Introduction
Law firms earn income in several different ways — hourly billing, flat fee arrangements, retainers, and contingency fees. Each has a distinct structure, and the timing of income recognition for tax purposes is not always what the billing arrangement itself implies. Getting this wrong can result in income being reported in the wrong year, creating either overpayments or underreporting — both of which have consequences.
The Accrual vs. Billed Basis Election
Most businesses in Canada report income on an accrual basis — income is recognised when it is earned, not necessarily when it is collected. For professional practices, including law firms, the CRA permits an alternative: the billed basis of accounting, under which income is recognised when it is billed rather than when work is performed.
Under the billed basis, work in progress (unbilled time and disbursements) is not included in income until a bill is issued. This can be a meaningful deferral for law firms with significant WIP at any given time.
The billed basis is a permitted election, not a default. It must be consistently applied, and switching from one method to another requires CRA consideration. If a law firm has been using one approach informally and the CRA determines on review that the chosen method does not match the return, adjustments can result.
Retainer Fees: Received Before Earned
Retainer fees are amounts paid by clients at the outset of an engagement, before any work is performed. For tax purposes, a retainer that is received as a deposit against future services — meaning it is refundable if services are not rendered — is generally not income in the year received. It is a liability until earned.
A retainer that is non-refundable from the moment of receipt is more likely to be considered income on receipt. The distinction depends on the terms of the retainer arrangement and the substance of what the client is paying for.
Law firms should review how their retainers are structured and ensure the accounting treatment (and income reporting) reflects the actual terms of the arrangement.
Contingency Fees: Income on Settlement or Judgment
In contingency fee arrangements, the lawyer receives a percentage of the client's recovery — typically upon settlement or judgment. The fee is not earned, and generally should not be included in income, until the contingency is resolved and the right to the fee is established.
The CRA's position on contingency fees under the billed basis is that the fee is included in income when the bill is rendered — i.e., upon settlement or judgment, when the amount is determinable and the right to collect is established.
Law firms using the billed basis and running large contingency practices should ensure that fee income is captured in the correct taxation year — particularly where settlements occur close to the firm's fiscal year end.
Disbursement Recovery
Law firms pay disbursements on behalf of clients — court filing fees, expert witness fees, title search costs, process servers, travel — and recover these from clients. Whether disbursement recoveries are income to the law firm depends on whether the firm is acting as agent or principal.
Where the firm acts as agent (paying on behalf of the client and recovering only the amount paid), the net recovery may not be income. Where the firm acts as principal (incurring the cost in its own name and then billing the client), the recovery is part of income and the original disbursement is a deductible expense.
Many law firms have mixed arrangements, and the documentation of each disbursement category matters.
Provision for Doubtful Accounts
Law firms operating on accrual basis that have billed amounts that are unlikely to be collected may be entitled to a reserve for doubtful accounts under section 20(1)(l) of the Income Tax Act. This reserve allows the deferral of income on amounts that are billed but unlikely to be collected.
The reserve must be reasonable and supported by analysis of the specific accounts in question — not a blanket percentage of receivables. For law firms with significant outstanding accounts, reviewing the doubtful accounts position before year end is part of annual tax planning.
When to Speak With a CPA
Income recognition for law firms is not a one-size-fits-all issue. The combination of billing structure, the billed vs. accrual election, the nature of specific engagements, and the year-end timing of significant settlements all affect how and when income is reported. A CPA who understands legal practice structures can review the firm's approach and ensure it is both defensible to the CRA and optimised from a planning perspective.