Deductibility of expenditures.

The IRS permits taxpayers to use the cash method of accounting even though that method does not perfectly match revenues with expenses. When they are too far out of line, however, the IRS can require a taxpayer to switch to the accrual method of accounting.

Most companies incur professional services expenses on a regular basis. As a result, many choose to hire attorneys, accountants and others on retainer. The deductibility of retainer fees has long been the subject of disagreement between taxpayers and the IRS. Recently, one taxpayer litigated both of these issues.

Accounting method. Dana Corp. and all but one of its subsidiaries used the accrual method of accounting. Leverage Leasing used the cash method. It received its rents in arrears and paid its interest expense in the same manner. In 1984, the company decided to pay the interest expense for the year in December, rather than in January 1985, when it was due. The IRS determined that the cash method did not clearly reflect income and required Leverage Leasing to switch to the accrual method.

Legal retainer. Dana Corp. hired the law firm of Wachtell, Lipton, Rosen and Katz. They paid Wachtell an annual retainer, primarily to prevent the firm from representing a company interested in acquiring Dana. The retainer agreement permitted Dana to reduce any actual legal fees by the amount of the retainer. Dana used Wachtell, Lipton for legal advice only occasionally, but in all cases deducted the retainer in the year it was paid. In 1984, Dana acquired another company and offset Wachtell, Lipton's legal fees in part with the retainer. The IRS denied a deduction for the retainer.

Result. Split decision: For the taxpayer on the accounting method issue and for the IRS on the capitalization of the legal retainer. Typically, the courts will uphold an IRS determination that a taxpayer's accounting method does not clearly reflect income. In this case, however, the Federal Circuit Court of Appeals decided that IRC section 461 (g) specifically permitted a deduction for

advance payment of accrued interest. The same section denies a cash method taxpayer a deduction for interest paid for periods after the close of the tax year. According to the court, by denying a deduction for prepaid interest, the code authorizes a deduction for all interest paid for the tax year--even if it is paid in advance. Therefore, the IRS does not have the authority to require a taxpayer to switch to the accrual method, even if the interest deduction is not properly matched with revenue under the cash method.

Congress enacted section 461(g) to prevent a cash method taxpayer from prepaying interest expense. Most other expenditures do not have comparable code sections. Therefore, other cash method taxpayers must be careful that in prepaying expenses they do not distort their income or the IRS could put them on the accrual method of accounting.

The Court of Federal Claims had held the legal retainer to be deductible based on the origin of the claim doctrine. The appellate court applied this doctrine differently, concluding that the right of offset in the retainer agreement made the origin of the payment the specific legal bill, not the annual retainer, as the earlier court had stated. Since the bill was for an acquisition, a capitalizable event, the company had to capitalize the retainer fee.

The result is that retainer payments are deductible or capitalizable based on the nature of the legal fees a company incurs. As the court pointed out, the company could deduct the retainer each year that it did not offset actual legal bills. Since most retainers have a right of offset, deductibility will depend on the services rendered each year, with any excess retainer deductible currently.

* Dana Corp. v. United States, 74 F.3d 1344, 99-1, USTC P50, 411 (CA-Fed. Cir.).