How to Record Legal Expenses in Your Books

Accurate accounting for legal expenses is critical for businesses and law firms alike. Proper classification affects financial statements, tax filings, and client billing. This article explains what legal expenses are, whether they are assets, liabilities, or expense accounts, how to record them correctly, and common pitfalls to avoid. It also covers tax deductibility specifically for law firms and explains how professional bookkeeping services, like Irvine Bookkeeping, can assist with accurate tracking and compliance.

Legal costs arise in many forms: retaining outside counsel, litigation fees, contract drafting, regulatory advice, and more. For businesses, these costs can be routine or extraordinary, and their treatment in the accounting records depends on the nature and expected benefit of the expense. Misclassification can distort profit reporting, complicate tax positions, and create issues during audits.

Understanding how to record legal expenses ensures that financial statements fairly present the company’s position while enabling timely tax deductions where allowed. This guide walks through practical steps, clear examples, and common mistakes to help firms and companies maintain clean, compliant books.

What Are Legal Expenses in Accounting?

Legal expenses refer to costs incurred for legal services and related activities. These include attorney fees, court filing fees, settlement costs, document preparation, legal research, and sometimes costs associated with expert witnesses or process servers. In accounting terms, they represent outflows tied to obtaining legal advice or defending a legal position.

Not all legal-related payments are identical in accounting treatment. For example, legal fees related to acquiring a fixed asset or defending title to property might be capitalized, while routine legal advice generally appears as an operating expense. The context—why the cost was incurred—determines its classification and treatment on financial statements.

Is Legal Expense an Asset, Liability, or Expense Account?

Generally, legal expense is recorded as an expense account on the income statement. Expenses reduce net income and reflect costs associated with running the business. Commonly, legal fees for ordinary business operations—like compliance advice or contract review—are expensed in the period they are incurred.

However, there are exceptions where legal costs may be capitalized as part of an asset’s cost or recorded differently. If legal fees are incurred to acquire or defend a long-lived asset, those costs may be included in the asset’s basis (capitalized) and depreciated or amortized over time. Likewise, contingent liabilities related to legal matters may be recognized as liabilities if a loss is probable and can be reasonably estimated.

How to Record Legal Expenses in Your Books

Recording legal expenses starts with identifying the nature and purpose of each cost. Small firms can track these costs using expense accounts labeled “Legal Fees” or “Professional Fees,” but larger organizations may benefit from greater granularity—splitting litigation, contract, regulatory, and transactional legal fees into separate subaccounts.

Accurate bookkeeping also distinguishes between firm-borne costs and client-billed expenses for professional services organizations. Client-related legal disbursements should be tracked separately, often as a receivable or as costs that are billed through client statements so that firm profit margins remain clear and client reimbursements are not incorrectly expensed.

Step 1: Identify the nature of the expense (business-related vs. personal).

Begin by establishing whether the legal expense pertains to business operations or personal matters. Business-related legal fees might include employment disputes, contract drafting, corporate governance issues, regulatory compliance, and litigation connected to business activities. These are typically recorded in the business’s books.

Personal legal expenses, such as divorce proceedings or personal injury counsel unrelated to the business, should never be recorded on company books. Mixing personal expenses with business records can lead to tax complications, audit exposure, and potential legal liability. If a business owner pays personal legal costs through the business, the transaction must be recorded as an owner distribution or loan, with proper documentation.

Step 2: Chart of Accounts: Which category to use.

Select or create appropriate accounts in the chart of accounts to capture legal activity accurately. Standard practice is to use an expense account labeled “Legal Fees” or “Professional Legal Fees.” For firms with higher volumes or varied legal work, subaccounts can be established: “Litigation Expense,” “Contract Legal Fees,” “Regulatory & Compliance Fees,” and “Client Reimbursable Legal Costs.”

For capitalized legal costs—such as fees related to acquiring property or defending an asset—use an asset account and include the legal costs in the asset’s capital cost. When a contingency meets recognition criteria, record a liability under “Accrued Legal Liabilities” or similar. Setting up clear accounts from the start simplifies month-end closing, financial reporting, and tax preparation.

Step 3: Journal entry example:

When a business pays an invoice for general legal advice, the typical journal entry is straightforward. Debit the appropriate expense account for the full amount of the fee and credit cash or accounts payable. For example: Debit Legal Fees $5,000; Credit Cash $5,000. This records the outflow and recognizes the cost in the income statement for the period.

If a legal expense is reimbursable by a client, create a receivable for the billed amount. Example: Debit Accounts Receivable—Client Reimbursements $2,000; Credit Legal Fees $2,000 (or track it as a reclass from expense). Once the client pays, debit cash and credit Accounts Receivable. For capitalized expenses, debit the related asset account and credit cash or accounts payable, rather than recording an immediate expense.

Tax Deductibility of Legal Expenses for Law Firms

Tax treatment of legal expenses for law firms follows general tax principles but has nuances because law firms may pay both firm-level and client-related costs. In most jurisdictions, ordinary and necessary business expenses are deductible in the year incurred, which includes many types of legal fees tied to the operation of the law practice.

However, deductions are limited by the nature of the expense and by specific statutory rules. Legal fees directly connected to generating business income, defending the firm’s business, or complying with regulatory requirements are typically deductible. Proper documentation and classification support these deductions in the event of an audit.

