Post by Gregg on Jan 14, 2014 4:28:24 GMT 4
Must Contingent Fee Lawyers Capitalize Litigation Costs?
Gregg D. Polsky
University of North Carolina (UNC) at Chapel Hill - School of Law
R. Kader Crawford
Robinson, Bradshaw & Hinson, P.A.
October 21, 2013
Tax Notes, Vol. 141, No. 295, 2013
UNC Legal Studies Research Paper No. 2345314
Abstract:
Lawyers who represent personal injury claimants are
typically compensated on a contingent fee basis. In addition, it is
becoming increasingly common for plaintiffs’ lawyers involved in other
types of litigation, such as patent enforcement, to also use contingent
fee arrangements. During the pendency of the litigation, contingent fee
lawyers often pay the litigation costs necessary to prosecute the
claim. For instance, contingent fee lawyers usually pay court fees,
expert witness and consultant fees, deposition and court reporters’
fees, travel costs, and copying costs.
Surprisingly, the tax
treatment of these payments remains stubbornly controversial. The
issue is whether contingent fee lawyers can immediately deduct
litigation costs in the year in which they are incurred or instead must
capitalize them. If the costs are capitalized, cost recovery would be
accomplished upon conclusion of the case, either through a basis offset
against the lawyer’s amount realized or as a bad debt or loss deduction.
The Internal Revenue Service ("IRS") has consistently taken
the position that all litigation costs paid by contingent fee lawyers
are capitalized, regardless of the technical particularities of the
contingent fee agreement. The IRS has thus far prevailed in all of the
reported cases on the issue with one notable exception. The exception
is a Ninth Circuit case, which concluded that a relatively unusual type
of contingent fee agreement — called a "gross fee" contract — allowed
the lawyer to immediately deduct costs. After that decision, the IRS
stated that it will continue to assert that litigation costs must be
capitalized in gross fee contract situations except in the Ninth
Circuit.
Despite the IRS’s well-known position on litigation
costs and its near-universal success in the courts, a prominent
commentator on litigation-related tax issues recently wrote that he
believed that "[t]he vast majority of plaintiffs’ law firms (either
unwittingly or aggressively) probably do deduct client costs as they pay
them, rather than waiting until the case settles." In addition to the
controversy over what current law requires, there is controversy over
what the law ought to be. Recent legislative proposals would allow all
contingent fee litigators to immediately deduct their costs. As might
be expected, lobbyists for trial lawyers strongly support these
proposals, while lobbyists aligned with common personal injury
defendants have announced their opposition.
In this article, we
contend that the INDOPCO regulations, promulgated in 2004, now control
the issue of whether litigation costs must be capitalized. The INDOPCO
regulations establish that, while lawyers who use conventional
contingent fee arrangements must capitalize their costs, lawyers who use
gross fee contracts can immediately deduct their costs.
We
also argue that, while litigation costs incurred under gross fee
contracts are immediately deductible under current doctrine, as a policy
matter these costs should be capitalized. Thus, we conclude that (i)
the Treasury or the IRS should issue prospective-only guidance, as
contemplated by the INDOPCO regulations, to require litigation costs
incurred under gross fee contracts to be capitalized, and (ii)
legislative proposals that allow immediate deductions for litigation
costs incurred under contingent fee agreements should be rejected.
typically compensated on a contingent fee basis. In addition, it is
becoming increasingly common for plaintiffs’ lawyers involved in other
types of litigation, such as patent enforcement, to also use contingent
fee arrangements. During the pendency of the litigation, contingent fee
lawyers often pay the litigation costs necessary to prosecute the
claim. For instance, contingent fee lawyers usually pay court fees,
expert witness and consultant fees, deposition and court reporters’
fees, travel costs, and copying costs.
Surprisingly, the tax
treatment of these payments remains stubbornly controversial. The
issue is whether contingent fee lawyers can immediately deduct
litigation costs in the year in which they are incurred or instead must
capitalize them. If the costs are capitalized, cost recovery would be
accomplished upon conclusion of the case, either through a basis offset
against the lawyer’s amount realized or as a bad debt or loss deduction.
The Internal Revenue Service ("IRS") has consistently taken
the position that all litigation costs paid by contingent fee lawyers
are capitalized, regardless of the technical particularities of the
contingent fee agreement. The IRS has thus far prevailed in all of the
reported cases on the issue with one notable exception. The exception
is a Ninth Circuit case, which concluded that a relatively unusual type
of contingent fee agreement — called a "gross fee" contract — allowed
the lawyer to immediately deduct costs. After that decision, the IRS
stated that it will continue to assert that litigation costs must be
capitalized in gross fee contract situations except in the Ninth
Circuit.
Despite the IRS’s well-known position on litigation
costs and its near-universal success in the courts, a prominent
commentator on litigation-related tax issues recently wrote that he
believed that "[t]he vast majority of plaintiffs’ law firms (either
unwittingly or aggressively) probably do deduct client costs as they pay
them, rather than waiting until the case settles." In addition to the
controversy over what current law requires, there is controversy over
what the law ought to be. Recent legislative proposals would allow all
contingent fee litigators to immediately deduct their costs. As might
be expected, lobbyists for trial lawyers strongly support these
proposals, while lobbyists aligned with common personal injury
defendants have announced their opposition.
In this article, we
contend that the INDOPCO regulations, promulgated in 2004, now control
the issue of whether litigation costs must be capitalized. The INDOPCO
regulations establish that, while lawyers who use conventional
contingent fee arrangements must capitalize their costs, lawyers who use
gross fee contracts can immediately deduct their costs.
We
also argue that, while litigation costs incurred under gross fee
contracts are immediately deductible under current doctrine, as a policy
matter these costs should be capitalized. Thus, we conclude that (i)
the Treasury or the IRS should issue prospective-only guidance, as
contemplated by the INDOPCO regulations, to require litigation costs
incurred under gross fee contracts to be capitalized, and (ii)
legislative proposals that allow immediate deductions for litigation
costs incurred under contingent fee agreements should be rejected.
Number of Pages in PDF File: 12