The Out-of-Pocket Cash Crunch

by Richard G. Halpern

Ouch! A recent IRS Technical Advice Memo is a painful blow to the way that many attorneys handle out-of-pocket expenses.

The Service ruled that when a law firm's out-of-pocket payments to third parties on behalf of clients are eventually reimbursable by the clients, they must be treated as loans and are therefore not deductible business expenses. Then, when the firm finally is reimbursed for the expenses, the firm is not treated as receiving income. The expense items cited in the ruling include court filing fees, expert fees, photocopying and other support service fees. Travel, meals, deposition costs and the like would also fall within this ruling.

What of those fees that are billed, but never recovered by the firm? Here the news is better: the firm may claim a bad debt deduction, but only in the year its claim becomes totally worthless. This could be long after the expense is incurred.

For those expenses that are never billed to a client, the firm may claim a business expense deduction, but only in the year it makes a final determination not to bill the client. [TAM 9432002]

In light of this ruling, every attorney should review how he or she handles out-of-pocket expenses. The ruling means that if you are deducting the expenses, the IRS will deny your deductions. Obviously, this can create a serious hardship in cases with heavy up-front costs, a plaintiff unable to finance those costs, and a long delay until the ultimate recovery. The problem is one of timing, and the ruling clearly favors the IRS to the detriment of plaintiff's attorneys.

What about those costs that were deducted in the past and are finally recovered? Can you argue now that the recovery does not constitute taxable income? You can argue it, but it isn't going to fly. A firm tried this logic and lost in the U.S. Tax Court. The Court ruled that even though the firm was wrong to deduct the expenses initially, the "duty of consistency" required that the firm must recognize income upon recovery of the expenses. [Hughes and Luce, LLP v. Commissioner, T.C. Memo 1994-559]

There is a cash flow solution: obtain a bank line of credit to finance the litigation. The interest charged is deductible as a business expense, but does, of course, add to the costs of the case. Otherwise, the plaintiff's attorney must, in the IRS' view anyway, go it alone as the proverbial "deep pocket."

Beyond this, your options are limited. The IRS has decided to treat plaintiff's attorneys as "deep pockets," carrying the initial financial burden for clients with no tax relief.