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.

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