House and Senate tax bills target contingency fees

Many lawyers assume that if they pay for a deposition transcript, a court reporter, or travel expenses for a hearing, they can deduct these costs as business expenses on their taxes. The same for expert witness fees. These are all usual kinds of business expenses for lawyers, one would assume. So how could there be a tax problem?

One question is who really bears the impact of these expenses, lawyer or client, and when? The tax law says that business expenses have to be ordinary and necessary to be tax deductible. Yet, what could be more ordinary and necessary that expenses of this sort for a lawyer?

Even so, the House and Senate tax bills both say otherwise for contingent fee lawyers until the conclusion of the case. That might be years later. Under most contingent fee agreements, the client pays nothing (not even costs) unless there is a recovery.

Under some fee agreements, costs are subtracted from the client's share. In others, costs are taken off the top, before the client and lawyer split the remainder. But someone has to pay these costs up front as they are incurred, and that is almost always the lawyer. Lawyers understandably want to write them off. But the IRS has battled mostly successfully to prevent these deductions.

In fact, for plaintiff lawyers who don't want to fight with the IRS about tax deductions, the safest course is to treat costs they pay for clients as loans to the client. You can't deduct loans. That is painful, for it means paying the costs currently, but not deducting them on your taxes until what could be many years later when the case finally resolves. Only at that point could you write them off.

But there was a way out in California, and throughout the 9th Circuit, thanks to a tax case called Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). The 9th U.S. Circuit Court of Appeals held that attorneys could currently deduct costs if they had a gross fee contract, under which the attorney receives a percentage of the gross recovery, with costs paid by the attorney taken solely out of the attorney's percentage. Any other type of fee agreement is a loan of the costs.

Some lawyers in California and other states in the 9th Circuit went to great pains to make sure they qualified. Some lawyers may be less careful but still hope they get some protection from Boccardo. The IRS has long been unhappy over this issue. In fact, the IRS issued a Field Service Advice, 1997 FSA 442 (basically a memo to IRS personnel) stating that it would not follow Boccardo except in the 9th Circuit.

But the IRS has long wanted uniform tax treatment, and now so does Congress. There have been a number of subsequent tax cases too, with lawyers litigating this issue with the IRS. But the fighting seems about to end.

Both House and Senate tax bills say no to deductions, even in the 9th Circuit. The job of the conference committee is to harmonize the two tax bills. There could still be a change, but it seems rather unlikely on this point.

Even though tax rules seem destined to be harmonized, how you draft a fee agreement to take costs into account impacts lawyer take-home pay. Consider these examples.

Example 1: You take a case on a 35 percent contingency, with costs subtracted from the gross recovery. You recover $1,000 and costs equal $100. You subtract the $100, which repays you for the $100 you advanced. The $900 balance is split 35 percent to you and 65 percent to the client: you get $315. Your total cash is $415, but $100 was your own money. Your net cash is $315.

Example 2: You are on a 35 percent contingency, and your agreement (in gross) is merely to divide the proceeds. You bear all costs. If you recover $1,000 and have $100 in expenses, you receive $350. However, $100 is really a reimbursement of your own money. Your net is $250.

Example 3: Your fee agreement says you will advance costs, but that when you split 65/35, your reimbursement of costs will come entirely out of the client's share. Your costs are still $100. When the case settles for $1,000, you first subtract the $100 which is reimbursed to you. The $1,000 gross is split 65/35, so your share is $350. You receive that $350 plus the $100 reimbursement. The client receives $550. Your net is $350.

Lawyers should consider anticipated costs, and should consider what kind of fee agreement they want to use. In the 9th Circuit, that decision up to now has been heavily influenced by taxes. But that may change, and soon.

Plaintiffs' lawyers in most of the country won't feel the burn, for they have had this rule for years now. Plaintiffs' lawyers in the 9th Circuit, though, may have a rude awakening. The House version of tax reform says: "No deduction shall be allowed ... for any expense paid or incurred in the course of the trade or business of practicing law, and resulting from a case for which the taxpayer is compensated primarily on a contingent basis, until such time as such contingency is resolved."

The Senate proposal includes the same, explaining that it "denies attorneys an otherwise-allowable deduction for litigation costs paid under arrangements that are primarily on a contingent fee basis until the contingency ends." Estimates say that this provision will save an estimated $500 million over 10 years.