By Daniel L. Britt, Jr. , and Christopher Eastwood[1]

Risk is endemic to any business enterprise; none, more so, than the risk inherent in plaintiffs’ trial law. Sadly, attorneys who rely upon contingent fees for their income also face risks filing their tax returns. Unlike any other business enterprise, attorneys, except in the Ninth Circuit, cannot deduct litigation costs paid on behalf of their clients as ordinary and necessary business expenses under 26 USC §162. Instead, under guidelines adopted by the IRS, attorneys must treat these unavoidable costs as loans to their clients payable upon recovery and deductible only if the costs cannot be recovered from the tortfeasor or from their clients. [2]

The IRS has designated law firms, and small and solo-practitioners specifically, as a “targeted group.” As such, lawyers are subject to closer scrutiny and greater risk of examination. Indeed, the IRS has developed a special Audit Guideline Manual for Attorneys. Under that manual and unlike similar costs for most other businesses, client litigation costs advanced under a contingent fee contract are loans and not current business expenses.[3]

The tax treatment of client litigation costs has been confused by a split between the IRS rule and the Ninth Circuit’s treatment of these costs as decided in Boccardo v. Commissioner and Opperwall v. C.I.R..[4] [5] In Boccardo, the Ninth Circuit carved out an exception by dividing lawyers’ contingent fee contracts into two classes, Gross Fee Contracts and Net Fee Contracts. In a Gross Fee Contract, a personal injury law firm pays all litigation costs up-front and recovers a fixed percentage contingency fee if successful. Under a Gross Fee Contract, the Ninth Circuit ruled client costs are deductible as current 26 USC §162, ordinary business expenses. Boccardo (9th Cir. 1995). Conversely, under a Net Fee Contract, litigation costs are recouped first and the firm’s contingent fee is a percentage of the balance of the award. If the Net Fee Contract gives the firm the right to be reimbursed for the costs, the IRS argued that litigation costs paid by the firm should be treated as loans and not allowed as current deductions.

The IRS has not acquiesced in Boccardo and has not altered or clarified its rules for treatment of client litigation costs. The IRS argues that, until other Circuits follow Ninth Circuit’s lead, law firms should treat all client litigation costs as loans. As the issue now stands, the IRS prevailed regarding the “net fee” contingency fee contracts in the Ninth Circuit’s decision. Thus client costs are never deductible as current expenses under a Net Fee Contract in which the client is obligated to repay the costs. However, since the Ninth Circuit Court of Appeals sided with plaintiff’s attorneys on Gross Fee Contracts[6], these expenses are deductible as current ordinary and necessary business expenses, at least within the Ninth Circuit.[7] [8]

The rules for deducting litigation costs are arguably still in dispute. In the aftermath of Boccardo, the IRS issued a Field Service Advice (FSA) saying it would not follow the Boccardo decision outside the Ninth Circuit. The IRS would continue to treat client litigation costs as loans, not currently deductible, and deductible only if ultimately uncollectible.[9] More recent Tax Court decisions have further muddied the issue. They suggest the Tax Court might follow the lead of Boccardo, for Gross Fee Contracts but declined to do so. In two cases, Pelton & Gunther v. Commissioner and Baddell v. Commissioner, the ax Court acknowledged the Ninth Circuit’s Boccardo decision but found both factually distinguishable because Boccardo involved a Gross Fee Contract but the Pelton and Baddell contracts required reimbursement. [10] [11] By recognizing Boccardo, the dicta in both cases are inconsistent with the position taken by the IRS in its FSA and have led to political wrangling. [12]

Then along comes the Tax Court in Pace v. Comm’r of Internal Revenue. [13] Pace was a successful plaintiff’s attorney. He deducted his clients’ litigation expenses in 2001 the year in which he received payment. He had not deducted those expenses when paid, 1997 to 2000. The taxpayer relied upon the Tax Court’s original decision in Canelo, ie., litigation costs are loans not expenses. [14] In effect, he was consistent with the IRS 1997 FSA 442. However, as a cash basis taxpayer, the Tax Court said he was wrong to deduct those expenses. Instead, he should have excluded the reimbursed advanced litigation expenses from income rather than deducted them. Rather than exalting form over substance the Tax Court allowed the exclusion but not without more.[15]

Since Boccardo and the ensuing Tax Court decisions, there have been various efforts to allow the current deduction for attorney-advanced litigation costs in all circuits, in many cases expanding the deduction to Net Fee Contracts. One such proposal made it into H.R. 6049, the Renewable Energy and Job Creation Act of 2008, which passed the House, May 2008. The Senate version of the bill did not include the client costs provision, and the bill was never enacted. This proposal reflected the new Obama administration’s desire for clarification on this issue.[16]

Finance Committee Chair Max Baucus, D-Mont., and Senate Assistant Majority Leader Richard J. Durbin, D-Ill., wrote to Treasury Assistant Secretary for Tax Policy Michael Mundaca[17] arguing that the Service’s position in the 1997 Field Service Advice added confusion to the deductibility of client costs and did not take into account more recent Tax Court decisions, including Pelton & Gunther v. Commissioner.[18]

