a recurring service expense or the acquisition or development of an asset that may need to be capitalized. The terms of the agreement and the nature of the payment affect the answer.
IRS Sources: Internal Revenue Code §162; IRS Publication 334
Accounting and Bookkeeping Fees
Law firm bookkeeping expenses, meaning fees paid to accountants, bookkeepers, and tax professionals for services related to operating the law practice may qualify as business expenses when they are ordinary and necessary. Fees connected with acquiring or creating an asset, or with certain transactions, may be subject to different rules.
IRS Publication 334 addresses legal and professional fees and tax preparation fees in its business expense chapter.
IRS Sources: Internal Revenue Code §162; IRS Publication 334
Review Your Firm's Expense Records With a Tax Professional
Tax Wealth Consultant provides bookkeeping and tax-planning services for law firms and other businesses in Irvine and Orange County. Schedule a consultation to review how your firm's expenses are recorded and documented.
taxwealthconsultant.com | (949) 409-8335
Advertising and Marketing
Advertising expenses directly related to the business, such as a website, online advertising, and printed marketing materials, may qualify as ordinary and necessary business expenses. The expenditure must have a business purpose. Personal spending does not become deductible because it is paid from a business account.
IRS Sources: Internal Revenue Code §162; IRS Publication 334
Business Insurance
Premiums for insurance related to the trade or business may be deductible, depending on the type of insurance and the purpose of the coverage. IRS Publication 334 includes a section on business insurance and identifies certain premiums as nondeductible, so each policy should be evaluated separately.
A firm should keep records identifying the policy, the business activity covered, the premium amount, and proof of payment.
IRS Source: IRS Publication 334
Professional Dues and Subscriptions
Dues and subscriptions that relate to the firm's trade or business may qualify as business expenses, depending on the facts. Section 162(e) disallows deductions for amounts paid in connection with influencing legislation and participation in political campaigns. A portion of dues paid to an organization that engages in those activities may therefore not be deductible.
IRS Sources: Internal Revenue Code §162(e); IRS Publication 334
Business Travel
Section 162(a)(2) refers to traveling expenses, including meals and lodging, while away from home in the pursuit of a trade or business, other than amounts that are lavish or extravagant under the circumstances. According to IRS Publication 463, a taxpayer's tax home is generally the regular place of business, and traveling away from home generally requires being away from the general area of the tax home for longer than an ordinary workday and needing to sleep or rest while away.
Commuting between home and a regular place of business is generally not deductible business travel. When a trip combines business and personal activity, the applicable allocation and substantiation rules apply.
IRS Sources: Internal Revenue Code §162(a)(2); IRS Publication 463, Travel, Gift, and Car Expenses
Business Meals
Meals are not always deductible. Section 274(k) provides that no deduction is allowed for the expense of food or beverages unless the expense is not lavish or extravagant under the circumstances and the taxpayer or an employee of the taxpayer is present when the food or beverages are furnished. Section 274(n) generally limits the deduction to 50 percent of the expense, subject to the exceptions in the statute.
IRS Publication 463 states that a taxpayer can generally deduct only 50% of the unreimbursed cost of meals, including meals during business travel. Section 274(a)(1) generally disallows deductions for activities of a type generally considered entertainment, amusement, or recreation.
Because meals and entertainment are subject to specific substantiation rules, a firm should record the amount, date, place, business purpose, and the business relationship of the people involved.
IRS Sources: Internal Revenue Code §274; IRS Publication 463; IRS Publication 334
Vehicle Expenses
When a vehicle is used for both business and personal purposes, expenses must be divided between business and personal use. IRS Publication 463 explains that for business use of a car, a taxpayer may generally use actual expenses or the standard mileage rate, subject to the applicable rules. The IRS publishes the standard mileage rate each year.
Section 274(d) requires substantiation of listed property by adequate records or sufficient evidence corroborating the taxpayer's own statement, including the amount, time and place, and business purpose. A mileage log with the date, destination, business purpose, and miles driven helps support business use.
Not every vehicle expense qualifies. Travel between home and a regular place of business is generally treated as personal commuting.
IRS Sources: Internal Revenue Code §274(d); IRS Publication 463; IRS Publication 583
Computers, Furniture, and Other Equipment
Purchases of computers, furniture, and other equipment are not necessarily treated like purchases of office supplies. Property expected to benefit the firm beyond the current tax year may need to be capitalized and recovered through depreciation.
Under Section 179, a taxpayer may elect to expense the cost of certain qualifying property. According to the Instructions for Form 4562, Section 179 property is property acquired by purchase for use in the active conduct of a trade or business, must be used more than 50% in the trade or business, and the deduction is limited to taxable income from the active conduct of a trade or business. Dollar limits apply, and the limits change by year, so the amount for the applicable tax year should be confirmed before relying on it.
