Lawsuit and related expenses

[Margaret CPA in OH]

A client called this morning to explain the difficult prior year when I emailed about possible 1099 prep. Husband is small contractor and was sued by a client. I don't yet have all the details but it appears as though, through ignorance, he did not wait 3 days before beginning job. Client refused to pay and 'friend' advised contractor to sue in small claims court for payment. His client then sued for damages so contractor had to hire attorney and lost the case. He is out materials, subs, attorney fees and whatever damages. I will get documents later.

Contractor also fell off ladder and was hospitalized several days. Family then qualified for Medicaid and went on welfare for a while. I cannot find readily where his legal expenses would be deductible. I'm pretty sure any damages assessed would not be, but what about the attorney fees?

Thanks for any guidance. The only other client I had with legal issues was a landlord sued by equal housing group for discrimination, never mind the details. It was clear that fine was not deductible and they chose not to even fight it so no other legal fees.

[BulldogTom]

If I am reading this correctly, your client sued to get paid for work done on a contract? Legal fees of a business related to the collection of taxable income would be deductible to your client on his (I am assuming here) schedule C. Winning or losing the case is not a precondition on the deductiblity of the legal expenses. The materials, subcontractor payments, etc would also be deductible on his sch. C. Damages paid would also be deductible by the business. Any fines imposed by the courts (or licensing authorities) would not be deductible as a business expense.

Hope this helps.

Tom

Lodi, CA

[Margaret CPA in OH]

I don't have all the documentation yet but, as I understand it,the contractor did the work but, because he didn't give the client 3 days to rescind, she didn't pay him. A 'friend' advised him to sue for payment. That infuriated the client so she sued the contractor for something like damages to her property (the work he did). That suit required him to hire an attorney and, I guess, he lost.

My question is not related to the expenses he incurred to get payment. I am uncertain of his expenses to pay the attorney to represent him and the subsequent damages that he had to pay to the client. The first case seems straightforward as it was to collect money becasue he did the work although he did not wait the 3 days and she changed her mind. The second, not so much, as he is defending himself and had to pay when, it seems, he lost.

I would think the defense expenses would be deductible but maybe not the 'damages' although that would not be a fine, I think. Yes, he is Sch C.

[kcjenkins]

Generally, 'damages' related to his work product would be a business expense. And the legal fees to defend his business reputation, as well as to try to collect moneys owed to him would also be a business expense. You should look at the written court ruling, to determine if there are any amounts that could be considered fines or penalties. But most likely it's all deductible, if it is only related to his job performance, and not some personal misbehavior.

[Margaret CPA in OH]

Thanks, KC. I have asked for all documentation so will see what they bring. I am just concerned that the lawsuit and damages may not be against the work product itself but that the client was not given the 3 days to rescind the contract before the work was done. We'll see.

I hope it will all be an expense although it will create an NOL. Since they qualified for Medicaid and food stamps and other welfare benefits when he couldn't work, I hope they can get something somehow. I suspect that my bill will be heavily discounted this year, too. They've always paid timely but she was afraid to even call me thinking that they couldn't afford to have their returns done or 1099's sent out. Of the 3 contractors I have, they are by far the hardest hit.

[kcjenkins]

Even if it is based on the lack of the rescinding time, that is still a business expense. Simple a part of doing business that this sort of thing sometimes happens. That does not make it personal.

[Margaret CPA in OH]

Now that is really good to know, KC. I was concerned that not waiting would be a major factor against him. From what I understand, hearsay from wife, the client was not dissatisfied with the work, just annoyed because he didn't wait for 3 days. She refused to pay so he sued for payment. That really ticked her off then. So he is out all the way around and I assume she has the benefit of the work done. Just really tough for these folks.