Source: https://brittandburroughs.com/litigation-costs-in-contingent-fee-contracts-loans-or-business-expenses/
Timestamp: 2019-04-21 05:02:27+00:00

Document:
The IRS has designated law firms, and small and solo-practitioners specifically, as a “targeted group.” As such, lawyers are subject to closer scrutiny and greater risk of examination. Indeed, the IRS has developed a special Audit Guideline Manual for Attorneys. Under that manual and unlike similar costs for most other businesses, client litigation costs advanced under a contingent fee contract are loans and not current business expenses.
The tax treatment of client litigation costs has been confused by a split between the IRS rule and the Ninth Circuit’s treatment of these costs as decided in Boccardo v. Commissioner and Opperwall v. C.I.R..  In Boccardo, the Ninth Circuit carved out an exception by dividing lawyers’ contingent fee contracts into two classes, Gross Fee Contracts and Net Fee Contracts. In a Gross Fee Contract, a personal injury law firm pays all litigation costs up-front and recovers a fixed percentage contingency fee if successful. Under a Gross Fee Contract, the Ninth Circuit ruled client costs are deductible as current 26 USC §162, ordinary business expenses. Boccardo (9th Cir. 1995). Conversely, under a Net Fee Contract, litigation costs are recouped first and the firm’s contingent fee is a percentage of the balance of the award. If the Net Fee Contract gives the firm the right to be reimbursed for the costs, the IRS argued that litigation costs paid by the firm should be treated as loans and not allowed as current deductions.
Then along comes the Tax Court in Pace v. Comm’r of Internal Revenue.  Pace was a successful plaintiff’s attorney. He deducted his clients’ litigation expenses in 2001 the year in which he received payment. He had not deducted those expenses when paid, 1997 to 2000. The taxpayer relied upon the Tax Court’s original decision in Canelo, ie., litigation costs are loans not expenses.  In effect, he was consistent with the IRS 1997 FSA 442. However, as a cash basis taxpayer, the Tax Court said he was wrong to deduct those expenses. Instead, he should have excluded the reimbursed advanced litigation expenses from income rather than deducted them. Rather than exalting form over substance the Tax Court allowed the exclusion but not without more.
Since Boccardo and the ensuing Tax Court decisions, there have been various efforts to allow the current deduction for attorney-advanced litigation costs in all circuits, in many cases expanding the deduction to Net Fee Contracts. One such proposal made it into H.R. 6049, the Renewable Energy and Job Creation Act of 2008, which passed the House, May 2008. The Senate version of the bill did not include the client costs provision, and the bill was never enacted. This proposal reflected the new Obama administration’s desire for clarification on this issue.
Finance Committee Chair Max Baucus, D-Mont., and Senate Assistant Majority Leader Richard J. Durbin, D-Ill., wrote to Treasury Assistant Secretary for Tax Policy Michael Mundaca arguing that the Service’s position in the 1997 Field Service Advice added confusion to the deductibility of client costs and did not take into account more recent Tax Court decisions, including Pelton & Gunther v. Commissioner.
In response to a suggestion that Treasury should issue guidance consistent with Boccardo, Mundaca wrote May 6 that Treasury was “considering issuing guidance to clarify this issue.” Of course, organizations and businesses opposed to plaintiffs’ trial lawyers arose in opposition to any such clarification.
In a July 29, 2010, letter to Treasury Secretary Timothy Geithner, some two dozen GOP senators predicted dire consequences should Treasury alter its rule and allow current deductions for litigation costs. They argued that allowing litigation costs as current expenses would worsen the federal debt and encourage harmful litigation. In an accompanying statement, Sen. John Thune, R-S.D., said “Instead of providing tax relief for political allies, we ought to be providing across the board tax relief for the average, hardworking taxpayer.” He noted that similar legislative proposals have not even achieved a committee hearing “due to the significant opposition that they face.” These Senators believe the IRS should reaffirm its opposition to the Boccardo rule. In a Field Service Advice issued after its loss in Boccardo, the IRS it directed agents not to follow that decision except in the Ninth Circuit. (1997 FSA 442).
Conversely, the American Association for Justice has been at the forefront in lobbying efforts to expand the deductibility of attorney-advanced litigation costs. The AAJ championed its members’ right to receive the same fair tax treatment that every other small business owner outside the Ninth Circuit enjoys. That is the simple right to deduct business expenses when paid.
For plaintiffs’ lawyers (using Gross Fee Contracts outside the Ninth Circuit) who want to avoid confrontation with the IRS, the safest course is to treat litigation costs and expenses as loans regardless of whether they use Gross Fee Contracts or Net Fee Contracts. Likewise, despite legislative efforts to the contrary, they should always treat client litigation costs as loans if they use Net Fee Contracts in which the client is ultimately responsible for the costs.
This places plaintiffs’ attorneys in a difficult position vis-à-vis potential clients. Gross Fee Contracts are routinely at a higher percentage to cover incurred costs. With competition by lower Net Fee Contracts, market forces will begin to punish attorneys seeking to comply with unclear rules.
Dan is an attorney with Britt & Associates Attorneys, LLC. Chris is a 2011 law grad of DePaul University, and is a part time a paralegal. Chris will sit for the Georgia Bar Summer 2012.
Canelo v. Commissioner, 53 T.C. 217, 219 (1969), aff’d 447 F.2d 484 (9th Cir. 1971).
IRS Attorneys Audit Technique Guide – Chapter 3.
Opperwall v. C.I.R., 105 F.3d 666 (9th Cir., 1997). In Opperwall, the Ninth Circuit followed its own rule from Boccardo.
Provided the client has no obligation to repay these costs unless there is a recovery.
Pelton & Gunther v. Commissioner, 78 T.C.M. 578, T.C. Memo. 1999-339 (U.S.T.C., 1999) Doc 1999-32749 or 1999 TNT 196-58.
Pace v. Comm’r of Internal Revenue, T.C. Memo. 2010-272 (U.S.T.C., 2010) Docket No. 13446-07.
The Tax Court went on to analyze the litigation costs and allocate them to various to match them against the reimbursements. The court also examined the taxpayer’s substantiation. In the end, the taxpayer had a mixed result.
Attorneys or their preparers considering claiming current deductions for litigation costs may want to consider IRS Form 8275 used to positions not otherwise disclosed on the return for which there is a reasonable basis. This disclosure may be able to avoid accuracy related penalties.
IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice that may be contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) that may be addressed herein.

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