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Discussion:Attorney - Client Expenses

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Discussion Forum Index --> Advanced Tax Questions --> Attorney - Client Expenses


Discussion Forum Index --> Tax Questions --> Attorney - Client Expenses

Jeff-Ohio (talk|edits) said:

11 March 2014
Attorney Firm - Cash basis S-Corp.

2 Shareholders

Winding down this company and had $0 income.

However, they have written off about $100K in client expenses (medical, etc) that were all sitting in prepaid expenses in prior years, but have now become uncollectable.

Can you write off expenses as a cash basis entity in a year where the expenses stem from multiple years?

Ckenefick (talk|edits) said:

11 March 2014
This stuff is basically a loan, it's not a prepaid. Law firm fronted costs for their clients.

Kevinh5 (talk|edits) said:

11 March 2014
And do make sure they have booked all of the retainers held in their escrow account as income. Or that they return all of them.

Dennis (talk|edits) said:

11 March 2014
Contingency firms do not get retainers. Client costs are written off when the particular lawsuit they relate to is either lost or abandoned.

Harry Boscoe (talk|edits) said:

11 March 2014
Do the clients have COD income from the forgiveness of the advances made to and/or for them?

Kevinh5 (talk|edits) said:

12 March 2014
Harry, not if they are gifts. You know most attorneys have a kind heart.

Nilodop (talk|edits) said:

12 March 2014
Wouldn't we need to know (from the perspective of the lawyer's clients) whether the payment of such expenses by them would have been deductible as business expenses? At least, that's what Pub 4681 says, and who am I to argue? "Deductible Debt If you use the cash method of accounting, you do not realize income from the cancellation of debt if the payment of the debt would have been a deductible expense. ...

Example. In December 2012, you get accounting services for your farm on credit. In early 2013, you have trouble paying your farm debts and your accountant forgives part of the amount you owe for the accounting services. How you treat the canceled debt depends on your method of accounting. Cash method. You do not include the canceled debt in income because payment of the debt would have been deductible as a business expense in 2013. Accrual method. Unless another exception or exclusion applies, you must include the canceled debt in ordinary income because the expense was deductible in 2012 when you incurred the debt."

I'd actually proffer the following argument, even for personal-type lawsuits. The idea is that the lawyer agrees to pay the costs and expenses of the lawsuit, but the client will reimburse them if (and only if) the suit is won. If, however, the suit is lost, the lawyer "eats" the costs and expenses. It is that contingency that causes IRS to disallow those costs. This article is a short summary of the reasoning. http://www.pwc.com/us/en/law-firms/assets/pwc-news-alert-tcm-2013.pdf Then, from the client's perspective, the argument would be (inconsistent with the IRS argument agains the lawyer's deduction) that upon accepting the case, the costs and expenses became those of the lawyer, with only the contingent possibility that the client would ultimately pay them. They were really marketing costs of a sort for the lawyer, and thus they were his costs, not those of his client. In a sense, the lawyer and the client become joint venturers in the lawsuit, and the expenses become expenses of production or collection of income.

As to the OP, reference is made to the expenses having become uncollectible. In a typical contingency practice, that does not happen. Either the case is won, and the expenses are taken out of the proceeds, or the case is lost, and the expenses are simply those of the lawyer, never expected to be collected from his client. At least, that is my understanding.

Ckenefick (talk|edits) said:

12 March 2014
These cases might not be contingency cases, although it is a high number. But all kinds of law firms incur filing fees, etc. on behalf of clients...to be "reimbursed" when the lawyer submits an invoice to the client.

The IRS came out with a ruling a while ago indicating that these weren't deductible when paid by the law firm, but rather, were loans.

Nilodop (talk|edits) said:

12 March 2014
There is a thorough discussion of the issue in this IRS Audit Technique Guide under the heading "Advanced Client Costs". http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Attorneys-Audit-Technique-Guide---Chapter-3#ch3-costs The guide was last updated in March, 2011, so does not include discussion of the 2013 decision discussed in the above-linked PwC document.

Ckenefick (talk|edits) said:

12 March 2014
But it's all consistent, right: Loan treatment prevails?

Remember that post about a Late Expense Report...

Jeff-Ohio (talk|edits) said:

12 March 2014
These are workers comp/personal injury ALL contigent fee attorneys

Jeff-Ohio (talk|edits) said:

12 March 2014
After researching it further, I think this is HOW the IRS would like it treated - you do not deduct the costs incurred UNTIl the case goes bust.

I am an attorney, you slip and fall, I pay for your hospital bills, I capitalize the cost and I sit and wait.

If the case goes bust, I take the expense in that year.

