Vested Interest - Tax Time Tips - February 1998 Issue

Members should be aware of these recent federal tax changes. Make sure your practice takes account of these important tax changes for 1998!

1. New Reporting Requirement: The Budget Reconciliation Bill, H.R. 2014, included a provision that will require greater disclosure by business defendants of fees paid to contingent-fee attorneys. Starting January 1, 1998, business defendants must disclose payments made to attorneys, even if the payment is for the gross amount of a recovery to a client. The defendant’s statement (Form 1099) would only include the total amount paid to the plaintiff, not the actual amount of attorneys fees paid. Nothing in the new law requires that attorneys submit or in any manner disclose to the defendants the amount of their fee.

   Attorneys are required to submit the Taxpayer Identification Number (TIN) to the defendant payor, or backup withholding can be triggered. Some insurance companies have demanded copies of the contingent fee contract between the attorney and the client, which the IRS and Treasury Department have informally told the Association of Trial Lawyers of America (ATLA) is not required by the bill.

   While this provision does not add any additional accounting or reporting duty on attorneys, members’ tax advisors may suggest new accounting procedures in response to the new IRS disclosure requirement. ATLA suggests that attorneys check with their tax advisor about any recommended changes in accounting procedure or additional filings. The new disclosure procedure only applies to "any payment to an attorney," so a payment made directly to the clients (and not the attorney) by the defendant or insurance company would not trigger the reporting requirement.

2. Increased Enforcement of IRS Deduction Ruling for Contingent Fee Practice.

   Many firms have reported that the IRS is cracking down on a common, though erroneous, accounting method used by some contingent fee attorneys. It is important of members to immediately ensure that the proper IRS-approved accounting method is used.

   Many firms contract with their clients for a contingent fee, with the client also responsible for any costs incurred, payable out of recovery. Some of these firms have been deducting expenses associated with a particular case in the year the costs are incurred. Then when a recovery is received, the entire amount received by the firm, including restitution for costs in the case, is included in taxable income - even if the settlement occurs years after the costs are incurred. This method is NOT allowed under long-standing IRS interpretation.

   When an attorney pays costs on behalf of the client when the client is required to repay those costs when a settlement is received, the IRS considers it a loan of those costs to the client. Therefore, under this interpretation, the costs are not deductible until they can be categorized as bad debts. Expenses which clients are contractually obliged to repay cannot be deducted until the "loan" is recoverable, i.e. until the case closes with no recovery sufficient to repay the costs.

   Firms should consult with their tax advisors to ensure that deductions conform with the IRS interpretation, because the consequences can be severe and costly. Possible approaches include changing the standard contingent fee arrangement or changing accounting procedures - check with your tax advisor to determine the options and which would be right for your practice. The IRS has recently made it easier to change accounting methods to come into compliance with their preferred system.