In response to a suggestion that Treasury should issue guidance consistent with Boccardo, Mundaca wrote May 6 that Treasury was “considering issuing guidance to clarify this issue.” Of course, organizations and businesses opposed to plaintiffs’ trial lawyers arose in opposition to any such clarification.[19]

In a July 29, 2010, letter to Treasury Secretary Timothy Geithner, some two dozen GOP senators predicted dire consequences should Treasury alter its rule and allow current deductions for litigation costs. They argued that allowing litigation costs as current expenses would worsen the federal debt and encourage harmful litigation.[20] In an accompanying statement, Sen. John Thune, R-S.D., said “Instead of providing tax relief for political allies, we ought to be providing across the board tax relief for the average, hardworking taxpayer.”[21] He noted that similar legislative proposals have not even achieved a committee hearing “due to the significant opposition that they face.” These Senators believe the IRS should reaffirm its opposition to the Boccardo rule. In a Field Service Advice issued after its loss in Boccardo, the IRS it directed agents not to follow that decision except in the Ninth Circuit. (1997 FSA 442).

Conversely, the American Association for Justice has been at the forefront in lobbying efforts to expand the deductibility of attorney-advanced litigation costs. The AAJ championed its members’ right to receive the same fair tax treatment that every other small business owner outside the Ninth Circuit enjoys. That is the simple right to deduct business expenses when paid.

As is common in policy discussions that devolve into partisan “side-taking,” the issue has been left in disarray. The Associate Chief Counsel of the Department of Treasury, George J. Blaine, wrote Senator Grassley telling him that neither the Treasury Department nor the IRS have “yet determined whether additional guidance on this issue is appropriate at this time.”[22]

For plaintiffs’ lawyers (using Gross Fee Contracts outside the Ninth Circuit) who want to avoid confrontation with the IRS, the safest course is to treat litigation costs and expenses as loans regardless of whether they use Gross Fee Contracts or Net Fee Contracts. Likewise, despite legislative efforts to the contrary, they should always treat client litigation costs as loans if they use Net Fee Contracts in which the client is ultimately responsible for the costs.

This places plaintiffs’ attorneys in a difficult position vis-à-vis potential clients. Gross Fee Contracts are routinely at a higher percentage to cover incurred costs. With competition by lower Net Fee Contracts, market forces will begin to punish attorneys seeking to comply with unclear rules.

However, for those attorneys who use Gross Fee Contracts in which litigation costs will be bourn as part of the contingent fee and the client is not otherwise responsible for these litigation costs, there is a legitimate basis to deduct litigation costs as current period deductions provide however that the treatment is clearly disclosed. [23] [24]

January 30, 2012
Daniel L. Britt, Jr., and Christopher Eastwood
Atlanta, GA

  1. Dan is an attorney with Britt & Associates Attorneys, LLC. Chris is a 2011 law grad of DePaul University, and is a part time a paralegal. Chris will sit for the Georgia Bar Summer 2012.
  2. Canelo v. Commissioner, 53 T.C. 217, 219 (1969), aff’d 447 F.2d 484 (9th Cir. 1971).
  3. IRS Attorneys Audit Technique Guide – Chapter 3.
  4. Boccardo v. U.S., 12 Cl. Ct. 184 (1987)., Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). ). (Link:
  5. Opperwall v. C.I.R., 105 F.3d 666 (9th Cir., 1997). In Opperwall, the Ninth Circuit followed its own rule from Boccardo.
  6. Provided the client has no obligation to repay these costs unless there is a recovery.
  7. Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). (Link:
  8. For further discussion of the cases, please read:
  9. 1997 FSA 442
  10. Opperwall v. C.I.R., 105 F.3d 666 (C.A.9, 1997)
  11. Pelton & Gunther v. Commissioner, 78 T.C.M. 578, T.C. Memo. 1999-339 (U.S.T.C., 1999) Doc 1999-32749 or 1999 TNT 196-58.
  12. Doc 2010-9903, 2010 TNT 86-19
  13. Pace v. Comm’r of Internal Revenue, T.C. Memo. 2010-272 (U.S.T.C., 2010) Docket No. 13446-07.
  14. Canelo v. Commissioner, 53 T.C. 217, 219 (1969), aff’d 447 F.2d 484 (9th Cir. 1971).
  15. The Tax Court went on to analyze the litigation costs and allocate them to various to match them against the reimbursements. The court also examined the taxpayer’s substantiation. In the end, the taxpayer had a mixed result.
  16. Document created by the Transition Project:
  17. Since resigned.
  18. Doc 2010-9903, 2010 TNT 86-19
  19. See link:
  20. See link:
  21. See link:
  23. Attorneys or their preparers considering claiming current deductions for litigation costs may want to consider IRS Form 8275 used to positions not otherwise disclosed on the return for which there is a reasonable basis. This disclosure may be able to avoid accuracy related penalties.
  24. IRS Circular 230 disclosure: To ensure compliance with requirements imposed by the IRS, we inform you that any tax advice that may be contained in this article is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction(s) or tax-related matter(s) that may be addressed herein.