Law firm continues battle over litigation costs.

Over the years, several law firms have done battle with the IRS over the deductibility of litigation costs related to contingent fee arrangements. The courts have repeatedly sided with the Service, holding that such costs were not deductible when paid, but rather represented loans or advances reimbursable by the client. Central to these decisions has been the fact that, although the law firm would receive no reimbursement of the litigation costs unless there was a recovery in the underlying cases, the law firm would (as would any prudent business person) generally not accept a case unless the likelihood of recovery was very high, thereby virtually eliminating the possibility that the litigation costs would not be reimbursed.

James Boccardo, a California attorney, was the subject of one of these decisions (Boccardo, 12 Ct. Cl. 184 (1987)). In that case, Boccardo claimed that advances made by a law firm on behalf of clients for litigation expenses, pursuant to contingent "net" fee arrangements, were deductible when paid by the law firm as a business expense. Under a net fee arrangement, the attorney's recovery was based on the amount of the client's recovery, net of costs reimbursable to the attorney. The Claims Court concluded that the costs were not deductible, but rather were to be treated as loans or advances, since the client had "an absolute obligation to repay the advance, subject only to an overall slight chance that there will be insufficient recovery to satisfy this obligation, a contingency of about 10 percent." It appears that Boccardo, rather than appealing the Claims Court decision, decided to head to Tax Court to test his theory about the deductibility of litigation costs, this time with his firm's "gross" fee arrangement.

As noted, under a net fee arrangement, attorney's fees are based on a percentage of the recovery after deducting costs. In a gross fee agreement, the attorney's fees are based on a percent age of the gross recovery amount; thus, the attorney's fee ed to cover litigation costs as well as the attorney's contingent fee. Unlike the net fee agreements, there was nothing in the gross fee agreement requiring the client to reimburse the attorney for litigation costs (unless the client terminated the relationship). Thus, on its face, the recovery of costs was more speculative than in the net fee arrangement (under which litigation costs came off the top of any recovery). In addition, the net fee agreement specifically provided that costs paid by the firm were "not a loan or an advance," while the gross fee agreement was silent in this regard.

In Boccardo, TC Memo 1993-224, Boccardo conceded that litigation costs advanced under a net fee arrangement were not currently deductible; he argued instead that litigation costs advanced by his firm pursuant to a gross fee arrangement were. Boccardo asserted that the net fee arrangements are distinguishable from the gross fee arrangements because the gross fee arrangement contains no contractual or implied right of reimbursement from the client for litigation costs (unless the attorney-client relationship is terminated). Boccardo also relied on the fact that the gross fee agreements did not state that the litigation costs were not loans or advances. The Tax Court found these distinctions illusory, and rejected Boccardo's claim.

The court explained that, despite the wording of the gross fee agreement, the law firm expected and received reimbursement of a substantial portion of the litigation costs, essentially to the same extent as in the net fee cases. The deductibility of costs did not depend on a contractual right of reimbursement, but rather on whether there was an expectation of reimbursement and actual reimbursement of a substantial amount of costs, even if recovery was contingent on winning or settling the case. Under this standard, current deductibility was not appropriate, since Boccardo's firm resolved 70% of cases under the gross fee agreements in their clients' favor, and generally recouped 90% of all litigation costs incurred by the firm under such arrangements.

The court also found no significance in the fact that the net fee agreements clearly stated that the costs were not loans or advances, while the gross fee agreements were silent in this regard. Finally, the court emphasized that under California law, a recovery is the property of the client. Consequently, contrary to the language of the gross fee agreement, the attorney's reimbursement of costs comes from the client, not from the recovery.

Despite Boccardo's second defeat, he may have opened the door for law firms with fee arrangements distinguishable in form as well as substance to pursue the current deductibility of litigation costs. Moreover, if a firm can create an arrangement which, unlike Boccardo's gross fee agreement, is not contrary to state law or the local rules of professional conduct, the issue may still have some life.