Attorneys: stop treating advanced client costs in contingency cases as deductible business expenses.
They are not your expenses to take, contends the IRS. They are considered loans for tax purposes. If you don’t succeed in recovering those loans, you may take a bad-debt deduction in the year that the costs are deemed uncollectable.
Attorneys who deduct those expenses—but later include their recovery as income—distort income and matching principles. Any later income recognition could take years, if at all.
Examples of impermissible deductions by cash-method taxpaying lawyers:
- travel expenses
- costs of medical records
- expert reports
- interpreters' fees
- witness fees
- deposition costs
- filing fees
- investigation costs
- photographs
- laboratory tests
- sheriff's fees for service
- process servers
- investigators
The above are considered “hard costs” or those directly related to the matter or case. Some attorneys may try to bury these costs in “other costs” or claim them under “cost of sales.”
But “soft costs,” or indirect costs, such as normal operating expenses (administrative, copy, etc.) are deductible in the year incurred, generally, in a service business.
Attorneys are supposed to keep ledger cards or other accounting records to attach these expenses to the clients’ cases. Later expense recoveries should be separated (cash receipts journal) from the fee income.
Some attorneys argue that the expense deductions are appropriate since there is no guarantee of being paid back. The IRS may investigate the attorney’s success rate of cost recoveries to determine the merit of that argument. But that argument seems contrary to what the IRS allows.
Potential Accounting-Method Adjustment
If the advanced client cost is material, the IRS may initiate a change in method of accounting under IRC § 446, which generally requires an IRC § 481 adjustment. The examining agent must apply the limitation-on-tax provision of IRC § 481(b) if the involuntary method change results in an increase in the taxpayer’s taxable income of the year of change by more than $3,000.00.
Attorneys themselves may initiate an accounting-method change by filing a Form 3115.
More Guidance on Audits
More elaboration of the adjustment, in addition to a comprehensive Audit Guide for attorneys, is contained here.
Here is the IRS web page providing more information about audits.