Definition of Terms
The term “Advanced Client Costs” applies to cash advances paid by the law firm for which they expect to be reimbursed by the client or from the proceeds of a transaction, judgment or settlement. Advanced Client Costs include such things as travel, cost of obtaining documents (e.g., medical records), witness fees, deposition costs, investigators and expert witness fees, filing fees, service of process and the like).
Advanced Client Costs are distinguished from normal Overhead Expenses (for example, secretarial costs, photocopy expense, telephone charges and allocable online legal research costs) which may or may not be reimbursed by the client.
Proper Accounting Treatment
It is common practice for law firms to incur, pay and bill clients for Advanced Client Costs. Accordingly, Advanced Client Costs should be treated as an asset and not as an expense. Should anyone seek authoritative support for this proposition, look no further than IRS Attorney Audit Technique Guide (the “Guide”) which can be found at:
http://www.irs.gov/Businesses/Small-Businesses-&-Self-Employed/Attorneys-Audit-Technique-Guide
Chapter 3 of the Guide is clear and concise on this point:
| Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement. A bad debt deduction may be taken in the year that any costs are determined to be uncollectible. |
According to the Guide, the mere expectation that these costs will be reimbursed is all that is required. Even if the matter is undertaken on a contingency basis, such expenditures are not deductible for tax purposes until they are deemed a bad debt. The Guide cites a number of Tax Court decisions in support of this position and advises IRS auditors to inquire into the accounting records detailing such expenses by client matter.
The Guide goes on to point out that Overhead Expenses are deductible for tax purposes in the current year because they would reasonably be incurred even if not charged to a particular client. Of course, if the law firm is later reimbursed for Overhead Expenses previously taken as a deduction, such reimbursement is treated as income in the year reimbursed.
In the Orion accounting system, the default settings treat cash advances paid on behalf of clients as an asset account on the balance sheet; this is accomplished by using the “CA” code when processing Advanced Client Costs. Similarly, the default setting for Overhead Expense payments is the “EX” code when treats such items as an expense even when allocating a client-matter number to the transaction. When “EX” code transactions are billed and subsequently collected by the law firm, such payments are treated as income upon receipt. These default settings conform to the IRS guidelines.
Alternative Treatment
If you wish to perform a “work-around” to the default settings, the Orion software may be overridden by using the “EX” code (as opposed to the “CA” code) when processing Advanced Client Cost payments. By utilizing the “EX” code, the payments are treated as an expense item (not as an asset) and when the client subsequently pays the law firm such payment is recognized as “Expense Reimbursement Income.”
If your firm is just starting on Orion and you wish to use this work-around, you can simply notify your Project Manager and trainer. This should be done before the Live Conversion, but no later than before any new entries are made into the software.
If you have already been using Orion with the standard Client Cost Interface, changing to the work-around will require significant changes. The process may require that all of the existing “CA” codes be eliminated and matching “EX” codes created. The Orion system interface will need to be changed. If possible, existing transactions will need to be translated to new “EX” codes. Finally, reconciling entries will need to be calculated and entered into the General Ledger. Each firm’s situation is unique and a plan will need to be developed after reviewing your data. Accomplishing this will require assistance from Orion’s business services staff (estimated 4 to 8 hours).
Orion does not recommend this change. We strongly encourage all law firms to report Advanced Client Costs as an asset.