Can I deduct contract attorney fees as a 1099 independent contractor?

[T2019T]

I will be a 1099 independent contractor (for providing a professional service), and I plan to create my LLC and begin operating my business in 2022 (the LLC does not exist yet). In 2021, I paid an attorney about $2000 to review and negotiate a contract with another company. This contract will be the primary source of income for my LLC.

1) Are the attorney fees deductible either as startup expenses or other expenses?

2) If they are deductible, is the deduction taken in 2021 or 2022? And is the deduction taken on Schedule C or another form?

[Opus 17 · Accepted solution]

You deduct ordinary and necessary business expenses on schedule C.  If the business is not active in 2021, you don't have a schedule C and can't deduct startup costs.  You will deal with your startup costs on your first tax return after the business is active and reports gross income.  Very briefly, you can take up to $5000 of startup costs as a deduction.  If your startup costs are more than $5000, you may deduct some as an expense and must amortize the rest over 15 years, according to a formula.

Since you won't have a schedule C this year, you have some time to educate yourself.

https://www.irs.gov/newsroom/heres-how-businesses-can-deduct-startup-costs-from-their-federal-taxes

https://www.irs.gov/publications/p535

https://www.irs.gov/publications/p583

[T2019T]

Thank you. So to clarify, the $2000 contract attorney fee paid in 2021 should be deductible as a startup expense in 2022 (assuming no phaseout and that other criteria are met)?

[Opus 17]

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@T2019T wrote:

Thank you. So to clarify, the $2000 contract attorney fee paid in 2021 should be deductible as a startup expense in 2022 (assuming no phaseout and that other criteria are met)?

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Yes.

[Mike9241]

there are frequently differences of opinion on this matter because the code nor regs specifically define when a business begins.  Here a link to a Tax Advisor article from 2015

https://www.ictaxadvisors.com/business-tax-services/when-can-you-start-deducting-your-expenses/ 

As is frequently the case, it depends on your facts and circumstances. There is no bright-line indicator for when you are actually in business. But, if you’re past the point of simply considering opening a business and you’re actively trying to court business or sell your product/services, then you are most likely already “in business” even if you haven’t generated a dollar or revenue. It wouldn’t be a bad idea to consult with a CPA regarding this if you’re not sure.

you state " I paid an attorney about $2000 to review and negotiate a contract with another company. This contract will be the primary source of income for my LLC."  it would seem you have actively courted business
in 2021 even though revenue won't be realized until 2022. what muddies the waters is your statement "and begin operating my business in 2022" The fact you will make your business an LLC is irrelevant as to when the business started. there are many other factors that would need to be considered.   

[Opus 17]

@Mike9241 

@T2019T 

If the taxpayer reports the start up expenses in 2022 along with their first income, I think the IRS is extremely unlikely to question the start up expenses. If the taxpayer claims start up expenses in 2021 with no income, that may warrant a second look, even if business has “begun” under some definition.

If the taxpayer claims the start up expenses in 2021, they would have a net operating loss that would reduce their other taxable income by $2000 and save them some income tax. But, they would not have the expense to deduct in 2022 and would be pay higher business taxes in 2022, including $300 in self-employment tax that they will not get as a deduction if they take the net operating loss in 2021.  If we assume the taxpayer is in the 22% marginal tax bracket, that means the choice between taking a $440 reduction of income tax in 2021 or a $740 reduction in income and self-employment tax in 2022.

In other words, even if it would be technically allowable to deduct the start up costs in 2021 as a net operating loss under some definition of “starting the business“, it does not seem to make financial sense unless the taxpayer has some very strong reason to take a smaller deduction now instead of a larger deduction later.

[Rick19744]

We can only provide broad statements based on the facts we currently have.

Deciding whether a taxpayer is better off taking the deduction in 2021 or 2022 based on a hypothetical set of facts is not what we currently have with the question.  This is not a tax planning matter, we have actual facts. You file the tax return based on those current facts.  So I do not agree with @Opus 17 analogy of determining that 2022 may be better regardless of "some definition of starting the business".  That is not how the tax laws and tax world operate.

If the taxpayer has begun to function based on the intent of the business, then the business has started.  This is regardless of whether the structure is in an LLC or as a sole proprietor.  That is not relevant. 

The tax courts look to all the facts and circumstances in each case (as does the IRS upon audit).  Looking at the regulation 1.248-1(a)(3) it provides "the determination of the date the [corporation] begins business presents a question of fact which must be determined in each case in light of all the circumstances of the particular case".  This same "test" is used for section 162 and 195.

The Tax Court ruled in Steven Austin Smith v Commissioner, "...that to function as a going concern means more than just sales...".

The bottom line is that if the original OP truly began business and began to function as a business in 2021, then that is the year the attorney fees would be deductible.