67 The Alabama Lawyer 445 (2006). Deductibility of Litigation Expenses Paid by Alabama Attorneys.

• Author: BY PROFESSOR JOSEPH W. BLACKBURN

The Alabama Lawyer

2006.

67 The Alabama Lawyer 445 (2006).

Deductibility of Litigation Expenses Paid by Alabama Attorneys

Deductibility of Litigation Expenses Paid by Alabama AttorneysBY PROFESSOR JOSEPH W. BLACKBURN Attorneys in the State of Alabama have an important advantage over their brethren in other states. The advantage lies in the long-standing conflict between the Internal Revenue Service and litigation attorneys throughout the United States over deductibility of litigation expenses paid or incurred by such attorneys "on behalf of their clients."(fn1)

In 1995, the Alabama State Bar proposed,(fn2) and the Alabama Supreme Court adopted, a progressive change in Alabama's Model Rules of Professional Conduct. The purpose of the change was to conform such rules to the demands of 21st century litigation on lawyers seeking to ethically and effectively represent their clients' interests.(fn3) As a result of the change in the Alabama Model Rules of Professional Conduct,(fn4) payment of litigation costs by attorneys is no longer required to be merely advances "on behalf of their client" which the client has an unconditional obligation to repay. Alabama attorneys may now incur and pay such expenses in their own name and on their own behalf.

Permitting an Alabama attorney to incur and pay such costs in the attorney's own name should allow attorneys to currently deduct such costs rather than being required to treat them merely as nondeductible "loans" made to their clients. Unfortunately, many Alabama attorneys and their tax advisors are still unaware of this important change. It is hoped that this article will highlight the change in the Alabama Model Rules of Professional Conduct, the resulting potential tax benefits and actions attorneys should consider in their contractual, tax and accounting treatment of litigation expenses.

The Tax Issue

The costs associated with prosecuting a civil action in today's legal environment are enormous. These costs are substantially beyond the ability of clients to pay during the course of the litigation or to even reimburse to their attorney at the conclusion of a successful litigation. Obviously, such costs are paid, and have been for decades, normally and properly, by the attorney and not the client.

Historically, the attorney's payment of such costs has been treated as an "advance" to the client, a treatment previously mandated by the Model Rules of Professional Conduct.(fn5) Generally, such advanced costs have also been contractually required to be repaid by the client to the attorney at the conclusion of the litigation. The client's obligation to repay was fixed and often not conditioned upon the outcome of such litigation. The attorney's tax, financial and accounting records would normally also be maintained in a consistent manner, i.e. litigation expenses would be reflected as an account receivable from the client, not as an expense of the attorney.

Based on the client's unconditional obligation to reimburse the attorney for out-of-pocket costs, the Internal Revenue Service has long held that payment of such costs is not a deductible expense for the attorney. Rather, such advances by the attorney have been treated by both the IRS and the courts as a "loan" to the client.(fn6) Such a loan was deductible, if at all, only when...