Accounting for client out-of-pocket expenses.

• Author: O'Connor, Eileen J.

In some areas of the country, the IRS is making the examination of law firms a high priority. One of the issues the examining agent generally looks for is the firm's deduction of out-of-pocket expenses it has paid on behalf of its clients. While this issue is most common in law firms, it can also arise in the context of other personal service businesses.

When law firms and some other personal service businesses ("firms") pay out-of-pocket costs on behalf of their clients, it is generally under an agreement with the client that the client will reimburse the costs. Several courts have sustained the Service's position that the firm may not deduct these costs. This follows the general rule that one taxpayer may not deduct expenses it pays on behalf of another because the expenses do not meet the ordinary and necessary requirement of Sec. 162.

These out-of-pocket expenditures are considered loans by the firm to the client, and the client's reimbursement of the expenditures is a repayment of the loan (neither of which has a tax effect to the attorney). Many firms, however, continue to deduct these costs when they pay them and to report the reimbursement as income when they receive it.

In addition to stating these established rules, however, Letter Ruling (TAM) 9432002 provides some additional guidance relating to deducting client out-of-pocket expenses.

When the expenses are incurred in connection with a contingency fee case, the firm may deduct them in the year in which the case is closed in such a manner that the firm will not recover these out-of-pocket expenses.

When the firm bills a client for out-of-pocket expenses but the client does not pay, the firm can claim a bad debt deduction when the debt is worthless and uncollectible and legal action to enforce payment would not result in collection.

The firm may also deduct out-of-pocket expenses in the year in which it determines that, for valid business...