In his book, Rauch describes the social problem that arises from groups engaged in transfer-seeking, i.e., when one group attempts to garner the wealth of another group. He points out that the process is never efficient, as agents take fees, resistance occurs and conflict adds to costs. He also demonstrates how transfer-seeking destroys wealth and serves no purpose in creating it.

Spending $198 to Acquire $100?
As an example, Rauch cites someone that wants $100 of your money. How much will he spend to get it? In principle, $99, because if he spent it to capture your money, he would be $1 ahead. How much would you be willing to spend to keep your $100? The answer is $99, since you would at least have something left over.

In practice, of course, each party will factor in the risks. But the simple reality is that when someone tries to capture wealth, the reaction triggers a defensive investment to protect it and the total sums involved can become quite substantial in comparison to the targeted amount.

Of course, anyone that has observed a wealthy couple in the throes of a divorce proceeding has also seen that theory at work. Moreover, the emotions of anger and resentment often override the logic of risk when a couple fights over accumulated wealth. One can easily imagine a husband and wife in the midst of a divorce war each spending $500,000 to garner a $1 million asset. In other words, the lawyers collectively earn the value of the asset fought over.

Adding Insult to Injury: No Tax Deduction
Adding insult to injury is that all too often the embattled couple is then told by their tax adviser that the Supreme Court's holding in the Gilmore case (U.S. v. Gilmore, 372 U.S. 39) denies any tax deduction in connection with the legal fees incurred in a divorce proceeding. Gilmore stands for the general principle that because the nature of divorce suits are purely personal, the legal fees are not deductible.

The court reached this conclusion despite the fact that the outcome of the case might have adversely affected the husband's controlling interest's in several corporations (thus, his argument that the expenses were incurred to conserve or maintain property and, accordingly, were allowable under section 212 of the Internal Revenue Code).

Subsequent cases have refined the law in this area. Legal fees incurred to retain income-producing property have been disallowed. On the other hand, where a corporation controlled by one of the parties to divorce was named in the proceedings, it was allowed to deduct the legal fees it paid [Dolese v. U.S. 605 F. 2d 1146 (10th Cir. 1979, cert. Denied 445 U.S. 961, 1980)].

Exceptions to the Rule
There are two principle exceptions to the general rule of non-deductibility.

The first is specifically addressed in Treasury Reg. 1.262-1(b)(7) and provides a deduction for legal fees incurred in connection with the production or collection of income incident to a divorce. This clearly includes legal fees attributable to securing current or past due alimony (but not child support allowances).

It also includes, according to at least one case (Genevieve M. Hahn T.C. Memo 1976-113), the legal fees for securing the right to income from a business. (I was involved in a divorce case some years ago where nearly $300,000 of legal fees were incurred and deducted to secure the right to an income stream of royalty payments from successful oil and gas tax shelter investments).

The second exception permits a deduction for fees incurred for tax advice in connection with a marital dissolution (see Davis v. U.S. 287 F. 2d 168, aff'd on this issue 370 U.S. 65). Not surprisingly, family law specialists and tax counsel have been very creative in their efforts to shoehorn all sorts of legal fee payments into this category. For example, tax advice might be worth $350 an hour as presented on billings, while a court appearance to argue child support issues might be assigned a billing rate of $175.

In allocating legal fees between deductible and non-deductible items, practitioners should refer to Rev. Rul. 72-545, 1972-2 C.B. 179. It presents differing situations and discusses the deductible aspects of tax advice.

AGI and AMT Limitations
I bet some you of wondered when these dicey little issues would surface. Well, the legal fees incident to a divorce--if deductible at all--are miscellaneous itemized deductions and therefore deductible only to the extent they exceed 2 percent of the taxpayer's AGI. Once included in allowable itemized deductions, they become subject to the AGI 3 percent phase-out provisions as well. In addition, as miscellaneous itemized deductions, they are not allowable deductions for purposes of determining alternative minimum taxable income.

In short, many relatively high earning taxpayers, having first successfully run the gauntlet of deductibility, end up seeing any tax benefit vanish in the fog of these "punish the rich" provisions of the tax law.

Salvaging Something - Capitalizing Legal Fees
A sometimes-overlooked opportunity to secure some benefit is the allocation of legal fees to increase the tax basis of assets involved in the resolution of the marital estate. This is particularly true where the benefit of tax deductibility may be lost to section 67, or the itemized deduction phase-out provisions or the AMT. At least as a capitalized cost, some future tax benefit (in the form of reduced capital gain) may be realized when the asset is sold.

The taxpayer in Gilmore--denied a deduction for legal fees incident to the divorce--took the proverbial second bite of the apple and added the disallowed fees to the basis of the property that he acquired in the settlement. In deciding this second case, the District Court [Gilmore v. U.S., 245 F. Supp. 383, DC Calif. (1965)] concluded that expenses in defending (or asserting) title to assets may be properly added to the basis of the asset(s) involved.

Gilmore - Round Two
This second Gilmore case has subsequently served as the foundation for allocating a portion of legal fees to acquire or protect ownership of property in divorce disputes to the underlying assets [e.g. Spector 71 T.C. 1017 (1979)]. The Court stated, "The well established general rule is that costs incurred in defending title are capital expenditures to be added to basis." The Court pointed out that whether the nature of those costs is personal or business is irrelevant; the law concerning whether an expenditure is properly characterized as a capital one does not make a distinction between personal or business origin.

Referring to the earlier case, the Court stated, "The Supreme Court did, indeed, rule against the deduction. The Government surely need not be reminded that all tax benefits are not tax 'deductions.' Neither reason nor authority support the Government position in blandly asserting that any expenses connected in any way with a divorce action should not in any conceivable sense result in a tax benefit. The [earlier] Gilmore decision compels no such consequence."

The District Court apparently felt obliged to state its position in such strong language because the Supreme Court left open the issue of capitalization in the earlier case.

In the Spector case, the government did not dispute the tax treatment of the legal fees as capital expenditures. But it did successfully argue that a portion of the fees should be allocated to the recovery of "cash" and, since the tax basis of cash cannot be increased beyond itself, that portion of the legal fees was neither deductible or could be capitalized.

The remaining fees, though, were properly capitalized and added to the basis of the fought-over stock and real estate. (Could legal fees be capitalized if they resulted in a "basis" in excess of the fair market value of the asset? Such treatment would appear to deviate from analogous case law).

Record Keeping
Practitioners advising clients in divorce proceedings should be reminded that the key to getting any tax benefit for any professional fees incident to divorce proceedings is predicated upon keeping accurate and complete records of how the billing amounts were determined.

In the end, practitioners and parties to a divorce owe a debt of gratitude to Mr. Gilmore and his tenacity for taking that second bite.