Taxing Lessons From Court Decisions

Of Chivalry and Attorney Fees

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Where else but at the tax court can you learn about The Sovereign Military Hospitaller Order of St. John of Jerusalem, of Rhodes, and of Malta, which was established in the mid-eleventh century, and qui tam litigation, which first showed up in the thirteenth century–all in the same case?

Other than the history lesson, most of T.C. Memo. 2010-272 (Pace) is fairly mundane, merely another litany of poor recordkeeping on the part of the taxpayer, who is a Knight in Obedience in the Sovereign Military Hospitaller Order of St. John of Jerusalem, of Rhodes, and of Malta. One issue of interest is the proper treatment of lawyers’ litigation expenses in contingency cases.

In general, out-of-pocket expenses paid by an attorney prior to the settlement of a case are deductible in the year paid (assuming cash basis). There’s an exception for contingency cases, where the lawyer gets paid a portion of the settlement if the case is successful. In that situation, treatment of the expenses depends on whether the lawyer has a contractual right to be reimbursed for expenses, or simply collects a percentage of the settlement without a separate reimbursement.

Having a contractual right for reimbursement (called a net fee contract) means the expenses are deductible in the year incurred. No contractual arrangement (called a gross fee contract) has no tax consequences when the expenses are paid–the advance of costs is treated like a loan, and excluded from income. If the lawyer fails to win the case and receives no compensation, the advanced expenses are deductible as a bad debt in the year the case is closed.

In this case, in addition to other litigation costs for non-contingency cases, the taxpayer deducted the costs of a gross fee contract in the year of settlement, when he received his contingent fee. The court said he should have excluded the costs, as opposed to deducting them, though the end result is the same.

The problem? The amount of the costs was in dispute, because of the taxpayer’s poor records.

The court sorted verifiable costs between contingency and non-contingency cases and the taxpayer ended up with only a partial deduction. To quote the tax court, “the Code imposes a more exact and less merciful accounting: business expenses, charitable contributions, and the costs of everyday life must be identified, segregated, and substantiated by reliable documents and credible testimony.”

Taxing Lesson: Learn from history: Paperwork is required, even if you’re a knight.

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