Gross income includes returned fees; advance litigation costs are loans.

IRC section 61 defines gross income as all income from all sources--unless specifically excluded by law. In general a taxpayer must include in gross income any increase in wealth he or she realizes in the period "realization" occurs. The claim of right doctrine says realization takes place whenever a taxpayer receives an amount without restriction as to how he or she can dispose of it. This happens when the recipient has no definitive obligation to repay the amount. Therefore, compensation for services is income when received--even if the taxpayer later voluntarily returns the payment to the employer.

John M. and Carolyn Merritt resided in Oklahoma City. John was a licensed attorney and sole owner of JMA & Associates, a personal service law corporation, also in Oklahoma City, which specialized in representing victims in personal injury and product liability cases on a contingent fee basis.

The law firm generally entered into two types of contingent fee contracts:

* Clients reimbursed the firm for litigation costs it had advanced and then paid the firm a fee equal to 50% of the net recovery remaining.

* Clients paid the firm a fee equal to 33 1/3% of the gross recovery and then reimbursed it, out of the clients' remaining 66 2/3% share of that recovery, for litigation costs the firm had advanced.

In 1994 and 1995 John received compensation from JMA in the form of wages and independent contractor lees of $703,800 and $299,925, respectively. In December 1994 he returned to JMA $129,000 of independent contractor lees. Initially, the firm's independent bookkeeper recorded the return as a reduction in the contractor lee expense account. However, in February of 1995, JMA's bookkeeper reclassified the funds as a reduction in accounts receivable due from John. John and Carolyn Merritt filed their 1994 joint federal individual income tax return on July 10, 1996, and did not include as income the $129,000 independent contractor lee John had returned to the law firm in December of 1994.

For the taxable years ending November 30, 1994 and 1995, JMA advanced litigation costs relating to client contingent lee contracts of $737,652 and $1,069,275, respectively. On August 28, 1995, and October 2, 1996, JMA filed its corporate federal income tax returns for the 1994 and 1995 fiscal years. On those returns the firm deducted as an ordinary and necessary business expense litigation costs of $705,647 and $629,834 it had paid on behalf of contingent lee clients whose matters had not been resolved by yearend. During the years at issue a third party performed all bookkeeping tasks.

A CPA--who also was licensed to practice law--with whom John had a business relationship for more than 20 years prepared the couple's individual and corporate federal income tax returns.

On July 6, 1998, the IRS determined a deficiency in the Merritts' 1994 joint federal income tax liability, disallowing exclusion of the $129,000 independent contractor lee John later returned. On audit the IRS also disallowed the law firm's deduction of the litigation costs associated with unresolved cases. On both the couple's individual returns and on JMA's corporate returns the IRS determined additions to tax for failure to timely file and also assessed accuracy-related penalties.

The taxpayers, citing Gregory v. Helvering (35-1 USTC [paragraph] 9043), 293 US 465,469 (1935), argued the $129,000 of compensation John returned to JMA was excludible from gross income because the couple was entitled to structure their transactions to pay the least amount of federal income tax. Further, since JMA did not advance payment of litigation costs based on the probability of recovery from contingent lee clients, such amounts were not loans.

Result. For the IRS. There was no evidence to indicate there were any restrictions on John's use of the $129,000 independent contractor lee of that he had any obligation to return the money to JMA. Section 61(a)(1) says "gross income" includes "all income from whatever source derived," including compensation for services and lees. The court held that the $129,000 John received and returned to JMA was not excludible from income.

In Canelo v. Commissioner (Dec. 29,827), 53 TC 217, 225-226 (1969), affd. per curiam (71-2 USTC [paragraph] 9598), the court decided that, generally; litigation costs advanced of paid by lawyers on behalf of their clients based on contingent fee contracts under which the clients are obligated to repay the litigation costs if matters are resolved successfully are treated in the year paid as loans to the client, not as ordinary and necessary business expenses. Upon resolution of the contingent fee matters, if the client does not repay the litigation costs, the firm should deduct them as bad debts.

The taxpayers argued the facts of Canelo were distinguishable from the facts of this case because Canelo carefully screened its contingent fee clients based on the probability of recovery while JMA did not do this and often any recovery was doubtful. Yet the court concluded the firm should treat the litigation costs in dispute as loans in the year the firm advanced them not as ordinary and necessary business expenses.

In addition the court held the taxpayers were liable for the additions to tax for failing to timely file their income tax returns for the years at issue. As a practicing attorney, John Merritt was fully capable of making sure the returns for himself, his wife and his firm were completed and filed on time. The court found his alleged reliance on the CPA for timely filing was not credible.

The court believed, however, the Merritts did reasonably rely on their CPA's advice on how to handle the issues at hand and therefore had reasonable cause for the deficiency and had acted in good faith. They were not liable for the accuracy-related penalties.

* John M. Merritt and Carolyn Merritt v. Commissioner, JMA & Associates, P.C. v. Commissioner, TC Memo 2003-187.

Prepared by Claire Y. Nash, CPA, PhD, associate professor of accounting, Christian Brothers University, Memphis, and Tina Quinn, CPA, PhD, associate professor of accountancy, Arkansas State University, Jonesboro.