Ckenefick (talk|edits) said:

12 March 2014
Yes, Jeff, the IRS guidance says the advances, on behalf of the client, are in the nature of loans. If they get repaid to the law firm, the loan goes to $0. If they do not, the law firm has a bad debt deduction and the loan goes to $0 that way.

I've had some experience with this. And, in the normal small law firm, where the bookkeeping is done by the "office manager," good luck with Loan Accounting.

Jeff-Ohio (talk|edits) said:

12 March 2014
Thank you CK

Nilodop (talk|edits) said:

12 March 2014
And as to Harry's COD question?

Ckenefick (talk|edits) said:

12 March 2014
Do the clients have COD income from the forgiveness of the advances made to and/or for them?

Would we agree that the payment by the law firm of the taxpayer's expense - since cast as a loan - is treated as if the Law Firm advanced the amount to the taxpayer and the taxpayer made the payment?

If that's the case, and if we have a loan, I don't see how the forgiveness of it could be anything other than COD. In fact, it doesn't even matter if the taxpayer did deduct, or could have deducted, his deemed payment of the expense. All that matters is that there's a loan. No different, really, than when a client gets a 1099-C for the charge off of a personal credit card balance.

Some might argue that this law firm situation shouldn't be cast as a loan, at least on the taxpayer's end. After all, this seems a little different than a known, fixed expense of a taxpayer, like a personal mortgage payment that is paid by someone else. In other words, the taxpayer's got nothing to lose here if the law firm agrees to pay all case expenses. If case goes bust, taxpayer doesn't have to make good on his "loan" with the law firm. Taxpayer's obligation isn't fixed, but is contingent. So, the argument goes, taxpayer really couldn't have deducted anything, on a deemed basis, up front, when the law firm paid the underlying case expense. One cannot deduct contingent expenses, as we know. However, is it really contingent if the taxpayer is deemed to have paid it? Likely, it is not, as the contingency has been theoretically resolved. So likely, it is deductible to the taxpayer, so likely, taxpayer has indebtedness, and likely, taxpayer has COD when he doesn't pay up.

Obviously, this creates a big mess in the tax world.

Ckenefick (talk|edits) said:

12 March 2014
I should note again, there's a Post about a Late Filed Expense Report that kind of gets into the exact same issues.

Take the expense report that will only be reimbursed if submitted by the last day of the next month. If it is not submitted, the "rules" say (1) employer gets no deduction, because employer didn't pay it and (2) employee gets no deduction because it was the employer's expense. Something ain't right about this...In my mind, if EE pays ER's expense, ER gets a deduction no matter what (payment with borrowed funds). ER debits Expense and credits Loan. If time passes and ER doesn't have to repay this loan, guess what: ER debits Loan and credits Income. And, EE gets a deduction: A bad debt deduction. EE advanced monies to ER and EE never got repaid.

Part of the issue here is the "contingency" - ER only has to pay if EE submits an expense report. As such, many would say it is proper if ER gets no deduction since it's obligation, to pay the employee, is contingent. I'm not so sure this is right. The underlying vendor did get paid and the underlying vendor was deemed paid by the ER. So, it's not the expense that's contingent to the ER (and note, ER benefited from the expense), it's the actual outlay to the employee that's contingent, which does not involve an expense, in theory - it involves a pure loan.

Southparkcpa (talk|edits) said:

12 March 2014
Agreed with most that this writeoff was proper when capitalized and now the writeoff is fine. The main issue I see is if many of these cases were settled in 2012...they should have been expensed then. To the point of contingency lawyers not having retainers, yes. BUT they have active trust accounts as cases settle but there are generally restrictions on full disbursement so Kevins point is well taken. The trust accounts MUST be zero for this writeoff to be wholly accurate.

Kevinh5 (talk|edits) said:

12 March 2014
Oh they're zero or empty all right. It's only the accounting for them that's missing.

Southparkcpa (talk|edits) said:

12 March 2014
Ahhh... that's hilarious. The stories of trust accounts being emptied and the lawyer gone. Priceless. A Grisham novel.

Ckenefick (talk|edits) said:

12 March 2014
No shit. A novel...because the bad guy knows the firm might not turn him in b/c the firm would be in a heap of trouble for not having adequate controls over the account. But that's never stopped a 1099 from being issued before. Now Law Firm turns the tables, in a way.

