Managing Advanced Client Costs and Complying with IRS Rules

By K. Jennie Kinnevy
December 27, 2007

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

If your firm treats advances for client costs as deductible expenses, what steps should it take to move from this incorrect method to a correct method of accounting?

First, determine the value of costs billed to clients. In other words, how much money has the firm billed to clients for costs that have yet to be reimbursed? A listing of these costs by client is most readily available in the client billing records. Since many law firms now keep computerized time and billing records, determining the amount of costs billed may be as easy as printing an accounts receivable aging report, segregated by fees and costs. The cost column is the amount of costs that the firm billed to clients.

But what if a firm has not yet billed a client for these costs? If the firm did not bill for the costs, but has kept track of them on the time and billing system, then the costs should be listed on an unbilled cost report or work in process report. Make sure this report is calculated with fees segregated from costs. Only unbilled costs should be used for the calculation.

Now the calculation gets a little more complicated. The courts distinguish between different types of costs, grouping them into two categories: hard costs and soft costs. Hard costs are treated as advanced client costs, and soft costs are not. The challenge is to make sure your accounting system is set up to track these different types of costs being charged to clients. Otherwise, your firm may be overstating its 'loans' to clients and understating its allowable tax deductions.

How does your firm distinguish between hard costs and soft costs? Hard costs are those costs for which a specific check is written. These costs include travel expenses, costs of expert witnesses, filings fees, court reporter fees, and outside reproduction costs, to name a few. Soft costs are those indirect costs charged to clients for which a specific check is not written. A good example of a soft cost is in-house photocopying cost. If a client is charged 35 cents per page for photocopies made in house by a law firm employee, then there is really not a direct check associated with this expense. The indirect expenses that made up the value of the photocopy include a portion of the salary of the law firm employee who is making the photocopies, lease expenses for the photocopy machine, and supplies costs for paper, toner, staples, binding, and mailing. These expenses are indirect expenses that are expensed by the firm when payroll is paid for employees, when the vendor who provides leased equipment is paid, and when the vendor for office supplies is paid. Income is recorded as revenue when the client pays the bill. Make sure your firm has specifically identifiable cost category codes in its time and billing system to distinguish between hard costs and soft costs.

But what if a cost is billed, but has not yet been paid? Just because a cost is entered into the time and billing system, it does necessarily mean it was paid or 'advanced' on behalf of your client. It all depends on when you enter the client costs into your system ' before payment or after payment. If you enter client costs in your time and billing system as they are received, but before they are paid, you need to consider and track which client costs are unpaid. This should be tracked on your accounting system as accounts payable. In order to capture this data accurately, your firm should set up an accounting system with two types of accounts payable: regular firm operating expenses payable and client costs payable.

Only costs that are advanced to clients and that are expected to be repaid should be treated as loans. Therefore, if you have an agreement with a client that you will not bill for costs, then you should expense these costs when paid. In addition, if a cost previously expected to be repaid by a client is deemed uncollectible, then that expense should be treated as bad debt by categorizing it as an 'uncollectible client cost' on the income statement. The specific rules for bad debt deductions should be followed to claim this expense on the firm's tax return.

To summarize, the value of costs advanced to clients to be treated as loans by the firm can be calculated using the following formula:

+ Value of 'hard' costs billed, included in accounts receivable

+ Value of 'hard' costs unbilled, included in work in process

' Value of client costs unpaid, included in accounts payable

' Value of 'hard' costs previously charged to clients and treated as loans now deemed 'uncollectible'

' Advances from clients applied against costs, i.e., transferred from client trust funds

________________________________

= Advanced client costs

The result of the calculation above is the amount that should be recorded on the firm's current asset section of its balance sheet as 'Advanced Client Costs' or 'Client Disbursements Receivable.'

If your firm capitalizes advanced client 'hard' costs, go through the formula above to ensure it is not overstating or understating the value. Overstating the value will result in overstating assets, equity, and taxable income; understating the value will result in understating assets, equity, and taxable income.

If your firm does not capitalize advanced client 'hard' costs, then consult with your tax adviser or tax return preparer to formalize a plan to transition to compliance. This type of correction is classified an automatic change and can be prepared with the filing of your next annual income tax return. The amount to be classified as a loan can be phased into income over a four-year period for tax purposes. There is, however, one catch. If the IRS audits your firm and makes the change, then it will be a one-year adjustment dating back to the earliest open tax period and rolled forward to the current period. In other words, it is best for your firm to initiate this change in accounting method than for the IRS to discover the error and initiate the change.

If your firm is capitalizing costs and treating them as loans correctly, what can you do to minimize the outflow of cash to fund client loans? There are several strategies to consider. One recommendation is the inclusion of a clause in the engagement agreement with clients requiring a retainer to be used to fund client costs. Any costs incurred on behalf of a client with this arrangement are paid by accessing and reducing the retainer accordingly, after being billed to and approved by the client. Not only does this strategy improve cash flow, but it also reduces the chance of incurring bad debt. Another strategy is to request that clients pay all such costs, or those over a set dollar threshold, directly. Alternatively, the firm can practice the prudent and risk-averse policy of billing clients for costs incurred, then trying to match the timing of payments to vendors with the receipt of clients' payment for those costs.

Once your firm has established agreements with clients for handling costs and a system for tracking them, it is important that you realistically review capitalized costs at least quarterly to determine if any are uncollectible. Uncollectible client costs must be deducted in accordance with IRS rules for determining bad debt expenses.

Conclusion

If your firm is not treating advanced client costs as loans or assets, then you should form a plan to come into compliance with IRS guidelines. But before doing so, take the necessary steps to reduce the amount that must be capitalized. Modify client agreements such that your firm funds fewer upfront costs, or change billing procedures by matching the payment of expenses with reimbursements from clients.

K. Jennie Kinnevy is the director of the Law Firm Services Group at Feeley & Driscoll, P.C. (www.fdcpa.com). The Law Firm Services Group provides tax, accounting, business advisory, and consulting services to law firms. Based in Boston, Kinnevy can be reached at [email protected] or by phone at 617-456-2407.