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 divorce, establishing 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...

CBA Publishes Family Law Resources

The Canadian Bar Association, the national association of Canadian lawyers, has just published an excellent resource from its national family law section and number of materials directed at the public further to its Equal Justice Initiative. (The CBA's Access to Justice Committee was another product of this Initiative, you may recall, and published its final report, Reaching Equal Justice Report: An Invitation to Envision and Act (PDF), in November 2013.)

Legal Health Checks

In a new resources page on its website, beneath the compelling banner "Law. You. Check it out.", the CBA says:

"An important part of improving access to justice is to ensure people have the information and tools they need to avoid legal problems in the first place, or to prevent those problems from becoming bigger than they might have been. As part of the CBA’s Reaching Equal Justice initiative, CBA is offering 6 Legal Health Checks for the public. ... The goal of the Checks is to encourage people to recognize legal problems early, and to take action when they do identify them. For lawyers, these materials are a way to start conversations with people about the law, how to get legal help and how to work effectively with a lawyer."

The "checks" are smartly-designed, one- or two-page documents that provide cursory information about different legal issues and encourage people to get legal advice. Five Steps to Legal Wellness (PDF), for example, tells people to deal with legal problems when they come up, keep paperwork like contracts, get help right away, get advice from a lawyer and remain calm when discussing the problem. Heady stuff.

On family law subjects, On My Own: Youth (PDF) says that sex without consent is a crime, warns against sharing explicit photographs and warns that "having a baby means financial and other consequences for both parents until the baby grows up." How to Avoid Surprises (PDF) cautions that being in a romantic relationship can have consequences and encourages people to get legal advice "before you live together, before you have a child, before you get married, when your marriage or common-law partnership is ending." 

Breaking Up (PDF), a concise one-page document, talks about the financial consequences of separation and encourages people to "speak to a lawyer when you are calm" and to use the lawyer for "legal advice, not counselling." A companion sheet, Breaking Up: Parenting (PDF), another one-pager, tells people that "by getting legal help with parenting decisions" they can focus on children's needs, avoid conflict, protect themselves and find lasting solutions.

I'm a staunch supporter of public legal information and public legal education, but with the greatest of respect I'm not sure what what the six checks are going to accomplish, or whether they will "encourage people to recognize legal problems early, and to take action" as intended. The materials on family law matters are brief and insubstantial, and provide little by way of legal information except to recommend speaking to a lawyer. Of course everyone with a legal problem, real or potential, ought to speak to a lawyer, but here is what Canada's Chief Justice said when addressing an access to justice conference in Toronto in February 2011:

"Do we have adequate access to justice? It seems to me that the answer is no. We have wonderful justice for corporations and for the wealthy. But the middle class and the poor may not be able to access our justice system."

And there's the rub.

Tax Matters Toolkit

The new material from the CBA's national family law section, a group for members who practice family law, is a resource called Tax Matters Toolkit: Separation and Divorce (PDF) that is published in two versions, one aimed at family law lawyers and one aimed at their clients. The client resource is short but jam-packed with useful information about the tax issues that come up when a relationship breaks down. It talks about:

• how and when the Canada Revenue Agency must be told about changes in marital status
• knowing when potential tax issues are worth the cost of speaking to a tax specialist
• the CRA's definitions of important terms like "child," "common law partner," "principle residence," "separation" and "shared custody"
• sharing RRSPs and other kinds of pension plans and pension funds

The resource also provides a list — complete with links! — of important CRA forms and describes what the forms are meant to accomplish. 

The resource does not talk about common but very complicated tax problems like tax arrears and potential taxes owing for present and past years, planning spousal support for the maximum tax advantage or sharing the value of family companies, but that's entirely understandable. Those issues can be very, very complicated and generally do require expert advice.

Good job, family law section!

Tax Court Rules on Deductibility of Legal Fees to Claim or Enforce Support

Ron Hooge, a respected Vancouver chartered accountant and business valuator with SmytheRatcliffe, has distributed a commentary on a recent Tax Court case, Sarophim v. Her Majesty the Queen, concerning the tax deductibility of legal fees incurred in relation to support payments to be made following separation.

The basic rule, as I had understood it, is that legal fees incurred to obtain or enforce a spousal or child support entitlement are tax deductible whereas legal fees incurred to defend a support claim are not. The taxpayer in Sarophim argued that this distinction was unconstitutional.

As Ron says in his commentary, the taxpayer lost:

"The Court found that it is now settled law that legal fees incurred by the payer of support (for example, to establish or increase, or decrease or terminate it) cannot be considered to have incurred for the purpose of earning income, and therefore not deductible. The Court referenced Interpretation Bulletin, IT-99R5, paragraph 21. 

"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 business or property, and 

b) are not outlays of a capital nature."

Ron then quotes paragraphs 17 to 21 of the Interpretation Bulletin, which are indeed worth the effort to read if you can make it through the heavy legal prose. What the Interpretation Bulletin says is this:

1. Legal fees incurred to establish a right to spousal support are not deductible.
2. Legal fees incurred to establish a right to child support are deductible.
3. Legal fees incurred to obtain an increase in the amount of child support or spousal support paid are not deductible.
4. Legal fees incurred to enforce a right to child support or spousal support established in an order or agreement are deductible.

My thanks to Ron for his commentary and to Megan Ellis, QC for bringing it to my attention. My extra thanks to Kathleen Packard for helping me find and correct an error in this post.