What expense category is Legal Settlement Costs?

Legal disputes are an unfortunate but common reality in business. When a company makes a payment to settle a legal claim, that cost can be a significant expenditure. For accountants and business owners, the tax treatment of these legal settlements is often complex and not always straightforward.

The deductibility of a settlement payment depends entirely on the nature of the legal claim being settled. Some settlements are fully deductible, some must be capitalized, and some are not deductible at all. This guide will clarify how to categorize legal settlement costs in accordance with IRS rules to ensure your business remains compliant.

Legal Settlement Costs Category

There is no single expense category for legal settlement costs. Their classification depends on the origin of the claim and the reason for the lawsuit.

1. Deductible Business Expense: If the settlement payment relates to the normal operations of your business (e.g., a breach of contract dispute), it is generally considered an ordinary and necessary business expense. These costs are typically reported under the category of Legal and Professional Fees.
2. Capital Expenditure: If the settlement involves acquiring a business asset or defending your title to a property, the cost is considered a capital expenditure. IRS Publication 334 states that legal fees to acquire business assets must be added to the basis of the property. The same principle applies to settlement costs.
3. Non-Deductible Expense: Some settlements, particularly those paid to a government or for certain types of claims, are not deductible.

Important Considerations While Classifying Legal Settlement Costs

The most critical factor is to analyze the underlying reason for the lawsuit to determine the correct tax treatment.

The Origin of the Claim Doctrine

This is the guiding principle. The tax treatment of a settlement payment is determined by the nature of the claim it resolves.

• Business Operations: A settlement for a dispute arising from your business operations is generally deductible.
• Acquiring or Defending an Asset: A settlement to resolve a dispute over the ownership or cost of a capital asset must be capitalized and added to the asset's basis.
• Personal Matters: A settlement for a personal matter, unrelated to your business, is not a deductible business expense.

Settlements Involving Government Fines and Penalties

IRS Publication 535 is very clear that you generally cannot deduct fines or penalties paid to a government for the violation of any law. This includes amounts paid in settlement of actual or possible liability for a fine or penalty.

Settlements for Sexual Harassment or Abuse

Publication 535 notes a specific and important rule: for amounts paid after December 22, 2017, no deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if the payment is subject to a nondisclosure agreement. The legal fees related to such a settlement are also non-deductible.

Tax Implications and Recordkeeping

The reporting for a settlement payment depends entirely on its classification.

How to Report the Costs

• Deductible Settlements: For a sole proprietor, these are reported on Schedule C (Form 1040), Line 17, Legal and professional services.
• Capitalized Settlements: The cost is added to the basis of the related asset and recovered through depreciation or amortization, or it reduces the gain upon the asset's sale.
• Non-Deductible Settlements: These payments must not be deducted anywhere on your business tax return.

What Records to Keep

It is essential to maintain meticulous records to substantiate the nature of the settlement. Your records must include:

• The final settlement agreement should ideally specify the nature of the payment (e.g., compensatory damages).
• Any related court documents or legal correspondence
• Invoices from your attorney.
• Proof of payment for the settlement and all related legal fees.

How Fyle Can Automate Tracking for Legal Settlement Costs

Fyle helps you capture and organize the significant costs and documents associated with a legal settlement, providing a clear record for your accountant to review and analyze.

• Centralize All Legal Documents: Forward and attach the settlement agreement and all legal invoices directly to the expense record in Fyle.
• Track by Legal Matter: Code all settlement and legal fee payments to a specific case for precise cost tracking.
• Categorize for Correct Tax Treatment: Flag the settlement payment as deductible, capital, or non-deductible for proper accounting.
• Automate Your Accounting: Sync the categorized cost to the correct GL account in QuickBooks, Xero, NetSuite, or Sage Intacct.