Tax enforcement issue causing stir.

Members from around the country are reporting that the Internal Revenue Service is auditing contingent fee law firms and disallowing deductions for expenses associated with litigation. ATLA advises all members who may be following the tax accounting procedure described in this article to immediately contact their accountants and tax attorneys to come into compliance.

Every trial lawyer knows that there are considerable expenses involved in bringing a case. In a contingent fee case, the attorney often takes the risk of the litigation by funding these costs rather than placing an additional burden on a sometimes severely injured client. Many attorneys itemize these costs and charge them back to the client in the event of a settlement or judgment. Of course, these costs are never repaid if the case is lost.

Many firms treat these costs as deductible "ordinary and necessary expenses," as provided in IRC [sections]162, and deduct these costs in the year the cost is incurred. However, the IRS argued successfully in court as early as 1962 that these expenses are, instead, a loan to the client. Money loaned to a client is not deductible.

Bad debts

In the IRS view, these costs only become deductible after they become bad debts. In most cases, this means that firms can take a deduction for expenses only after a case has been lost and there is no longer any possibility of repayment of the "debt." This means that litigation costs will have to be carried on the books for years before a deduction can be taken.

The IRS argues that state ethics rules support its position that these costs are a loan rather than deductible business expenses.

Clearly, trial lawyers are in a unique financial position with regard to these costs. These "loans" are hardly comparable to commercial loans. What other "lender" gives "borrowers" an unsecured no-interest loan for an indeterminate time, repayment of which is contingent on the "lender" succeeding in negotiations or litigation with a third party? The IRS interpretation is out of step with prevailing legal practice. However, the task of changing the tax code is difficult, particularly in the current atmosphere on Capitol Hill.

A 1995 case, Boccardo v. Commissioner of internal Revenue (56 F.3d 1016 (9th Cir. 1995)), points to one possible way to deduct costs even under the current code. James Boccardo switched to a "gross fee" contingent fee agreement with his clients. This contract provided that the attorney would pay all expenses for the litigation unless discharged by the client, in which case the client would pay a "reasonable" fee for services rendered.

The attorney bore all the expenses of litigation, regardless of the outcome. This contrasts with a "net fee" agreement, where the contingent fee is charged on the recovery, with costs added.

The IRS suggested that the "gross fee" agreement merely changed the contingency of the repayment, but did not mean the money was being advanced without the expectation of repayment. The IRS position was that the difference between a gross fee and a net fee contingency agreement is cosmetic.

Further, the IRS argued that any alternative violates the California State Bar Rule against paying a client's business or personal costs. The California State Bar Rules of Professional Conduct prohibit paying the personal or business expenses of a client but do not prohibit "advancing the cost of prosecuting . . . a claim . . ., the repayment of which may be contingent on the outcome of the matter."

The Ninth Circuit overturned the Tax Court, saying that "it is difficult to see how the label of `advances' with its implication of `loans' can be applied as a matter of law to payments when there is no obligation on the part of the client to repay the money expended." But if the payments were not an advance, did they then violate the state bar rule?

The court reasoned that the state bar rule could only deny the deduction if the payment was deemed to be an "illegal payment" under the tax code provision denying deductions for bribes and kickbacks. However, that rule required that the provision be "generally enforced." Since, at least in this case, the court had no evidence that the provision was generally enforced in California as required by the tax code, the court held that the arrangement was not illegal --and, therefore, the costs were deductible.

Is this kind of arrangement a way out of the deductibility trap? Perhaps, but caution is warranted. Only the Ninth Circuit has ruled on the deductibility of costs under a gross fee agreement. The analysis depended on the practices of the California State Bar and its Rules of Professional Conduct.

No consensus

Other circuits could rule differently, based on a more persuasive case by the IRS or different practice standards or enforcement. Until a consensus in the courts emerges, there is still a serious risk of tax liability even under a gross fee agreement.

Further, it is important to consider whether this kind of arrangement would work in a particular law practice. Will the deduction for costs offset the possible loss of income by paying the litigation costs out of fees rather than charging them back to the client? In some cases, raising the contingent fee may offset the loss, but the costs of cases requiring huge up-front expenditures may not be recovered even with high contingent fees.

Once again, the most important steps are to contact your tax attorney and your accountant and to take appropriate action. Penalties can be substantial for noncompliance, but the IRS may be more lenient when a firm acts to voluntarily come into compliance.

Philip Buchan is an associate director of ATLA Public Affairs.