Costs incurred on behalf of clients.

Many professional service firms incur costs on behalf of their clients. Are these deductible as Sec. 162 ordinary and necessary expenses, with subsequent reimbursements included in income when received? Or do these costs constitute advances not deductible when incurred, with any subsequent reimbursements not included in income when received? Do different types of costs incurred result in different tax treatments?

Net Fee Arrangements

In Canelo, 53 TC 217 (1969), aff'd per curiam, 447 F2d 484 (1971), the Tax Court ruled that costs incurred by a law firm on behalf of clients are advances. The court stated that the attorneys "made expenditures on behalf of a particular client, under a reimbursement agreement signed by the client, to pursue a claim held by the client--a claim of no use to any person other than the client. In reality, they are the client's expenditures."

A number of other cases like Canelo have addressed contingent "net-fee arrangements," under which a law firm pays for costs associated with the case on behalf of its client during litigation. If the case is decided in the client's favor, the litigation costs paid by the law firm are reimbursed from the proceeds. After the reimbursement is made, the law firm receives an agreed-on percentage of the remaining net proceeds for services rendered. If the case is lost, it is understood that the client owes nothing for either fees or costs. A law firm would agree to these terms to remain competitive with other firms offering similar fee arrangements. Also, some clients do not have the funds to pay litigation costs, and the law firm may believe there is a strong probability that it can win the case and ultimately recoup its expenses.

The courts have ruled that reimbursable costs incurred on behalf of clients under such contingent net-fee arrangements are nondeductible advances when incurred. When reimbursements are received from clients, the reimbursement is not income to the firm. Typical costs viewed by the courts as advances to clients have included travel expenses, medical records, reports, expert witness fees, deposition costs, filing fees and other similar items. These costs are specific to the case involved and, except for the case, would not be incurred.

Support-Type Service Charges

In Letter Ruling 9432002, the IRS considered the deductibility of costs paid to third parties and incurred on behalf of clients and support-type service charges. The costs incurred and paid to third parties were similar to those previously determined to be advances under case law, and the Service ruled accordingly. However, support-type service charges previously had not been addressed. These charges included costs for in-house photocopying, word processing, online research and other support-type services rendered to the client by the law firm. The IRS ruled that support-type service charges were deductible when incurred and includible in income when paid by the client.

That letter ruling also concluded that a bad-debt deduction under Sec. 166(a), related to costs paid on behalf of clients under a contingent-the arrangement, was not allowed, because no valid and enforceable obligation existed until the case was closed. However, when a case is closed, the liability exists; accordingly, a bad-debt deduction under Sec. 166 would be allowed if all the worthlessness requirements of Regs. Sec. 1.166-2(b) were met. Thus, under the letter ruling, a bad-debt deduction cannot be taken until the case is closed, even if the professional service firm believes there is no possibility of recovering the costs paid by the firm.

Gross Fee Arrangements

In Boccardo, 56 F3d 1016 (1995), the Ninth Circuit held that litigation costs paid by a law firm under a contingent "gross-fee arrangement" qualify as ordinary and necessary business expenses deductible under Sec. 162. The costs at issue were filing fees, witness fees, travel expenses and medical consultation fees--costs that under contingent net-fee arrangements have been ruled advances. The fees received by the law firm under gross-fee arrangements were based solely on a percentage of the gross proceeds received by the client and did not require reimbursement of costs paid on the client's behalf.

The Ninth Circuit stated that,

[w]hen the firm, on advice of counsel, chose to adopt different contractual terms, with a different economic result than those obtaining under the net fee contracts, the firm created an arrangement that cannot be governed by the automatic application of the cases decided on the basis of the net fee contracts.

The court added that,

under the gross fee contract, the firm, like other businesses, can only make a profit if it succeeds in deriving gross fee revenues that exceed its own expenses--that is, if it succeeds in keeping its own costs, including the type singled out by the IRS, lower than the fees it obtains over the course of a given year from the clients whose cases are successful.

The Ninth Circuit ruled that the gross-fee form of agreement allowed a taxpayer an ordinary and necessary expense deduction for the costs incurred on behalf of clients.

Reimbursable Service Charges

According to the Service, in Letter Ruling (CCA) 9937031, it had tentatively formed an adverse position on a taxpayer's proposed change in accounting treatment for reimbursable service charges. The taxpayer had filed Form 3115, Application for Change in Accounting Method, to deduct reimbursable service charges when paid and report reimbursements as income when received. The CCA did not provide a description of the types of costs included in reimbursable service charges; therefore, it cannot be determined if this CCA conflicts with Letter Ruling 9432002. The taxpayer also requested permission to change the accounting treatment of out-of-pocket expenses to the method of treating the expenditures as loans; the IRS concurred. The taxpayer withdrew the application prior to the Service's ruling on the method-change request.

Advisers should be aware of the tax implications of costs incurred on behalf of clients. Care should be taken in determining which costs incurred may be potentially deductible service charges and which may be nondeductible expenditures incurred on behalf a client.

FROM L. MICHELLE CARLONE, CPA, WASHINGTON, DC

Robert Zarzar, CPA
Partner
Washington National Tax Service
PricewaterhouseCoopers
Washington, DC