Nilodop (talk|edits) said:

13 March 2014
So, Ck, I take it from your ER/EE expense report discussion that you analogize it to the OP's facts. In fact, I don't have to "take it", you said it right out when you called the lawyer's payment of the client's costs a loan. Then you said "If that's the case, and if we have a loan, I don't see how the forgiveness of it could be anything other than COD." That, of course, puts you squarely on the side of the IRS, a position in which I am not accustomed to seeing you. And, of course, it is a logical position, supported by debits and credits that balance neatly, unlike my wacky position above. Here it is again, so you don't have to look for it. Then, from the client's perspective, the argument would be (inconsistent with the IRS argument agains the lawyer's deduction) that upon accepting the case, the costs and expenses became those of the lawyer, with only the contingent possibility that the client would ultimately pay them. They were really marketing costs of a sort for the lawyer, and thus they were his costs, not those of his client. In a sense, the lawyer and the client become joint venturers in the lawsuit, and the expenses become expenses of production or collection of income.

I had some hope when you stated Some might argue that this law firm situation shouldn't be cast as a loan, at least on the taxpayer's end. After all, this seems a little different than a known, fixed expense of a taxpayer, like a personal mortgage payment that is paid by someone else. In other words, the taxpayer's got nothing to lose here if the law firm agrees to pay all case expenses. If case goes bust, taxpayer doesn't have to make good on his "loan" with the law firm. Taxpayer's obligation isn't fixed, but is contingent. So, the argument goes, taxpayer really couldn't have deducted anything, on a deemed basis, up front, when the law firm paid the underlying case expense. One cannot deduct contingent expenses, as we know. However, is it really contingent if the taxpayer is deemed to have paid it? Likely, it is not, as the contingency has been theoretically resolved. So likely, it is deductible to the taxpayer, so likely, taxpayer has indebtedness, and likely, taxpayer has COD when he doesn't pay up. But then you dashed my hopes, yes, dashed them, with the late expense report analogy (a weak analogy, I think).

To be clear, the expenses I am talking about all arise directly from whatever the case is about, not the client's general living expenses.

Ckenefick (talk|edits) said:

13 March 2014
I intentionally tried to be all over the place, because that's where the law leaves us.

The IRS position, with the law firm, is that it is *not* the law firm's expense, at least initially. Why is this? Must be for one of two reasons. Must either be viewed as an outright loan or must be viewed as a contingent expense of the law firm. Either way, we have something that is non-deductible, at least initially, on the law firm's end. The position, it seems though, is not to say that it *is* the plaintiff's expense initially. The IRS doesn't opine on this point as their guidance is directed to the law firm. Is it, or is it not, the plaintiff's expense initially? It does seem that this should be the next inquiry if we're satisfied that, for whatever reason, the law firm cannot deduct it, at least initially.

If it is the plaintiff's expense, plaintiff has an immediate deduction (assuming it would otherwise be deductible under Sec 162, 212, etc...and not ND under 262). If it is not immediately deductible to the plaintiff, it is likely because the expense is viewed as contingent on the plaintiff's part. Plaintiff might not have to pay it if the case is a loser.

So, from the IRS' standpoint, from what I can tell: An expense has surely been paid, but it just might be contingent all the way around, to all parties involved. The plaintiff might never have to pay it (contingent) and Law firm has a right of reimbursement, which makes it contingent to the law firm as well.

To be clear, the expenses I am talking all arise directly from whatever the case is about, not the client's general living expenses.

I get it. I'm just pointing out that with a contingent legal case, everything is contingent. This is not the case where there is no contingency. I had a case one time with three defendants. The money defendant paid all the legal bills. But each of the three guys deducted 1/3rd on his return. Was this legit? Of course it was. There was no contingency. The contingent legal case, which is the focus of this post, is quite a bit different, in that there are contingencies all the way around.

Expense report is very similar, actually. Employee has a right of reimbursement for a period of time. The expense in question belongs to the employer, but we don't know if employer will ever have to pay it.

The standard stuff we hear is this: EE gets no deduction if he fails to submit the report, because it could have been reimbursed. ER gets no deduction because it's obligation was contingent and ER never rec'd the expense report, so ER never had to pay it.

That about sums up the conventional Late Expense Report wisdom. But do note what thing about the Law Firm's contingency case: IRS says law firm has a bad debt deduction when the case goes sour. Yet, IRS has never said that EE gets a bad debt deduction when his expense report goes stale. No, sir. The situations are very parallel and, we'd think, should have the same outcome, with that being: EE gets a deduction when his right of reimbursement vanishes. And, how is a bad debt of an EE treated when the "borrower" is the ER? (Someone look that up please).

Now, with that said, there is this doctrine of, "Well you could have been reimbursed...and said reimbursement was within your control, so you lose the deduction for this reason." We see that with theft and property losses: If you fail to file an insurance claim, that would have covered your loss, you get no deduction. This is the only reason, that I can think of, as to why the EE gets no bad debt deduction for his unfiled expense report. However, the case law doesn't really say this. The case concludes that the EE gets no deduction under Sec 162 because the expense "must not have been ordinary and necessary." Okay, fine, I say. Then let's take it as a non-business bad debt.

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