It is common practice for law firms to incur 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 noncompliance.
Advanced client costs
Your law firm will typically incur two types of expenses on behalf of clients –hard costs and soft costs. The tax treatment of each is based on the type of expense incurred.
Hard Costs – Direct expenses
This includes advance payment for such things as deposition fees, experts’ fees, witness fees, and filing fees. In general, hard costs are considered a “loan” to your client and are not deductible as a business expense. This is true whether your firm reports on a cash basis or accrual basis for tax purposes. If your client does not reimburse you for the costs, you then can deduct the amount you paid as an expense – i.e. Client Costs Written Off.
Since the expense is considered a loan, the costs should be reflected as assets. We set the account up for our clients as Client Costs Advanced. It is on the Balance Sheet as an Accounts Receivable. 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.
Soft Costs – 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. Firms often set up contra accounts for the soft costs.
The typical expenses included in this category are listed in Canelo v. Commissioner, 53 T.C. 217, 219 (1969), aff’d 447 F.2d 484 (9th Cir. 1971): The types of costs advanced by petitioners’ law firm include travel expenses, costs of medical records, reports, interpreters’ fees, witness fees, deposition costs, filing fees, investigation costs, photographs, laboratory tests, and sheriff’s fees for service …. Petitioners ordered the services of process servers, shorthand reporters, investigators, doctors, and expert witnesses to whom litigation costs were paid.
The Tax Court explains in Herrick v. Commissioner, 63 T.C. 562, 569 (1975) (discussing Burnett v. Commissioner, 356 F.2d 755 (5th Cir. 1966)) that: in our view the clear inference of the Fifth Circuit’s opinion in the Burnett case is that if the amounts deducted were advances by the attorney to his clients whether for living expenses or other expenses normally paid by the clients and there was an agreement or understanding that the attorney would be repaid, the advances are in the nature of loans and were not deductible business expenses.
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.
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