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BGBC: Court agrees with IRS that advanced client expenses are loans

January 29, 2014
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By Howard I. Gross, Steven W. Reed, Erika M. Gowan, Casey L. Higgs, and Samuel M. Pollom

An important U.S. Tax Court ruling last year may affect you and your law firm. The case settled a long-standing dispute between attorneys and the Internal Revenue Service regarding advanced client expenses for lawyers who handle cases on a contingency basis. Such lawyers routinely pay litigation expenses (e.g., court fees, medical records, expert witnesses, etc.) on behalf of their clients before ever receiving any funds from them. Whether these lawyers get reimbursed for advanced expenses depends on the agreements with their clients and the results of their particular case.

Many law firms and attorneys take the position that attorneys who work on a contingency basis should be allowed to deduct case expenses advanced to their clients in the year the expenses are paid. Their theory is that because the attorney has no assurance that advanced expenses will ever be reimbursed, a tax deduction should be allowed in the current year. The IRS position has always been that advanced expenses are actually loans to the client and should be capitalized on the books of the attorney until the case is resolved. If the client receives an award or settlement, the advanced expenses can then be deducted as case expenses. If the case is not successful, and no income is received by the lawyer, the advanced expenses can be written off the books as a bad debt.

Many cases between attorneys and the IRS have been heard on this subject, and virtually all have been decided in favor of the IRS. Arguments that lawyers are incurring an expense without the expectation of being reimbursed have been met with little to no success. However, last year a Missouri law firm challenged the IRS position on this matter in the U.S. Tax Court. Humphrey, Farrington & McClain, PC v. Commissioner, TC Memo 2013-23. The case is significant because the firm offered a well-reasoned argument for the method it used to account for advanced expenses based on real data showing its particular rates of reimbursement. The firm contended this data proved that it was really bearing the cost of expenses advanced in its contingency cases.

The Tax Court was not impressed with this argument. In fact, the court held that the data failed to demonstrate the possibility of reimbursement was remote. Rather, it found there was a significant possibility these advanced expenses would be reimbursed. The court stated that the firm screened its cases and clients, and thus had a very good opportunity to assess the merits of each case before accepting it. Since an attorney is less likely to take a case that has a low probability of success (and a low probability of being reimbursed for advanced expenses), the expectation of reimbursement is generally higher. Additionally, the court agreed with the IRS and found that such advanced expenses are in the nature of loans, not ordinary and necessary business expenses, even if there is a low likelihood of reimbursement.

This case effectively took the wind out of the sails of many law firms and attorneys that have for many years deducted advanced expenses at the time they are paid without regard to the ultimate resolution of the case to which the expenses are related. The decision in Humphrey makes it clear that this method of tax accounting will be challenged by the IRS, and the attorney will most likely lose if he or she attempts to contest the IRS in court.

To add injury to insult, the Tax Court in Humphrey ordered the firm to change its method of accounting by filing Form 3115 with the IRS, which effectively forced the firm to pay tax on the expenses it had already deducted before the related cases were resolved. The IRS considers a change from a current deduction of advanced expenses to capitalization of the expenses to be a material item requiring a change in accounting method. In the case of Humphrey, the firm was required to make a $2.7 million adjustment to its income tax.

Law firms that handle cases on a contingency fee basis should not deduct case expenses advanced on behalf of a client in the current year. Advanced expenses are to be treated as loans to contingent-fee clients. Advanced expenses should be capitalized on the firm’s books until the case is resolved. If the attorney is successful in settling a case or winning in litigation, the associated advanced expenses can then be deducted as an offset to the fees earned by the attorney. If the case is not successful, and the attorney gets no recovery in the form of fees or expense reimbursement, the attorney can then deduct the associated advanced case expenses as a bad debt expense.

If you are an attorney who handles cases on a contingency basis and are affected by this ruling, seek a seasoned tax expert who has experience working with attorneys for assistance in proper accounting treatment of advanced expenses.•

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Howard I. Gross, CPA/ABV/CFF, CFP; Steven W. Reed, CPA/ABV; Erika M. Gowan, CPA/CFF, CFE; Casey L. Higgs; CPA/CFF, CFE, CVA, and Samuel M. Pollom, JD, CPA, are with BGBC Partners LLP – Litigation, Forensic and Business Valuation. Contact BGBC at 317-633-4700 or visit www.bgbc.com. The opinions expressed are those of the authors.

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  1. Indianapolis employers harassment among minorities AFRICAN Americans needs to be discussed the metro Indianapolis area is horrible when it comes to harassing African American employees especially in the local healthcare facilities. Racially profiling in the workplace is an major issue. Please make it better because I'm many civil rights leaders would come here and justify that Indiana is a state the WORKS only applies to Caucasian Americans especially in Hamilton county. Indiana targets African Americans in the workplace so when governor pence is trying to convince people to vote for him this would be awesome publicity for the Presidency Elections.

  2. Wishing Mary Willis only God's best, and superhuman strength, as she attempts to right a ship that too often strays far off course. May she never suffer this personal affect, as some do who attempt to change a broken system: https://www.youtube.com/watch?v=QojajMsd2nE

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  5. What a fine article, thank you! I can testify firsthand and by detailed legal reports (at end of this note) as to the dire consequences of rejecting this truth from the fine article above: "The inclusion and expansion of this right [to jury] in Indiana’s Constitution is a clear reflection of our state’s intention to emphasize the importance of every Hoosier’s right to make their case in front of a jury of their peers." Over $20? Every Hoosier? Well then how about when your very vocation is on the line? How about instead of a jury of peers, one faces a bevy of political appointees, mini-czars, who care less about due process of the law than the real czars did? Instead of trial by jury, trial by ideological ordeal run by Orwellian agents? Well that is built into more than a few administrative law committees of the Ind S.Ct., and it is now being weaponized, as is revealed in articles posted at this ezine, to root out post moderns heresies like refusal to stand and pledge allegiance to all things politically correct. My career was burned at the stake for not so saluting, but I think I was just one of the early logs. Due, at least in part, to the removal of the jury from bar admission and bar discipline cases, many more fires will soon be lit. Perhaps one awaits you, dear heretic? Oh, at that Ind. article 12 plank about a remedy at law for every damage done ... ah, well, the founders evidently meant only for those damages done not by the government itself, rabid statists that they were. (Yes, that was sarcasm.) My written reports available here: Denied petition for cert (this time around): http://tinyurl.com/zdmawmw Denied petition for cert (from the 2009 denial and five year banishment): http://tinyurl.com/zcypybh Related, not written by me: Amicus brief: http://tinyurl.com/hvh7qgp

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