Costs incurred on behalf of clients.

• Author: Zarzar, Robert
• Position: Law firms; professional services

Many professional service firms incur costs on behalf of their clients. Are these deductible as Sec. 162 ordinary and necessary expenses, with subsequent reimbursements included in income when received? Or do these costs constitute advances not deductible when incurred, with any subsequent reimbursements not included in income when received? Do different types of costs incurred result in different tax treatments?

Net Fee Arrangements

In Canelo, 53 TC 217 (1969), aff'd per curiam, 447 F2d 484 (1971), the Tax Court ruled that costs incurred by a law firm on behalf of clients are advances. The court stated that the attorneys "made expenditures on behalf of a particular client, under a reimbursement agreement signed by the client, to pursue a claim held by the client--a claim of no use to any person other than the client. In reality, they are the client's expenditures."

A number of other cases like Canelo have addressed contingent "net-fee arrangements," under which a law firm pays for costs associated with the case on behalf of its client during litigation. If the case is decided in the client's favor, the litigation costs paid by the law firm are reimbursed from the proceeds. After the reimbursement is made, the law firm receives an agreed-on percentage of the remaining net proceeds for services rendered. If the case is lost, it is understood that the client owes nothing for either fees or costs. A law firm would agree to these terms to remain competitive with other firms offering similar fee arrangements. Also, some clients do not have the funds to pay litigation costs, and the law firm may believe there is a strong probability that it can win the case and ultimately recoup its expenses.

The courts have ruled that reimbursable costs incurred on behalf of clients under such contingent net-fee arrangements are nondeductible advances when incurred. When reimbursements are received from clients, the reimbursement is not income to the firm. Typical costs viewed by the courts as advances to clients have included travel expenses, medical records, reports, expert witness fees, deposition costs, filing fees and other similar items. These costs are specific to the case involved and, except for the case, would not be incurred.

Support-Type Service Charges

In Letter Ruling 9432002, the IRS considered the deductibility of costs paid to third parties and incurred on behalf of clients and support-type service charges. The costs incurred and paid to third...