Law firms overlook deduction for certain client costs.

Amounts paid by an attorney or law firm on behalf of a client generally have to be capitalized and may not be deducted until the case is concluded. There are exceptions, however, and many amounts are being capitalized that could be expensed.

Letter Ruling (TAM) 9432002 provided that out-of-pocket expenses not charged to a client and not to be reimbursed may be deducted in the year it is determined not to bill the client. The letter ruling also provided that "soft costs," such as telephone, in-house photocopying, on-line research and work processing, may be expensed as incurred. Reimbursement of such amounts is taxed as income on receipt. This is distinguished from out-of-pocket expenses, such as court filing fees, which are client advances and must be capitalized.

The Boccardo case, 9th Cir., 1995, rev'g TC Memo 1993-224, addressed the issue of expenses of a law firm under a "gross fee" arrangement. The firm's contract with its clients provided for reimbursement of costs solely from recovery of the client's claim. The percentage of recovery was fixed, regardless of the expenses incurred, and in the event of no recovery, the law firm would receive nothing. The comparison was made by the Boccardos between this arrangement and that of a self-employed salesman who incurs travel costs to make a sale. The gross fee arrangement was different in form and economic consequence from a "net fee" arrangement in which the client agreed that such costs should be repaid out of any recovery. The Ninth Circuit reversed the Tax Court and decided that expenses under a gross fee arrangement were ordinary and necessary business expenses in the payment of costs and charges in connection with the firm's client litigation and, therefore, were deductible when paid under the cash method of accounting.