Handling contingent attorney fee expenses: what tax preparers need to know.
Status in the Courts
Except for the Ninth Circuit (covering much of the western United States), the courts have determined that, for contingent-fee attorneys, the costs paid on behalf of a client should be treated as "loans" for tax purposes. In fact, the IRS describes these as "advanced client costs," and therefore not currently deductible (Attorneys Audit Technique Guide, chapter 3). The IRS is well aware that some plaintiff's attorneys generally use a cash basis of accounting and might attempt to deduct those expenses when paid, and then later have the recovered costs included in income when received. As such, the IRS and the courts have noted that these expenses should be viewed as belonging to the client, rather than to the attorney, because there is an expectation of reimbursement. Consequently, litigation expenses are not immediately deductible until a particular case is resolved. When the case settles, which can be many years after the costs were incurred, the recovery is treated as income and costs are deducted in the year of recovery. At issue is the timing of the expenses to match the "potential future revenue," because these expenses are viewed to be loans and not currently deductible when paid by the attorney. For the attorney, a bad debt deduction may be taken in the year that any costs are determined to be uncollectible. The Exhibit lists notable court cases related to contingent fees.
There has been continual debate over the IRS and the courts' stance that plaintiff's attorneys cannot take an expense deduction in the year the costs are incurred, as opposed to the year the case is settled. The contention from attorneys is that treating these expenses as a loan causes a distortion of income, given that it can take years to resolve cases.
Momentum seemed to swing toward the "expense" side, which could have provided tax relief to attorneys. An April 2010 letter from Senators Max Baucus (D.-Mont.) and Richard Durbin (D.-Ill.) to Michael Mundaca, assistant secretary for tax policy, that sought clarity on the Ninth Circuit's ruling in Boccardo v. Comm'r [56 F.3d 1016 (9th Cir. 1995)], gave plaintiff's attorneys hope that the current rules might be changing; however, neither the IRS or the courts have given any indication that they would allow current expense treatment (see "Is a Big Tax Break for Plaintiffs' Lawyers on the Way?" Wall Street Journal LawBlog, Jul. 15, 2010).
Exception to "The Loan Rule"
In the first James F. Boccardo v. U.S. case listed in the Exhibit, the IRS asserted that expenses incurred on behalf of clients while prosecuting contingency fee cases are not deductible because the law firm expected reimbursement upon resolution of a settlement or judgment. In this case, the law firm used the net fee contingency agreement method, and the claims court concluded that those client costs were nondeductible loans. The law firm then changed to the gross fee method and continued to deduct these expenses.
In subsequent litigation, the Tax Court determined that the contingent nature of reimbursements meant that these costs were nondeductible, similar to a net fee arrangement (Boccardo, TC Memo 1993-224). On appeal, the Ninth Circuit reversed the decision, holding that the gross fee contract did not involve advances with the implication of a loan, where, as a matter of law, the client had no obligation to repay the money expended and the advances were considered ordinary business expenses [Boccardo, 56 F.3d 1016 (9th Cir. 1995)]. The appellate court "held that attorneys who represent clients in contingency fee cases may treat litigation costs that are paid by the attorneys, such as filing fees and witness expenses, as deductible ordinary and necessary business expenses ... when the attorney and client agree to a specific fee arrangement known as a gross fee contract." The IRS, however, has taken the position that it will continue to challenge these expenses and classify them as loans, except in the Ninth Circuit [Field Service Advisory, 1997 WL 33313738 (IRS FSA) 6-2-97].
Net Fee Arrangement Versus Gross Fee Method
Plaintiff's attorneys taking cases on a contingency fee basis generally use one of two kinds of contractual fee agreements: net fee arrangements or gross fee contracts. The former specifically provide that advanced litigation costs are repaid to the attorney before calculating the contingency fee percentage paid from the settlement or judgment proceeds. The latter states that the contingency fee percentage paid from the settlement or judgment proceeds is calculated without regard to advanced litigation costs. The attorney is only entitled to a percentage of the settlement or judgment and is not reimbursed separately for advanced litigation costs; thus, the attorney's profit from the case is reduced.
It should be noted that, if a contingency fee case is lost, the attorney does not normally recover costs from the client under either of these agreements. The IRS has advised its examiners to ask questions regarding the types of contingency fee contracts used. The examiners will also inquire as to whether the attorneys include a provision in their contingency fee contracts that they are repaid their advanced litigation costs even if they lose a case. In an audit, the IRS will examine the attorney's success rate for recovering advanced litigation costs as a factor in showing that an attorney has an expectation of reimbursement for these costs.
Except for those located in the Ninth Circuit, attorneys should not deduct litigation expenses in the year incurred, even with gross fee contracts. In a recent tax case in Missouri (Eighth Circuit), Humphrey, Farrington & McClain P.C. v. Comm'r V (TC Memo 2013-23), where one of the fee arrangements of the firm was gross fee contracts, the law firm argued that its percentage success rates showed that it was really bearing the costs; however, the Tax Court ruled that even a small chance that the firm would be reimbursed was enough for the court to deny the deductions.
Plaintiff's attorneys in the Ninth Circuit should be able to deduct their case-related expenses when paid, but only if they use gross fee contracts (see "9th Circuit Lawyers Get Better Tax Breaks," Perspective, Los Angeles Daily Journal, Feb. 8, 2013). For all others, the IRS and courts will continue to argue that, no matter the contractual fee agreement, these expenses are considered advanced client costs--and, as such, loans that are not currently deductible.
Contingent Fee Court Cases: Loans versus Expenses
* Henry F. Cochrane v. Comm'r; 23 BTA 202 (1931)
* Thomas Hart Fisher; 5 TCM (CCH) 374 (1946)
* Reginald G. Heam v. Comm'r, 36 TC 672 (1961) aff'd, 309 F.2d 431 (9th Cir. 1962)
* Warren Burnett v. Comm'r; 42 TC 9 (1964), aff'd on this issue, 356 F.2d 755 (5th Cir. 1966)
* John J. Watts v. Comm'r, TC Memo 1968-183, 27 TCM (CCH) 886 (1968)
* Adolph B. Canelo, III v. Comm'r, 53 TC 217 (1969) aff'd, 447 F.2d 484 (9th Cir. 1971)
* John W. Herrick v. Comm'r, 63 TC 562 (1975)
* Ronald R. Silverton v. Comm'r, TC Memo 1977-198, 36 TCM (CCH) 817(1977), aff'd, 647 F.2d 172 (9th Cir. 1981)
* James F. Boccardo v. U.S., 12 Cl. CL 184 (1987), 87-1 USTC 9288 (1987); Boccardo, TC Memo. 1993-224; Boccardo, 56 F.3d 1016 (9th Cir. 1995)
* Milan, Miller, Berger, Brody and Miller P.C. v. U.S., 679 F. Supp. 692 (E.D. Mich. 1988), 88-1 USTC 9209 (1988)
Source; Attorneys Audit Technique Guide, Chapter 3, IRS
Frank Messina, DBA, CPA, is the Alumni & Friends Professor of Accounting in the Collat School of Business at the University of Alabama at Birmingham and also serves as the tax scholar-in-residence for Carr, Riggs & Ingram LLC.
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|Title Annotation:||Taxation: federal taxation|
|Publication:||The CPA Journal|
|Date:||Aug 1, 2014|
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