Potential Tax Advantages of Gross Fee Arrangements

Potential Tax Advantages of Gross Fee Arrangements

by Charles R. Brown

Depending on the circumstances, a trial lawyer undertaking a matter for a client on a contingent fee basis may wish to consider a “gross fee” contract instead of the more customary “net fee” contract. Under a “gross fee” arrangement, a law firm agrees to pay all litigation costs, but, upon recovery of a settlement or judgment, receives only a specified percentage of the recovery with no separate reimbursement of costs advanced. This is in contrast to the more customary net fee’ arrangement, where the firm agrees to advance all litigation costs, but, upon recovery, receives the costs advance in addition to the contingent fee.

In a recent decision by the United States Court of Appeals for the Ninth Circuit, an attorney licensed to practice in California and the District of Columbia was allowed to deduct his share of the litigation costs paid by his cash method partnership pursuant to its “gross fee” arrangement with the firm’s clients. See, Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995). In prior cases involving this issue, “net fee” arrangements were determined to be non-deductible “advances” or loans when paid, rather than deductible business expenses under section 162 of the Internal Revenue Code of 1986 (the “Code”). See, Boccardo v. Commissioner, 12 Cl. Ct. 184 (1987); Burnett v. Commissioner 356 F.2d 755 (5th Cir. 1971); John W. Herrick, 63 T.C. 562 (1975). In the underlying United States Tax Court decision involving the taxpayer, which was appealed to the United States Court of Appeals for the Ninth Circuit, the Tax Court agreed with the Internal Revenue Service that litigation costs paid in a “gross fee” arrangement were not deductible in the year paid. See, James R. Boccardo, 65 T.C.M. 2739 (1993). The Tax Court held that litigation costs incurred in a “gross fee” arrangement, although more contingent than in a “net fee” arrangement, would still constitute advances that ultimately would be repaid out of the recovery. In ruling against the taxpayer, the Tax Court also determined that, as to the California practice, if a “gross Fee” arrangement does not constitute an “advance to the client,” it would violate the California Rules of Professional Conduct. That violation would cause the expenditure to be non-deductible under the provision of section 162(c) of the Code, which states: “No deduction shall be allowed for any payment. . . if the payment constitutes an . . . illegal payment under any law of the United States, or under any law of a State. . . which subjects the payor to a criminal penalty or the loss of license or privilege to engage in a trade or a business.”

In reversing the Tax Court and holding for the taxpayer, the Court of Appeals accepted the taxpayer’s argument that in a “gross fee” arrangement, the payment of costs by the law firm is not an “advance” of the costs. The court agreed that in a “gross fee” arrangement, the firm has no contractual right to reimbursement; the firm is no more reimbursed its expenses than a self-employed commissioned salesman is reimbursed for the travel costs incurred in making a sale when the commission check for the sale finally arrives.

Regarding the Tax Court’s holding that if the costs paid by the law firm do not constitute an “advance,” then the “gross fee” arrangement must be a violation of the California Rules of Professional Conduct, the Untied States Court of Appeals for the Ninth Circuit distinguished the California rule from the District of Columbia Rules of Professional Conduct (Rule 1.8(d) and comments (5) to that rule), which do not require the client to remain ultimately liable for the expenses. The court also held that, even if the “gross fee” agreement violated the California Rules of Professional Responsibility, there was no evidence concerning enforcement of the California rule that would cause it to raise to the level of violation of “a law of the United States” or a “State law that is generally enforced, which subject the payor to a criminal penalty or the loss of a license of privilege to engage in a trade or business, “ as proscribed by section 162(c) of the Code.

The ethical constraint and the section 162(c) argument are not a problem for attorneys license to practice in Utah. Specifically, Rule 1.8(e) of the Utah Rules of Professional Conduct states as follows: “A lawyer shall not provide financial assistance to a client in connection with pending or contemplated litigation, except: (1) a lawyer may advance court costs and expenses of litigation, the repayment of which may be contingent upon the outcome of the matter.”

The comments following the Utah rule specifically state that “[p]aragraph (e)(1) eliminates the requirement that the client remains ultimately liable for such expense.” This rule is precisely the same as the District of Columbia rule discussed by the United States Court of Appeals for the Ninth Circuit.

The I.R.S. can be expected to continue to challenge the deductibility of litigation costs in “gross fee” arrangements in jurisdictions outside of the Ninth Circuit, including Utah, under the theory that the costs are still” advanced” with some contingency of repayment. Nevertheless, the rationale of the Boccardo decision is persuasive, and should constitute “substantial authority” for taking the deduction on a tax return, in the absence of an adverse decision on the issue by the Untied States District Court for the District of Utah or the United States Court of Appeals for the Tenth Circuit.

Assuming that the Boccardo holding is not rejected in Utah, what is its relevance to a Utah lawyer? As noted, the advantage to a “gross fee” contract is that the costs may be deducted by the law firm when paid, and will not have to be funded out of the after-tax dollars.

An example: Assume that the litigation costs total $25,000, and resolution of the case will no occur until four or five years after the case is undertaken. In a “net Fee” arrangement, the law firm would have to fund the $25,000 out of after-tax dollars. Assuming a marginal income tax rate of thirty-five percent, that would result in a total expenditure exceeding $35,000, including the taxes which must be paid on the income generated to fund that expenditure. For heady hitters in the highest brackets, the marginal rate could exceed forty-five percent, which could result in a total expenditure exceeding $45,000, including taxes. In a “gross fee” arrangement, the law firm will pay the $25,000 and deduct it in the year paid, with the result that the total cots is, in fact, $25,000.

In an unsuccessful case where the costs are not fully recovered, the economic cost to the law firm is substantially worse under a “net fee” arrangement. The firm may not deduct the unrecovered costs until final resolution, and has lost the use of the “time value” of the taxes paid to fund the costs incurred in earlier years. In a “gross fee” arrangement, the payment of costs and the deduction occur in the same year. There is no loss of the use of the “time value” of the taxes that would have been paid under a “net fee” arrangement.

If the contingent fee rate is the same in both a “gross fee” and a “net fee” case, say thirty-three and one-third percent, and there is a successful recovery, the law firm of course, will recover more gross dollars in a “net free” arrangement. For example, assuming a recovery of $300,000, the law firm would recover its costs advanced of $25,000, in addition to a contingent fee of $100,000. In a “gross fee” arrangement, the total amount recovered by the law firm would be limited to the contingent fee of $100,000. But a more sophisticated analysis would determine the extra recovery in the “net fee” arrangement is not as disproportional as it appears, one the last earning on the additional taxes incurred in earlier years are factored in.

A slightly adjustment in the contingency percentage may also compensate for the difference. For example, if, in the “gross fee” contract, the contingent fee were forty percent rather than thirty-three and one-third percent, the law form would receive $120,000 in the year of recovery and could have deducted the $25,000 in expenses when paid. The client may retain more in a “gross fee” arrangement at forty percent than a “net fee” arrangement at thirty-three and one-third percent, depending upon the amount of the costs.

Because of the tax advantages, a “gross fee” arrangement may be more economically advantageous, to both the client and the law firm, depending upon the circumstances, the predictability of the costs, and the duration of the case.