Legal fees can be a burden, but they're only tax deductible in certain circumstances
“He who is his own lawyer has a fool for a client.”
While there is plenty of wisdom in this old adage, at the same time, I’ve yet to meet a client who enjoys paying for legal advice.
Though it cannot (and should not!) be avoided in many circumstances, legal representation and the fees that come with it can be a severe burden. While there are some tax remedies available, the tax deductibility of legal as well as other professional fees is not straightforward and depends on who is paying them and in what context.
For example, employees (or former employees) can claim legal fees they paid to collect or establish a right to salary or wages owed to them as well as to collect (or establish a right to) a retiring allowance or pension benefit. Business owners can generally deduct legal fees paid for the purpose of earning business income.
Legal fees are also tax deductible if you incur them to challenge a Canada Revenue Agency assessment, perhaps because the CRA has questioned your income, deductions, or credits for a particular tax year, or you decide to object to, or appeal, a tax assessment or decision.
Unfortunately, most other legal fees paid by individuals are simply not tax deductible. For example, the cost of preparing a will, suing your neighbour over their untrimmed hedges, or fees paid to your real estate lawyer for reviewing the lease agreement on your personal condo rental, are all not tax deductible.
In the realm of family law disputes, the question of tax deductibility comes up frequently. You cannot claim legal fees you incurred to get a separation or divorce or to establish custody of — or visitation arrangements for — a child; however, fees relating to support payments that your current (or former) spouse or common-law partner paid to you may be tax deductible.
A recent tax case, decided last week, involved a taxpayer who attempted to deduct $33,653 in legal, accounting and other professional fees he incurred to wind up his Individual Pension Plan (“IPP”) as a result of his divorce. An IPP is a defined-benefit registered pension plan set up for the owner (and, occasionally, their spouse) of a private corporation to provide enhanced retirement savings.
The taxpayer, a management consultant, had his corporation establish an IPP for him in 2003. In February 2013, as a result of the breakdown of his marriage, he was ordered by a Family Court judge to make an equalization payment to his spouse and pay lump sum spousal support. A month later, as a result of this court order, the taxpayer filed for bankruptcy.
In February 2015, his company was forced into bankruptcy, yet continued to operate until it was discharged from bankruptcy in May 2016 and was dissolved. In June 2016, the insolvency coordinator with the Financial Services Commission of Ontario appointed an administrator to wind up the taxpayer’s IPP.
In August 2016, a second court order stated that one-half of the amount accrued under the taxpayer’s IPP was to be transferred to his spouse, net of legal, accounting and professional fees that totalled the $33,653. All required distributions from the IPP were completed on Nov. 10, 2016.
The only issue in the tax case was whether the legal, accounting and other professional fees paid were tax deductible. The taxpayer took the position that the expenses claimed were legitimate business expenses related to the company and, more particularly, related to the administration of his IPP. He argued that, “they were incurred for the sole purpose of gaining or producing income from business or property.” He testified that the IPP had incurred expenses of this nature for “around 15 years and such had always been allowed as deductible business expenses.”
The CRA argued that the expenses were not incurred for the purpose of producing income from a business and that they were “personal in nature and were incurred only for the purpose of satisfying the Court Order requiring (the taxpayer) to wind up his IPP in order to effect equalization payments upon the dissolution of his marriage.”
The judge explained that legal, accounting and professional fees can ordinarily be deducted as business expenses when they are incurred in the normal course of a business’s income-earning operations or are incurred to defend those business activities. In this case, however, the judge noted that when the company and the IPP were wound up, the company was not carrying on any income-earning activities. In fact, the company was bankrupt and being dissolved, and the IPP was being wound up in order to satisfy a court order mandating the division of the IPP.
In other words, the judge felt that the legal, accounting and other professional fees were not paid for the purpose of earning income for the company, the IPP or the taxpayer, nor were they paid to defend their income earning activities. The judge acknowledged that while it may have been true that in the past that such fees were in fact deductible from income earned by the company or the IPP, that was when the company and the IPP were actively engaged in earning income. As the judge wrote, “The legal, accounting and other professional fees incurred … were simply too remote and unrelated to the company’s and the IPP’s income-earning activities in order to qualify as valid tax deductions.”
Finally, even if it could be said that there was a business purpose to the professional fees paid, there is a specific rule in the Tax Act that states that legal expenses related to the division or settlement of a pension plan arising out of the breakdown of a marriage are specifically not deductible.
As the judge concluded, “The marriage breakdown entailed certain legal consequences such as the equalization of assets. It very often happens that a spouse’s pension plan has to be shared on the breakdown of a marriage. Therefore, even if (the taxpayer) was not a business man, he still would have had to share family assets, including any pension plans, with his spouse and therefore it is very likely that he would still have had to pay the fees associated with the winding up of the IPP.”