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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.•

__________

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. First comment on this thread is a fitting final comment on this thread, as that the MCBA never answered Duncan's fine question, and now even Eric Holder agrees that the MCBA was in material error as to the facts: "I don't get it" from Duncan December 1, 2014 5:10 PM "The Grand Jury met for 25 days and heard 70 hours of testimony according to this article and they made a decision that no crime occurred. On what basis does the MCBA conclude that their decision was "unjust"? What special knowledge or evidence does the MCBA have that the Grand Jury hearing this matter was unaware of? The system that we as lawyers are sworn to uphold made a decision that there was insufficient proof that officer committed a crime. How can any of us say we know better what was right than the jury that actually heard all of the the evidence in this case."

  2. wow is this a bunch of bs! i know the facts!

  3. MCBA .... time for a new release about your entire membership (or is it just the alter ego) being "saddened and disappointed" in the failure to lynch a police officer protecting himself in the line of duty. But this time against Eric Holder and the Federal Bureau of Investigation: "WASHINGTON — Justice Department lawyers will recommend that no civil rights charges be brought against the police officer who fatally shot an unarmed teenager in Ferguson, Mo., after an F.B.I. investigation found no evidence to support charges, law enforcement officials said Wednesday." http://www.nytimes.com/2015/01/22/us/justice-department-ferguson-civil-rights-darren-wilson.html?ref=us&_r=0

  4. Dr wail asfour lives 3 hours from the hospital,where if he gets an emergency at least he needs three hours,while even if he is on call he should be in a location where it gives him max 10 minutes to be beside the patient,they get paid double on their on call days ,where look how they handle it,so if the death of the patient occurs on weekend and these doctors still repeat same pattern such issue should be raised,they should be closer to the patient.on other hand if all the death occured on the absence of the Dr and the nurses handle it,the nurses should get trained how to function appearntly they not that good,if the Dr lives 3 hours far from the hospital on his call days he should sleep in the hospital

  5. It's a capital offense...one for you Latin scholars..

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