Potential tax law change may provide trial lawyers an incentive for gross fee contracts

October 11, 2011
Jennifer Thomas, CPA, Baker Tilly

Gross vs. net fee contracts

In a gross fee contract, an attorney’s compensation is based on a set percentage of the total monetary recovery. Any litigation costs advanced by the attorney are their costs of doing business and there is no obligation for the client to reimburse the attorney if there is no recovery. Conversely, in a net fee contract, litigation costs paid by an attorney are reimbursed from the total monetary recovery first, and an attorney’s compensation is based on a set percentage of the remaining recovery.

Since net contracts involve a contractual right to reimbursement, albeit on a contingency basis, tax law treats these advances as loans made to a client. Thus, they are not currently deductible as ordinary and necessary business expenses under Internal Revenue Code (IRC) §162, and only become deductible as business bad debts in the event of little or no recovery under IRC §166. If advances are reimbursed, then the loan is offset and no income is recognized for this amount.

While the tax treatment of net contracts is straightforward, treatment of gross contracts is uncertain.

Treatment of gross contracts after Boccardo

The Internal Revenue Service (IRS) believes that while a gross contract does not involve a contractual right to reimbursement, these litigation advances are still effectively loans.

However, in the 1995 Boccardo court case, the Ninth Circuit Court of Appeals ruled that an attorney who represented a client in a gross contract was not extending a loan to that client and therefore could treat any related litigation costs, such as filing fees, witness fees, travel expenses, and medical consultations, as deductible business expenses under IRC §162.

Despite this ruling, the IRS issued 1997 Field Service Advice (FSA) Memoranda 442 stating that the IRS would follow the Boccardo ruling only in the Ninth Circuit Court, and it would continue to treat gross contracts the same as net contracts in all other jurisdictions.

A tax law change or clarification in the works?

During a July 2010 American Association of Justice (AAJ) convention, John Bowman, Director of Federal Relations for AAJ, revealed the Treasury Department’s plan to issue an administrative order on the timing of the deductibility of litigation costs advanced to contingency clients.

This speculation arose after proposed legislation by U.S. Senator Arlen Specter (D-PA) failed in Congress in 2009. This Senate Bill 437 would have allowed attorneys to currently deduct all fees and expenses advanced in contingency fee lawsuits. Since then, various Senators and House Representatives have expressed opinions on both sides of the issue, and change remains uncertain.

Tax planning implications of a change or clarification

Without a legislative or administrative change, the tax treatment of gross vs. net contracts outside the Ninth Circuit Court remains neutral; therefore, the decision between the two structures remains purely an economically-driven decision. Many firms choose net contracts because of the economics of the arrangement and the additional planning burden associated with gross contracts to accurately estimate litigation costs.

However, if the speculation turns to reality, and tax law changes to allow litigation fees in gross contracts to be currently deductible as business expenses, attorneys would find a tax benefit to selecting gross contracts over net contracts. Economics should still drive the decision, but the tax benefit of accelerating the deduction may influence the decision of gross vs. net contracts.

Tax planning if no change or clarification

If no change in tax law occurs, law firms outside of the Ninth Circuit Court may consider whether or not the Boccardo case provides them with substantial authority for deducting litigation costs as incurred. However, firms would then need to determine whether the cost of defending this position upon audit and the potential for appeals and even litigation is worth the benefit to accelerate the deductibility of these litigation costs.

We welcome the opportunity to meet with you to discuss how we can help you meet your business goals. For more information or any questions you might have on this topic, please contact Jennifer Thomas by e-mail at jennifer.thomas@bakertilly.com or phone at 920 739 3444 or 800 362 7301.