Which legal expenses are deductible for law firms.

Deductible legal expenses commonly include attorney fees for defending malpractice suits, employment disputes, lease negoti ations, and contract work done in the normal course of business. Fees for professional advice on tax matters, practice management, regulatory compliance, and risk mitigation generally qualify as ordinary and necessary business expenses.

Costs incurred to collect business income, negotiate commercial leases, or pursue legal redress directly related to the firm’s operations are also deductible. Reimbursable client costs are usually treated as pass-through items: the firm may show them as expenses offset by client reimbursements or record them as client disbursements with corresponding receivables, depending on accounting policy and tax rules.

Which ones are not deductible (personal, illegal activities, lobbying).

Certain legal expenses are not deductible. Personal legal costs—such as fees for divorce, personal estate planning unrelated to the business, or personal criminal defenses—are non-deductible on the firm’s tax return. Additionally, legal costs incurred to further illegal activities or those tied to tax-exempt activities generally cannot be deducted.

Lobbying and political legal fees are often specifically disallowed or subject to limitations under tax law. Similarly, fines and penalties imposed by government authorities typically are non-deductible. It is essential to consult tax regulations or a tax professional for jurisdiction-specific rules and exceptions that may apply to particular legal matters.

Importance of accurate tracking for IRS compliance.

Accurate, contemporaneous recordkeeping of legal expenses ensures proper deduction claims and reduces audit risk. Keeping invoices, engagement letters, billing statements, and explanations of the legal matter helps substantiate whether a cost was ordinary and necessary for the business. Documentation also supports capitalization decisions, client reimbursements, and allocation between deductible and non-deductible items.

In the event of an IRS or local tax authority examination, clear records showing why a legal expense was incurred can mean the difference between an accepted deduction and a disallowed one. Maintaining consistent accounting policies and obtaining professional tax advice for complex legal matters helps maintain compliance and minimizes exposure to penalties and interest.

Read more: How to Track Client Costs and Disbursements in Your Law Firm

Common Mistakes Law Firms Make When Recording Legal Expenses

Even experienced firms sometimes make avoidable errors when recording legal costs. These mistakes can distort profitability, complicate client invoicing, and create tax issues. Knowing typical pitfalls helps prevent them and keeps the firm’s financial records reliable.

Frequent errors include failing to separate client-billable disbursements from firm operating expenses, not documenting the business purpose of certain legal matters, and misapplying capitalization rules. Another common problem is inconsistent account use, which makes comparisons across periods and budgeting less meaningful.

Mixing client costs with firm expenses.

Mistaking client disbursements for firm expenses is a frequent and serious error. If client-related costs are expensed on the firm’s income statement rather than recorded as receivables or pass-through items, the firm understates profit and overstates operating costs. This also complicates billing and can create cash flow problems when clients have not yet reimbursed the firm.

Best practice is to record client costs in separate accounts and track them as client receivables until reimbursed. Clear billing entries that show disbursements and reimbursements maintain transparency and support proper revenue recognition and client trust accounting where applicable.

Misclassifying reimbursable client expenses.

Misclassification occurs when reimbursable costs are recorded as non-billable or when partial reimbursements are incorrectly accounted for. Such errors distort both expense reporting and accounts receivable balances. Reimbursable expenses should be recorded with a clear link to the client matter and the invoice that will seek reimbursement.

Establish workflow controls to ensure that every client disbursement has supporting documentation and is coded to the correct client matter in the billing system. Reconciling client ledgers regularly helps catch and correct misclassifications early.

Not keeping receipts/documentation.

Failing to retain invoices, engagement letters, and supporting documents undermines the ability to substantiate deductions and client charges. Receipts and detailed invoices demonstrate the nature of the legal service, the date incurred, service provider identity, and the business purpose—elements often requested during audits.

Implement a consistent document retention policy and use digital document management to store and link legal invoices to accounting transactions. This practice improves audit readiness, simplifies tax preparation, and supports internal reviews of legal spending patterns.

Read more: How to Reduce Legal Costs with Better Accounting

How Irvine Bookkeeping Helps Law Firms Stay Accurate and Compliant

Irvine Bookkeeping provides specialized bookkeeping services tailored to law firms and professional practices. With experience in trust accounting, client matter tracking, and legal expense classification, the service ensures that firm records meet both accounting standards and regulatory requirements. Techniques include segregating client disbursements, maintaining ledgers per matter, and ensuring accurate reporting of reimbursable costs.

Beyond day-to-day bookkeeping, expert teams help set up appropriate chart of accounts, provide journal entry guidance, and support tax preparation through organized documentation. This reduces the administrative burden on attorneys and firm managers, enabling focus on client service while preserving financial accuracy and IRS compliance.

Final Thoughts

Proper classification and recording of legal expenses protect a firm’s financial integrity and support accurate tax reporting. Distinguishing between personal and business legal costs, capitalizing when required, segregating client disbursements, and maintaining robust documentation are foundational practices. These steps reduce audit risk and improve financial clarity.

Implementing strong bookkeeping protocols, leveraging experienced bookkeeping services, and consulting tax professionals for complex legal matters help ensure that legal expenses are treated correctly in the books. Clear, consistent accounting not only keeps records compliant but also provides management with reliable information for decision making and strategic planning.