What’s Your Tax Issue? – Legal Fees for Severance

The Tax Issue:

I was helping my roommate with his taxes and we were debating whether to file a T1 adjustment for prior years.  He worked at a company from November 2004 to January 2007 and was laid-off in January 2007.  He contested his severance and ended up paying about $1,000 in legal fees which he never deducted against employment income.  The issue is whether those legal fees should be deducted against the severance payment he received in 2007, or whether those legal fees can be pro-rated over the course of his entire employment.  The thing is, he went back to school in 2007, so, besides the severance payment, he didn’t earn any other income in 2007.  As such, deducting the legal fees in 2007 would have no tax benefit.  If we could deduct them over the course of his employment (i.e. 2004-2007) by pro-rating them, he would receive some tax benefit.

The Answer:

The deduction for legal fees is always a hot topic, as I discussed in an earlier post. Legal fees paid to establish or enforce a severance payment (a retirement allowance in technical terms) are specifically dealt with in subsection 60(o.1) of the Income Tax Act.
Unfortunately the news is not great for your friend. For any given tax year, you can deduct legal fees paid in that year or in any of the 7 previous years. This essentially gives you a carryforward, but there is no provision for a carryback of fees to previous years.
But the restrictions don’t end there. The fees are deductible only against the income to which they relate and only to the extent that they were not deductible in past years. So, to the extent that he received severance payments in 2007, he must deduct his legal fees paid against that income. Then, if he still hasn’t used up all of his legal expenses, he can deduct them only if he is paid similar income in one of the next 7 years.

The Tax Treatment of Legal Fees (And Other Important Lessons)

Did you ever get yourself into a bad relationship? How about a lousy business venture? How about a bad relationship, three lousy business ventures, a few lawsuits and a tax court case? Consider the case of John G. Dalfort v. Her Majesty the Queen (2009 DTC 1278), and the relationship from hell. Apparently, while they were together, John and his ex, Karen Conquergood, attempted a few enterprises that didn’t quite pan out. The first was an escort service. Then they tried a pyramid scheme, and finally a crab-fishing business. Well, you can’t say they didn’t diversify! They also received cash from two separate lawsuits brought, first against an insurance company and then a physician.

John and Karen - Even crabs couldn't keep them together

After they split up (yes, somehow they were not destined to last), she sued him for spousal support, her share of the take from the aforementioned ventures, as well as for her share of the proceeds from the sale of their house and a 45-foot sailboat. Finally, there was the small matter of the damages she sought for assault.

Ms. Conquergood was only mildly successful in her claims, but poor John then tried to deduct the legal fees he paid to defend himself. And so, The Tax Issue must now discuss the mundane topic of legal fees and their tax treatment.

The CRA has summarized their position on legal fees in their bulletin IT-99R5. First, there is nothing in the law that allows for the general deduction of legal fees. Apart from a few specific provisions which we discuss below, legal fees are only deductible if they are non-capital expenses incurred to earn income from a business or property.

Examples of deductible legal fees for business purposes include:

  • Preparation of general sales contracts
  • Obtaining security for trade debts
  • Preparation of annual minutes and corporate filings

Legal fees for obtaining financing or issuing shares are capital in nature, but under a special rule, they may be amortized over five years.

Other legal fees that are capital in nature may be added to the cost of capital assets acquired or to cumulative eligible capital.

Apart from the above, specific sections of the law allow you to deduct legal fees incurred for:

  • Enforcing or establishing a right to salaries and wages
  • Enforcing or establishing a right to pension benefits or a retiring allowance (including damages for wrongful dismissal)
  • Preparing an appeal to a tax assessment
  • Making representations to a government body
  • Establishing a right to child support
  • Enforcing a pre-existing right to spousal support or child support

Legal fees incurred to establish a right to spousal support are not deductible.

From a payer’s point of view, fees to contest a claim for support payments or to reduce pre-existing support amounts are not deductible.

But let’s get back to our hero, John. The Tax Court ruled that his legal fees were incurred to defend against claims which were either personal in nature, or involved business activities which had been, but were no longer carried on. His claim was dismissed.

I think there are many lessons to be learned from this case, the tax treatment of legal fees being probably the least important.