Deduction or advance?

Taxpayers frequently incur expenditures on behalf of clients that the client later reimburses. Is the taxpayer entitled to deduct these expenditures, or are they considered nondeductible advances? What is the effect of changing the accounting for these expenditures?

Pelton & Gunther (P&G) is a professional legal corporation that specializes in defending personal injury automobile accident lawsuits. Each time the California State Auto Association (CSAA) retained the firm to defend a policyholder, it received a $400 payment. As it performed services, P&G paid various expenses, including filing fees, witness fees and deposition expenses, which often exceeded the $400 retainer. After a case was resolved, P&G billed CSAA for services rendered at a fixed hourly rate, plus expenditures.

It was P&G's practice to deduct expenditures when paid and to report income when it received retainers or settlements from CSAA. The IRS denied the expenditure deductions and made an IRC section 481 adjustment for prior year reimbursements.

Result. For the IRS. The Tax Court concluded that based on long standing precedent the expenditures were advances not deductions. It rejected the taxpayer's reliance on Boccardo v. Commissioner, 65 F.3d 1016 (CA-9, 1995) where the taxpayer had a gross fee arrangement that did not provide for reimbursements in addition to a fixed fee. The court permitted Boccardo to take a deduction because he was not reasonably assured of receiving a reimbursement for the expenses he incurred. In net tee arrangements similar to the one P&G had, reimbursement is reasonably assured, thereby making the expenditures advances.

The IRS proposed P&G make a section 481 adjustment. Such an adjustment applies to taxpayers that change their accounting methods and prevents double-counting or omission of income or deductions. Accounting methods include overall methods as well as the method used for a material item. The regulations define a material item as one that affects the tinting for inclusion of an item of income or deduction. The Tax Court concluded that its decision about the reimbursed expenditure in this case was not one involving timing, but rather the deductibility of an expenditure. The result is that the change was not an accounting method change, and therefore the Tax Court rejected the section 481 deduction the IRS imposed on the taxpayer.

The court upheld the imposition of an accuracy-related penalty under IRC section 6662. The penalty applies if a taxpayer is negligent or disregards rules or regulations. Negligence involves the lack of due care or failure to do what a reasonable person would do. In measuring whether a taxpayer is negligent, the court can and will consider the taxpayer's background and experience. As the taxpayers in this case were attorneys, the court said their failure to know the existing precedent was negligent.

In addition to providing clarification of what constitutes an advance, the court's decision also was an attempt to define "method of accounting." Classifying the dispute as one of deductibility rather than tinting, however, raises as many questions as it answers. The court's decision to uphold the penalty reinforces the conclusion that negligence is determined based on a specific taxpayer, not a hypothetical one.

* Pelton & Gunther, PC v. Commissioner, TC Memo 1999-339.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama.

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--Michael Lynch, CPA, Esq., professor of tax accounting at Bryant College, Smithfield, Rhode Island.