If tax deductions were ranked on a scale from best to worst, business related expenses incurred by employees would rank near the bottom. This lowly status was recently confirmed by the Tax Court in the case of James and Barbara Purdy v. Commissioner, decided in March. The taxpayer was a financial adviser at Merrill Lynch. His employment was terminated and he filed a wrongful termination claim with the National Association of Securities Dealers. He was awarded $393,165, from which he paid his attorney $120,000. He deducted the payment to his attorney on Schedule C of his Federal income tax return.

IRC Section 162 allows a deduction (taken by individuals on Schedule C) for expenses incurred in connection with a trade or business. For this purpose, working for someone else as an employee is not considered a trade or business. The Tax Court held that the taxpayer was an employee of Merrill Lynch so he could deduct his legal fees only on Schedule A, as a miscellaneous itemized deduction. These types of deductions are subject to several limitations: i) IRC Section 67 provides that miscellaneous itemized deductions are only allowed to the extent they exceed 2% of the taxpayer’s adjusted gross income; ii) pursuant to IRC Section 56, these deductions are not allowed at all for purposes of computing the alternative minimum tax; and iii) under IRC Section 68, these deductions are subject to a reduction of up to 80%, depending on the taxpayer’s level of income.

In this case the employee incurred legal fees but the same limitations would be applicable to any un-reimbursed expenses incurred by an employee in connection with his job. This could include things like business meals and entertainment, business or professional organization dues, and business related travel. Employees are at a considerable tax disadvantage compared to those who generate self employment income (“independent contractors”) but are not employed by an employer. They can claim all of their business-related deductions on Schedule C and such amounts are deductible in full.