Accounting for client out-of-pocket expenses.

In some areas of the country, the IRS is making the examination of law firms a high priority. One of the issues the examining agent generally looks for is the firm's deduction of out-of-pocket expenses it has paid on behalf of its clients. While this issue is most common in law firms, it can also arise in the context of other personal service businesses.

When law firms and some other personal service businesses ("firms") pay out-of-pocket costs on behalf of their clients, it is generally under an agreement with the client that the client will reimburse the costs. Several courts have sustained the Service's position that the firm may not deduct these costs. This follows the general rule that one taxpayer may not deduct expenses it pays on behalf of another because the expenses do not meet the ordinary and necessary requirement of Sec. 162.

These out-of-pocket expenditures are considered loans by the firm to the client, and the client's reimbursement of the expenditures is a repayment of the loan (neither of which has a tax effect to the attorney). Many firms, however, continue to deduct these costs when they pay them and to report the reimbursement as income when they receive it.

In addition to stating these established rules, however, Letter Ruling (TAM) 9432002 provides some additional guidance relating to deducting client out-of-pocket expenses.

When the expenses are incurred in connection with a contingency fee case, the firm may deduct them in the year in which the case is closed in such a manner that the firm will not recover these out-of-pocket expenses.

When the firm bills a client for out-of-pocket expenses but the client does not pay, the firm can claim a bad debt deduction when the debt is worthless and uncollectible and legal action to enforce payment would not result in collection.

The firm may also deduct out-of-pocket expenses in the year in which it determines that, for valid business reasons, it will not bill the client for them. As authority for this deduction, the TAM cites an exception to the general rule that one taxpayer may not deduct expenses it pays on behalf of another. The exception applies when the expenses the taxpayer seeks to deduct are ones it has expended to protect or promote its own established business.

This TAM points up some planning opportunities.

* For firms deducting client out-of-pocket expenses in the year in which they pay or incur them, some preemptive action can prevent an IRS adjustment on examination. If the Service finds this issue on examination, the examining agent will generally propose the adjustment in the earliest year possible, and require the entire amount of the adjustment resulting from the change to be taken into account in that year. The adjustment will result in interest, and possibly penalties.

If the taxpayer takes action before the IRS notifies the firm of a pending examination, the taxpayer can request the change in the current year, with a six-year spread of the adjustment. Even if the firm has been notified of a pending examination, it can still request a voluntary change if it does so within 90 days of the notification.

* For firms not deducting client out-of-pocket expenses as early as they might be under the rules outlined for costs that the client will not reimburse, or for which the client might not be billed, a request for permission to change an accounting method can be filed for the first available year.

From Eileen J. O'Connor, CPA, J.D., Washington, D.C.