IRS flip-flop on accounting change issue.

When a law firm enters a contingent fee arrangement with a client, it is well-established that reimbursable litigation expenses paid by the law firm on behalf of the client are not deductible by the firm, but rather are treated as loans to the client (see Boccardo, Cl. Ct., 1987, and Canelo, 53 TC 217 (1969), aff'd, 447 F2d 484 (9th Cir. 1971)). Although many law firms have been slow to adopt this treatment, a number of firms in recent years have applied to the IRS for approval to change their methods of accounting to begin classifying the expenses as loans.

Under Regs. Sec. 1.446-1(e)(2)(ii)(a), a change in method of accounting includes a change in the taxpayer's overall plan of accounting for gross income or deductions or a change in the treatment of any material item. This includes the proper time for inclusion of an item in income or the taking of a deduction. If approved, a change in accounting method enables the taxpayer to spread any resulting adjustments over a period of years (generally four to six) under Sec. 481.

At one time, the Service apparently approved most applications submitted by law firms on this issue, on the basis that a change in the treatment of reimbursable litigation expenses constituted a change in the treatment of a "material" item. During 1990, however, the IRS began rejecting law firms' accounting change requests. The Service reasoned that the change requested was not an accounting method change under Sec. 446, but rather was merely the correction of an error. The law firms were advised to file amended returns to correct the error for years not closed by the statute of limitations.

In an about-face, the IRS has now contacted firms that previously had their accounting change applications rejected, to advise them that the Service has reevaluated its position, and once again believes that changing the treatment of reimbursable litigation costs from deductible expenses to loans is a change in accounting method.

Firms contacted by the Service have been permitted to refile Form 3115, Application for Change in Accounting Method, to request a change in accounting method for the years covered by the original requests. The new applications must be filed, together with a $200 user fee, within 30 days from the date of the letter notifying the firm of the IRS's change in position. Law firms that still deduct reimbursable litigation expenses, but wish to reclassify them as loans, should consider filing a timely Form 3115. This should protect the firm from exposure to penalties if prior year returns are examined by the Service, and will enable the firm to make the change prospectively and spread the resulting income pick-up over several years. Presumably, such future requests will be approved.