15 May 2014

Family Law Disputes and the Deductibility of Legal Fees

I was talking with a colleague the other day about how she manages the accounting side of her practice and it reminded me about the deductibility of legal fees for certain family law issues, and the importance for lawyers of tracking that portion of their fees if their clients wish to claim the deduction.

The basic idea with all income tax deductions is that they reduce the amount of income tax you pay by reducing your taxable income. Most employees have provincial and federal income taxes deducted off each paycheque automatically, so that tax they have to pay at the end of the year already paid. If your taxable income is reduced, then you've overpaid your taxes and you get a refund. Refunds are good. If you haven't overpaid your taxes, you'll at least have to pay less taxes.

Legal Costs in Family Law Disputes

Happily for people embroiled in family law disputes, the federal Income Tax Act lets you deduct some but not all of the money you're spending on your lawyer. The Canada Revenue Agency's Income Tax Interpretation Bulletin IT-99R5 sets out the basic rule, which I think comes from s. 8 of the act, that:
Except where there is a specific provision in the [Income Tax Act] dealing with legal or accounting fees ... legal and accounting fees are deductible only to the extent that they 
(a) are incurred for the purpose of gaining or producing income from a business or property, and 
(b) are not outlays of a capital nature.
Here are the rules applicable to family law matters:
¶ 4. "Legal costs to prosecute or to defend most tort, contract or other civil claims arising in the ordinary course of business will generally be deductible." (Torts include claims for damages for assault, battery, negligence, malicious prosecution and so on.) If you are successful, you can deduct your legal fees minus any legal costs you are awarded and actually receive. 
¶ 17. Legal costs of getting a divorceestablishing a right to spousal support under the Divorce Act or obtaining an increase in spousal support are not deductible.  
¶ 17. Legal costs of getting an order for child support are deductible. The costs of obtaining an increase in child support are not deductible. 
¶ 21. Payors' costs of addressing a claim for support are not deductible. 
¶ 18. Legal costs of defending against the reduction of support are deductible.  
¶ 21. Payors' costs of reducing support or terminating support are not deductible. 
¶ 18. Legal costs of enforcing an existing right to support are deductible. An existing right of child support or spousal support may come from a separation agreement, a court order or the legislation on family law matters. Child support is an existing right under the Divorce Act
¶ 20. However, legal expenses of getting a lump-sum payment other than for arrears are not deductible. 
¶ 21. Legal expenses relating to custody or access are not deductible.
Suggestions for Parties

If you have hired a lawyer to negotiate, apply for or enforce child support or to enforce an agreement or order for spousal support, you should tell your lawyer right away that you want to claim this deduction if your lawyer doesn't bring it up him- or herself. Your lawyer will need to write a letter to the CRA stating the amount of his or her fees that relate to those claims — you will file this letter with your income tax return — and it will be much easier for the lawyer to write the letter if the lawyer tracks his or her time on these issues right from the beginning, instead of having to review your file and make a guesstimate.

Practice Suggestions for Lawyers

If you are a lawyer representing or about to represent someone in negotiating, applying for or enforcing child support or in enforcing an agreement or order for spousal support, you should consider:
  1. Raising the issue of these tax deductions in your retainer letter so your client is aware of them from the start.
  2. Maintaining a separate yearly tally of your hours and disbursements incurred in relation to these issues, as you bill for your time or incur those expenses, so that you have an accurate record for your letter to the CRA. 
  3. Providing the client with an annual statement, in January or February, around the time T-slips are due, setting out the amount of your fees and disbursements related to these issues. 
You may wish to take these steps this regardless of whether the client mentions his or her wish to claim these deductions when you are retained; clients often ask for an accounting at tax time, and you do not want to put yourself to the trouble of a file review to calculate the client's deduction or to the risk of making a guesstimate to CRA.

Update: 7 July 2014

See the comments to this post for an important point raised by a reader which suggests that the CRA document referenced above may not reflect current CRA policy on the deductibility of legal fees. Stay tuned while I figure this out...