STATEWIDE INVESTIGATION UNDERWAY

California's Franchise Tax Board has targeted the income tax accounting methods of law firms in a state wide program that is currently underway to determine the level of their compliance in the tax treatment of client costs and court costs and related advances. Apparently not satisfied to sit back and reap the dividends by letting the IRS do the field audit work for them, California has taken the IRS's Market Segment Specialization Program (MSSP) industry audit guide for attorneys, and developed its own program to test the income tax compliance of the legal community.

THE TAX ACCOUNTING PROBLEM

Almost all law firms utilize the cash basis method of accounting for income tax purposes. Generally speaking, the collections of receivables are taxable income when received and expenses are deducted when paid. All in all, it's a fairly simple tax accounting concept. So what's the problem?

The federal and state tax authorities say there is no problem unless the law firm is recognizing income tax deductions for client costs, court costs and related advances when paid by the law firm. The IRS and the Franchise Tax Board (supported by favorable tax court decisions) say the law firm must treat these advance payments as a loan on behalf of its client and reclassify the payments from the expense accounts to a receivable account on the balance sheet, hence, no tax deduction. When the related receivable is collected, the collection of the advance cost portion will not be taxable income. The fee portion of the receivable will continue to be recognized as taxable income when received, however. If the various types of advance costs become uncollectible, the law firm can take a bad debt deduction in the year in which the advance costs become worthless. So, the average law firm that keeps a simple set of cash basis books and records for income tax purposes also has to be able to account for an accrual basis concept.

TAXABLE INCOME INCREASE - THE ADJUSTMENT

For law firms that are still incorrectly deducting client costs, court costs and related advances when paid, the audit adjustment increase to taxable income would, simplistically put, be equal to the amount of advanced costs paid by the law firm and billed to it's clients, but not yet reimbursed by the end of the law firm's tax year. The advanced costs paid and reimbursed in the same tax year, however, would escape the audit adjustment. The audit adjustment increase, times the taxpayer's marginal federal and state income tax rates, would yield the amount of taxes due. The adjustment will be made against the earliest year still open under the statute of limitations and, interest (and maybe penalties) will also be assessed. At subsequent year ends, taxable income would be increased or decreased by the amount of the change in the year-end total of the advanced costs. If an adjustment of this kind results from an audit, it is tantamount to a forced accounting method change upon the taxpayer, which eliminates the taxpayer's opportunity to spread out the tax effect over as many as four years.

Reprinted from IRS' MSSP Guide for Attorneys:

Mertens Law of Federal Income Taxation (25.28) states, "Although loans frequently represent necessary incidents to the carrying on of a trade or a business, they do not constitute deductible expenses of the lender, inasmuch as they are conditioned upon repayment and do not constitute the current cost of operating the business." Thus costs advanced by an attorney are not deductible by him as a business expense.

According to the RIA Federal Tax Coordinator, "A bad debt deduction will be allowed to an attorney for un-reimbursed advances on behalf of his clients where the requisites for a bad debt deduction are met."

As noted earlier, the IRS's and California's authority is derived from case law that supports their position, as follows:

• Henry F. Chochrane v. Commissioner, 23 B.T.A 202 (1931)
• Thomas Hart Fisher, T.C. Memo OP Dkt 5438(1946)
• Reginald G. Hearn v. Commissioner, 36 T.C. 672 (1961), aff'd 309 F.2d 431
• Warren Burnett v. Commissioner, 42 T.C. 9 (1964)
• John J. Watts v. Commissioner, 27 T.C.M. (CCH)886 (1968)
• Adolph B. Canelo, III v. Commissioner, 53 T.C. 217 (1969), aff'd, 446 F.2d (9th Cir. 1971)
• John W. Herrick v. Commissioner, 63 T.C. 562 (1975)
• Ronald R. Silverton v. Commissioner, 36 T.C.M.(CCH) 817 (1977), aff'd, 647 F.2d 172 (9th Cir. 1981)
• James F. Boccardo v. United States, 87-1 U.S.T.C. 9288 (1987)
• Milan, Miller, Berger, Brody and Miller, P.C. v. United States, 88-1 U.S.T.C. 9209 (1988)

In the Boccardo case, the court made an important distinction between gross fee contracts and net fee contracts. Boccardo's gross fee contingency contracts provided for the recovery of client costs indirectly (presumably, Boccardo's contingency percentage of the settlement in the typical contract is higher to provide for cost recovery) and only if the case was settled favorably. Accordingly, the court allowed the deduction of the client costs when paid by Boccardo.

The court also reaffirmed that costs advanced under a net fee contract are loans and are not deductible. In a typical net fee arrangement, the law firm is reimbursed advanced costs first before the settlement is split.

The above illustrates that while a plaintiff type law firm will have to choose and account for client costs differently based upon which contract it uses, the typical defense type law firm most likely won't have a choice. Since defense work is seldom, if ever, approached on a contingency basis, the net fee contract would almost always be used: in essence, fees plus reimbursement of costs. Therefore, most (if not all) defense law firms will have to record costs advanced as receivables when paid.

As previously noted, if the tax authorities force the accounting change upon the taxpayer, the taxpayer will have to pay all of the assessed tax when assessed. Alternatively, if the taxpayer (that is not under audit) steps-up and initiates the accounting change, the taxpayer is usually allowed to spread out the increase in taxable income ratably over four years, beginning with the year of change. Therefore, instead of having to pay all of the tax at once, the taxpayer can pay the tax (interest free) over four years.

When a taxpayer is already under audit, the taxpayer's ability to then initiate the accounting method change and get the four year spread is severely restricted. However, if the taxpayer (that is already under audit) files for the accounting method change within either of the following "windows" of opportunities, then the taxpayer should be allowed the four year adjustment period.

• 90 Day Window: Accounting method change requested within first 90 days of any taxable year, if the taxpayer has been under audit for at least 12 months as of the first day of the taxable year.
• 120 Day Window: Accounting method change requested within the 120 day period following the date the audit ends regardless of whether a subsequent examination has commenced

Neither of the above windows is available if the auditor has already made an issue of the incorrect accounting method.

Revenue Procedure 97-37 provides simplified and uniform procedures for obtaining an automatic consent for law firms that want to make this accounting method change for tax years ending on or after August 18, 1997. If the taxpayer complies with all of the requirements of Rev. Procedure 97-37 in a timely manner, the taxpayer is protected from having to make the change in a year prior to the year of change.

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