Law firms that understand the IRS’s position on tax deductions for advanced client costs can potentially avoid audits, penalties, and unproductive efforts.
It is common practice for law firms to incur litigation expenses on behalf of clients. But there is often confusion about the proper tax treatment of advanced client costs. Several court cases and IRS rulings have helped to clarify the issue, but many firms are still not in compliance. An understanding of the basic principles underlying the IRS’s position can help avoid audits, penalties, and unproductive efforts.
Advanced client costs
Your law firm will typically incur two types of litigation expenses on behalf of clients. The tax treatment of each is based on the type of expense incurred.
Direct litigation expenses
This includes advance payment for such things as medical records, experts’ fees, witness fees, deposition costs, filing fees, and laboratory fees. In general, direct litigation costs are considered a “loan” to your client and are not deductable as a business expense. This is true whether your firm reports on a cash basis or accrual basis for tax purposes.
Since the expense is considered a loan, the costs should be reflected as assets. When these costs are later recovered — sometimes months or even years from when they were incurred — they then offset the amounts previously capitalized, resulting in no impact to your firm’s reported income.
Support-type services
This category includes photocopying, word-processing, and other clerical services and expenses that would have been paid whether or not they are being billed to a client. For cash basis taxpayers, support service costs are deductible when they are paid. Any reimbursements of these costs should be included as income in the year they are received.
Deducting litigation expenses
When clients are billed for advanced litigation expenses, a bad debt deduction is available in the year the balance becomes uncollectible. A review of outstanding advanced litigation expenses should be conducted at least once a year to determine if any amounts are uncollectible, and, if so, those amounts can be written off as a bad debt.
Correcting non-compliance
If your law firm should discover that it is not fully compliant, consider filing Form 3115 to change your accounting method for the treatment of advanced client costs. The resulting increase in income from treating advanced client costs as client loans receivable (rather than a deductible business expenses) could potentially be recognized over a four-year period, rather than in a single year.
How we can help
In addition to offering insight on how to enhance law firm profitability, CliftonLarsonAllen provides tax compliance services, including annual filings and changes in accounting method. We can help determine the impact of a change in accounting method and offer advice on how to mitigate the resulting tax outcome.