In a recent Tax Court case, a law firm was denied a current deduction for litigation expenses advanced on behalf of its contingent fee clients. The Tax Court held that the expenses were in nature of loans, and not ordinary and necessary business expenses that could be deducted when paid (advanced), even if there was low likelihood of reimbursement. At issue in the case were both expenses for contingency fee cases with individual clients as well as class action cases. The Tax Court found the cost advances in both types of cases to be loans and not currently deductible. With respect to the contingency fee cases with individual clients, the taxpayer had a system for classifying cases as high risk vs. low risk and would only deduct the advances on the higher risk cases. Only the advances for the low risk cases were booked as loans. The Tax Court found that there was a significant likelihood for reimbursement of the expenses advanced and stated that a low likelihood of recovery does not justify deductibility when advanced. With respect to the class action cases, the taxpayer argued that advanced expenses in class action cases were not loans and were therefore deductible because expense awards required court approval and/or there was “no identifiable obligor” until judgment was entered. The Tax Court rejected this argument on the basis that the taxpayer was entitled to reimbursement of those expenses from class members under common-fund doctrine.
(Humphrey, Farrington & McClain, P.C. v. Commissioner, (2013) TC Memo 2013-23, 2013 RIA TC Memo ¶2013-23).