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Law firms are required to treat advances to and costs paid on behalf of clients as loans for tax reporting purposes. Because most law firms are cash-basis taxpayers, this practice could represent a significant outlay of cash by a law firm in a given year without being eligible for a corresponding tax deduction. How can your law firm manage its cash requirements for advancing client costs, while maintaining compliance with the tax law requirement that these advances be treated as loans? Through planning, revised fee engagement letters, and close monitoring, your firm can minimize its cash requirements for client costs and reduce its exposure for bad debt.
As determined by various court cases, expenses paid on behalf of a client that will be billed to the client are not ordinary costs of a law firm to operate its business, but rather are considered advances or loans to the client, for which repayment is expected. In other words, these payments are not allowed to be deducted as expenses for tax purposes when paid. The only time these costs can be deducted as expenses is when they are deemed uncollectible. Then they can be deducted as bad debt for tax reporting purposes. Generally, law firms pay taxes on a cash-basis method of accounting. As cash-basis taxpayers, law firms generally deduct expenses when cash is disbursed, and record revenue when cash is received. There are various exceptions to this rule. An exception that will be discussed in this article occurs when a law firm pays expenses on behalf of its client. Sometimes attorneys even pay living expenses of clients while a court case is pending. It's no wonder why, then, at the inception of many law firms, expenses paid for client costs are treated as deductions when paid and then treated as income when recovered. But this practice is incorrect; the correct accounting method is to treat them as loans when paid by the firm and as repayments of loans when reimbursed.
Steps to Correct Accounting Methods
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