ILNews

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

January 29, 2014
Keywords
Back to TopCommentsE-mailPrintBookmark and Share

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.•

__________

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.

ADVERTISEMENT

Post a comment to this story

COMMENTS POLICY
We reserve the right to remove any post that we feel is obscene, profane, vulgar, racist, sexually explicit, abusive, or hateful.
 
You are legally responsible for what you post and your anonymity is not guaranteed.
 
Posts that insult, defame, threaten, harass or abuse other readers or people mentioned in Indiana Lawyer editorial content are also subject to removal. Please respect the privacy of individuals and refrain from posting personal information.
 
No solicitations, spamming or advertisements are allowed. Readers may post links to other informational websites that are relevant to the topic at hand, but please do not link to objectionable material.
 
We may remove messages that are unrelated to the topic, encourage illegal activity, use all capital letters or are unreadable.
 

Messages that are flagged by readers as objectionable will be reviewed and may or may not be removed. Please do not flag a post simply because you disagree with it.

Sponsored by
ADVERTISEMENT
Subscribe to Indiana Lawyer
  1. Where may I find an attorney working Pro Bono? Many issues with divorce, my Disability, distribution of IRA's, property, money's and pressured into agreement by my attorney. Leaving me far less than 5% of all after 15 years of marriage. No money to appeal, disabled living on disability income. Attorney's decision brought forward to judge, no evidence ever to finalize divorce. Just 2 weeks ago. Please help.

  2. For the record no one could answer the equal protection / substantive due process challenge I issued in the first post below. The lawless and accountable only to power bureaucrats never did either. All who interface with the Indiana law examiners or JLAP be warned.

  3. Hi there I really need help with getting my old divorce case back into court - I am still paying support on a 24 year old who has not been in school since age 16 - now living independent. My visitation with my 14 year old has never been modified; however, when convenient for her I can have him... I am paying past balance from over due support, yet earn several thousand dollars less. I would contact my original attorney but he basically molest me multiple times in Indy when I would visit.. Todd Woodmansee - I had just came out and had know idea what to do... I have heard he no longer practices. Please help1

  4. Yes diversity is so very important. With justice Rucker off ... the court is too white. Still too male. No Hispanic justice. No LGBT justice. And there are other checkboxes missing as well. This will not do. I say hold the seat until a physically handicapped Black Lesbian of Hispanic heritage and eastern religious creed with bipolar issues can be located. Perhaps an international search, with a preference for third world candidates, is indicated. A non English speaker would surely increase our diversity quotient!!!

  5. First, I want to thank Justice Rucker for his many years of public service, not just at the appellate court level for over 25 years, but also when he served the people of Lake County as a Deputy Prosecutor, City Attorney for Gary, IN, and in private practice in a smaller, highly diverse community with a history of serious economic challenges, ethnic tensions, and recently publicized but apparently long-standing environmental health risks to some of its poorest residents. Congratulations for having the dedication & courage to practice law in areas many in our state might have considered too dangerous or too poor at different points in time. It was also courageous to step into a prominent and highly visible position of public service & respect in the early 1990's, remaining in a position that left you open to state-wide public scrutiny (without any glitches) for over 25 years. Yes, Hoosiers of all backgrounds can take pride in your many years of public service. But people of color who watched your ascent to the highest levels of state government no doubt felt even more as you transcended some real & perhaps some perceived social, economic, academic and professional barriers. You were living proof that, with hard work, dedication & a spirit of public service, a person who shared their same skin tone or came from the same county they grew up in could achieve great success. At the same time, perhaps unknowingly, you helped fellow members of the judiciary, court staff, litigants and the public better understand that differences that are only skin-deep neither define nor limit a person's character, abilities or prospects in life. You also helped others appreciate that people of different races & backgrounds can live and work together peacefully & productively for the greater good of all. Those are truths that didn't have to be written down in court opinions. Anyone paying attention could see that truth lived out every day you devoted to public service. I believe you have been a "trailblazer" in Indiana's legal community and its judiciary. I also embrace your belief that society's needs can be better served when people in positions of governmental power reflect the many complexions of the population that they serve. Whether through greater understanding across the existing racial spectrum or through the removal of some real and some perceived color-based, hope-crushing barriers to life opportunities & success, movement toward a more reflective representation of the population being governed will lead to greater and uninterrupted respect for laws designed to protect all peoples' rights to life, liberty & the pursuit of happiness. Thanks again for a job well-done & for the inevitable positive impact your service has had - and will continue to have - on countless Hoosiers of all backgrounds & colors.

ADVERTISEMENT