IRS Sources: Internal Revenue Code §179; IRS Publication 946, How To Depreciate Property; Instructions for Form 4562
Continuing Education and Professional Training
IRS Publication 970 includes a chapter on the business deduction for work-related education. It addresses education required by an employer or by law, education to maintain or improve skills, education to meet minimum requirements, and education that qualifies a taxpayer for a new trade or business.
Whether a particular course, seminar, or program may be deductible depends on those rules and the facts, including the attorney's existing practice and the purpose of the education.
IRS Source: IRS Publication 970, Tax Benefits for Education
Personal Expenses vs. Business Expenses
Law firm business expenses should be kept separate from personal spending. Section 262(a) states that, except as otherwise expressly provided, no deduction is allowed for personal, living, or family expenses. IRS Publication 583 advises keeping the business bank account separate from a personal checking account and using the business account for business purposes only.
Other payments are also not deductible under Section 162, including certain illegal payments under Section 162(c), amounts disallowed under Section 162(e) for influencing legislation and political campaigns, and certain fines and penalties paid to a government under Section 162(f), subject to the exceptions in the statute.
IRS Sources: Internal Revenue Code §§162, 262; IRS Publication 583
Mixed Personal and Business Expenses
Some expenses have both personal and business use, such as vehicles, phones, and equipment. Only the portion that meets the requirements for business treatment may qualify. IRS Publication 583 states that for a vehicle used for both purposes, the taxpayer must divide expenses between business and personal use.
A firm should document how it determined the business portion, using records such as mileage logs or usage records, and apply the same method consistently.
IRS Sources: IRS Publication 583; IRS Publication 463
Capital Expenditures vs. Current Business Expenses
A current business expense is generally deducted in the period it is paid or incurred, subject to the firm's accounting method. A capital expenditure is generally recovered through depreciation or another provision over time.
For tangible property, the IRS explains that amounts paid to improve property, including betterments, restorations, and adaptations to a new or different use, are treated differently from amounts paid for repairs and maintenance. Build-out or renovation of a leased law office can raise these questions, and the answer depends on the facts.
IRS Sources: IRS Publication 946; IRS Tangible Property Final Regulations; Internal Revenue Code §179
Documentation and Substantiation
Deductible expenses for law firms depend on adequate records, and law firm tax deductions are easier to support when records are complete. IRS Publication 583 states that supporting documents include sales slips, paid bills, invoices, receipts, deposit slips, and canceled checks, and that supporting documents for an expense should show the amount paid and that the amount was for a business expense. Proof of payment alone may not establish that a cost was incurred for a business purpose, so invoices should be kept as well.
For each expense, a firm may retain:
Invoice, receipt, or bill
Date and amount paid
Payee or vendor
Business purpose
Proof of payment
For travel, meals, and vehicles, the additional information required by Section 274(d)
The IRS generally states that records should be kept until the period of limitations for the return expires. IRS Publication 583 lists generally 3 years, and 6 years if more than 25% of gross income is omitted, along with other periods depending on the circumstances.
IRS Sources: IRS Publication 583, Starting a Business and Keeping Records; Internal Revenue Code §274(d)
Why Accurate Bookkeeping Matters for Law Firm Expenses?
Law firm expenses bookkeeping is the process that creates the records described above. If transactions are recorded in the wrong category, such as an equipment purchase recorded as supplies or a personal expense recorded as a business expense, the tax return may not reflect the correct treatment.
Law firm bookkeeping expenses are easier to review when the firm:
Uses a dedicated business bank account
Records expenses by category as they occur
Keeps invoices and receipts with the related transaction
Separates equipment and other assets from operating expenses
Records the business purpose for travel, meals, and vehicle use
Reconciles accounts periodically to find missing or duplicated transactions
IRS Source: IRS Publication 583
How Law Firm Bookkeeping Connects to Tax Planning?
Tax planning begins with accurate classification of transactions, and law firm expenses bookkeeping done consistently throughout the year gives the firm the information to do that. When a firm's books separate operating expenses, payroll, equipment, owner transactions, and personal items, the firm and its tax professional can evaluate how each is treated while records and documentation are still available.
Waiting until filing season to determine what an expense represented can make accurate reporting more difficult, and unsupported law firm tax deductions are harder to defend. Tax treatment depends on each taxpayer's specific facts and circumstances, and this article is general educational information, not tax advice.
Tax Wealth Consultant provides bookkeeping and tax-planning services for law firms and other businesses in Irvine and Orange County.
Schedule a Law Firm Tax Planning Consultation
Tax Wealth Consultant provides bookkeeping and tax-planning services for law firms and other businesses in Irvine and Orange County. Schedule a consultation to review how your firm's expenses are recorded and documented.
taxwealthconsultant.com | (949) 409-8335
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