Magazine article The CPA Journal

Ninth Circuit Holds "Gross Fee" Litigation Costs Deductible

Magazine article The CPA Journal

Ninth Circuit Holds "Gross Fee" Litigation Costs Deductible

Article excerpt

In May, the Ninth Circuit Court of Appeals unsettled decades of case law pertaining to attorney client fee contracts. Costs that firms currently capitalize and may never deduct or may deduct after years of litigation followed by a client's default, may, with some planning, be currently deductible! This decision should cause legal and accounting firms to rethink the contractual relationships they have with clients.

Boccardo's quest for this result began with a 1987 Claims Court decision that he lost. In that case, the court held that Boccardo's cash-basis law could not deduct disbursements it made on behalf of clients under a traditional contingent fee arrangement. That type of arrangement anticipates that the firm would "pay all preparation and trial costs," which typically include filing fees, deposition costs, medical expenses, expert witness fees, and investigation expenses. The agreement became known as the "net fee" agreement because it provided that litigation costs would be subtracted from any settlement or judgment prior to calculating the law firm's charge for professional services. Under traditional case law, these costs were advances to the client and not deductible by the firm unless the client reneged on the obligation to reimburse the firm in the event the litigation was unsuccessful.

Undeterred by the 1987 decision and with the advice of a creative tax advisor, Boccardo began using a new arrangement. Under the new gross fee approach, the firm agreed that its fee for professional services (i.e., fees and expenses) would be a fixed percentage of the gross amount recovered either through settlement or a slightly higher fee if recovered through a judgment. The agreement also provided that, except in the event that a client terminated the relationship, the law m would pay litigation costs.

Since litigation costs were not reimbursable under a gross fee method, the firm deducted them when paid. The IRS disagreed and disallowed litigation costs as firm expenses because-

* the litigation costs were paid on behalf of clients with the expectation of reimbursement,

* the gross-fee agreements were substantially similar to the net fee arrangements, under which courts have held litigation expenses to be loans or advances.

* the California Code of Professional Responsibility only permits an attorney to advance litigation costs, and

* the firm accounted for the costs on a client-by-client basis.

This time, Mr. Boccardo decided on the Tax Court for his forum...and once again lost. In its memorandum decision, the Tax Court admitted that the gross fee arrangement differed from the net fee arrangement because there was less certainty that litigation costs would be recovered under the gross fee approach. …

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