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
2015 Distinguished Barrister &
Up and Coming Lawyer Reception

Tuesday, May 5, 2015 • 4:30 - 7:00 pm
Learn More


ADVERTISEMENT
Subscribe to Indiana Lawyer
  1. A traditional parade of attorneys? Really Evansville? Y'all need to get out more. When is the traditional parade of notaries? Nurses? Sanitation workers? Pole dancers? I gotta wonder, do throngs of admiring citizens gather to laud these marching servants of the constitution? "Show us your billing records!!!" Hoping some video gets posted. Ours is not a narcissistic profession by any chance, is it? Nah .....

  2. My previous comment not an aside at court. I agree with smith. Good call. Just thought posting here a bit on the if it bleeds it leads side. Most attorneys need to think of last lines of story above.

  3. Hello everyone I'm Gina and I'm here for the exact same thing you are. I have the wonderful joy of waking up every morning to my heart being pulled out and sheer terror of what DCS is going to Throw at me and my family today.Let me start from the !bebeginning.My daughter lost all rights to her 3beautiful children due to Severe mental issues she no longer lives in our state and has cut all ties.DCS led her to belive that once she done signed over her right the babies would be with their family. We have faught screamed begged and anything else we could possibly due I hired a lawyer five grand down the drain.You know all I want is my babies home.I've done everything they have even asked me to do.Now their saying I can't see my grandchildren cause I'M on a prescription for paipain.I have a very rare blood disease it causes cellulitis a form of blood poisoning to stay dormant in my tissues and nervous system it also causes a ,blood clotting disorder.even with the two blood thinners I'm on I still Continue to develop them them also.DCS knows about my illness and still they refuse to let me see my grandchildren. I Love and miss them so much Please can anyone help Us my grandchildren and I they should be worrying about what toy there going to play with but instead there worrying about if there ever coming home again.THANK YOU DCS FOR ALL YOU'VE DONE. ( And if anyone at all has any ideals or knows who can help. Please contact (765)960~5096.only serious callers

  4. He must be a Rethuglican, for if from the other side of the aisle such acts would be merely personal and thus not something that attaches to his professional life. AND ... gotta love this ... oh, and on top of talking dirty on the phone, he also, as an aside, guess we should mention, might be important, not sure, but .... "In addition to these allegations, Keaton was accused of failing to file an appeal after he collected advance payment from a client seeking to challenge a ruling that the client repay benefits because of unreported income." rimshot

  5. I am not a fan of some of the 8.4 discipline we have seen for private conduct-- but this was so egregious and abusive and had so many points of bad conduct relates to the law and the lawyer's status as a lawyer that it is clearly a proper and just disbarment. A truly despicable account of bad acts showing unfit character to practice law. I applaud the outcome.

ADVERTISEMENT