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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. I grew up on a farm and live in the county and it's interesting that the big industrial farmers like Jeff Shoaf don't live next to their industrial operations...

  2. So that none are misinformed by my posting wihtout a non de plume here, please allow me to state that I am NOT an Indiana licensed attorney, although I am an Indiana resident approved to practice law and represent clients in Indiana's fed court of Nth Dist and before the 7th circuit. I remain licensed in KS, since 1996, no discipline. This must be clarified since the IN court records will reveal that I did sit for and pass the Indiana bar last February. Yet be not confused by the fact that I was so allowed to be tested .... I am not, to be clear in the service of my duty to be absolutely candid about this, I AM NOT a member of the Indiana bar, and might never be so licensed given my unrepented from errors of thought documented in this opinion, at fn2, which likely supports Mr Smith's initial post in this thread: http://caselaw.findlaw.com/us-7th-circuit/1592921.html

  3. When I served the State of Kansas as Deputy AG over Consumer Protection & Antitrust for four years, supervising 20 special agents and assistant attorneys general (back before the IBLE denied me the right to practice law in Indiana for not having the right stuff and pretty much crushed my legal career) we had a saying around the office: Resist the lure of the ring!!! It was a take off on Tolkiem, the idea that absolute power (I signed investigative subpoenas as a judge would in many other contexts, no need to show probable cause)could corrupt absolutely. We feared that we would overreach constitutional limits if not reminded, over and over, to be mindful to not do so. Our approach in so challenging one another was Madisonian, as the following quotes from the Father of our Constitution reveal: The essence of Government is power; and power, lodged as it must be in human hands, will ever be liable to abuse. We are right to take alarm at the first experiment upon our liberties. I believe there are more instances of the abridgement of freedom of the people by gradual and silent encroachments by those in power than by violent and sudden usurpations. Liberty may be endangered by the abuse of liberty, but also by the abuse of power. All men having power ought to be mistrusted. -- James Madison, Federalist Papers and other sources: http://www.constitution.org/jm/jm_quotes.htm RESIST THE LURE OF THE RING ALL YE WITH POLITICAL OR JUDICIAL POWER!

  4. My dear Mr Smith, I respect your opinions and much enjoy your posts here. We do differ on our view of the benefits and viability of the American Experiment in Ordered Liberty. While I do agree that it could be better, and that your points in criticism are well taken, Utopia does indeed mean nowhere. I think Madison, Jefferson, Adams and company got it about as good as it gets in a fallen post-Enlightenment social order. That said, a constitution only protects the citizens if it is followed. We currently have a bevy of public officials and judicial agents who believe that their subjectivism, their personal ideology, their elitist fears and concerns and cause celebs trump the constitutions of our forefathers. This is most troubling. More to follow in the next post on that subject.

  5. Yep I am not Bryan Brown. Bryan you appear to be a bigger believer in the Constitution than I am. Were I still a big believer then I might be using my real name like you. Personally, I am no longer a fan of secularism. I favor the confessional state. In religious mattes, it seems to me that social diversity is chaos and conflict, while uniformity is order and peace.... secularism has been imposed by America on other nations now by force and that has not exactly worked out very well.... I think the American historical experiment with disestablishmentarianism is withering on the vine before our eyes..... Since I do not know if that is OK for an officially licensed lawyer to say, I keep the nom de plume.

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