Managing Advanced Client Costs and Complying with IRS Rules

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.