Are legal fees deductible?
As with many tax matters, that depends on a number of variables.The Income Tax Act is clear that legal fees are not deductible as of right. The specific nature of the legal matter is highly relevant when deciding if you can deduct the fees. This gives rise to quite a bit of confusion.
Firstly, legal expenses must be related to carrying on a business for the purpose of deriving “assessable income”. There must be a ‘nexus’ (or connection) between expenditure and income. In other words, you’re spending a buck to make a buck.
Secondly, legal expenses are those services performed by someone who holds a practising certificate from the New Zealand Law Society, or the Australian equivalent. It might seem like stating the obvious but legal fees are invoices received from lawyers, not HR advisors or other consultants.
Thirdly, if legal expenses exceed $10,000 in any financial year then consideration needs to be given as to whether the fees relate to capital (land, assets) or revenue (deriving income). Where the fees exceed $10,000 and are related to capital, no deduction is allowed. Of course if the fees are under $10,000 then this test is not relevant.
Finally, where legal fees are preparatory to carrying on a business, they are often not deductible. That means that start-up fees might not be deductible.
Any legal fees that are of a private nature are not deductible. This would be particularly relevant in relationship property matters.
So what might this all mean?
- Rental properties – Legal fees to buy or sell a rental property are probably deductible as there is a nexus with deriving income. The fees would likely be related to securing mortgage finance which is definitely deductible. Remember that if the fees were over $10,000 in any financial year, they wouldn’t be deductible as they exceeded the limitation for capital expenditure. So if the fees are under $10,000, you would probably qualify for the deduction.
- Incorporating a company – Legal fees to set up a company are not deductible unless the company has taken significant and essential steps in carrying on a business. This would include steps such as advertising, hiring staff or leasing premises. So if you were to incur legal expenditure to set-up a company such as a shareholders agreement but then subsequently did not ‘carry on a business’, it is unlikely a deduction would be available.
- Administration of a trust or estate – legal expenditure would be deductible if the expenditure was related to better administration of trust assets, monitoring etc… However, if the expenditure was otherwise private such as for the beneficiaries, it would not be deductible. It is almost certain that legal fees for estate work are not deductible as it fails the first test of carrying on a business.
You should be aware that the IRD makes no distinction in terms of the threshold between private and business related expenditure. So if some of the work related to a business activity and some was personal, the IRD look at the total amount of expenditure – they don’t deduct the personal portion.
Non-deductible legal expenses
The IRD has indicated that no deductions are allowed for the following legal expenses:
- fees incurred in the sale of a business
- the cost of incorporating or liquidating a company
- fees for drafting a partnership deed or deed of trust, and
- the cost of settling any dispute that may arise between the partners.
There are no specific limitations on accountancy fees or other consultants’ advice in the Income Tax Act – so long as the expenditure is incurred in carrying on a business and there is a nexus between the expenditure and any income.
Legal fees can seem a bit complicated. As always, this advice is general in application so if you’d like advice specific to your situation, please don’t hesitate to call us.