When business expenses are not deductible

A general principle of tax accounting is that we deduct ordinary and necessary business expenses from our gross income before reporting the net taxable income. However, this is not always the case. In some cases it is necessary to modify your tax accounting to comply with specific tax laws – even sometimes when the tax laws contradict other basic accounting principles.¹

One common example of this required deviation in accounting is that expenses paid to a lawyer and then eventually repaid by the client are not deductible business expenses. IRS treats these as loans that the lawyer makes and is then repaid².

Even after a lawyer successfully argued in court that these are not loans that have to be repaid by the client, the IRS persists with this tax accounting requirement in most parts of the country.³.

From a practical perspective, I remind attorneys of two points:

• This only has impact when a case spans for more than one tax year.
• This is only a “timing” issue. Ultimately your total multi-year taxable income remains the same.
• The adjustment in accounting is simple and automated. It is not necessary to change the way the law firm reports cash-based income internally but rather only make the adjustment on tax filings.

1 The basic principle of Section 162 of the Internal Revenue Code is that ordinary and necessary business expenses are deductible. Clearly litigation expenses fit the requirement of “ordinary and necessary” but are not deductible.

2 Expenses paid by a lawyer and then eventually repaid by the client are not deductible business expenses. IRS treats these as loans that the lawyer makes and is then repaid. See IRS publication “Attorney Audit Technique Guide” for more information.

3 The exception is in the ninth circuit where the IRS does not challenge these cases after losing a 1995 case on appeal.