In James F. Boccardo vs. Commissioner, 56 F.3d 1016 (9th. Cir. 1995) the 9th Circuit Court of Appeals modified well established case law and benefited personal injury lawyers. The 9th Circuit Court of Appeals held that all preparation and trial costs paid by the Boccardo personal injury firm, were deductible in the year paid, even through the cases might be settled years down the road. It might not seem like a big change for the public, but there are many ramifications for allowing the deductibility of expenses that might later be repaid. This article will analyze the Boccardo case and its meaning.
The Boccardo firm initially filed a case in the Court of Claims, Boccardo vs. United States 12 Ct. Cl. 184 (1987) under a net fee agreement. The firm, in 1987, would receive its net fees, plus the client would reimburse the firm for all expenses and costs of such case. In Boccardo vs. United States, the Court of Claims ruled that “just as the case belongs to the client, so too does any recovery. So merely because the plaintiff must look to the recovery for reimbursement, does not mean it is also looking to the client. Id at 187. Current deduction for litigation expenses advanced was denied.
In Canelo vs. Commissioner, 53 TC 217 (1969), Aff’d. 447 F.2d 484 (9th Cir. 1971) the Appellate Court addressed the current deductibility of litigation costs, advanced under a contingent fee agreement. The fee agreement at issue provided for repayment of costs solely from the amount recovered in such cases. Fees were based upon a percentage of recovery. The court in Canelo concluded that costs were not deductible because they constituted loans or advancements which the firm fully intended to be repaid. The firm had carefully screened its cases and had good “hopes” of recovery of the costs, even though its rights to recover were contingent upon winning or settling the cases. The court further held that there was a distinction between a law firm advancing fees and an ordinary business person advancing fees or costs. An expenditure by a law firm was on behalf of a particular client to pursue a client’s claim. In reality, the Appellate Court held that the expenses and costs were the client’s expenditures not the attorney’s. Canelo at 225.
Mr. Boccardo went back to his law firm and contacted a tax attorney. On contacting tax counsel, they discussed that they had lost their case based upon a net fee agreement. On suggestion of tax counsel, the fee agreement was modified to a “gross fee” agreement. The new agreement provided the following:
“It is further agreed:
Said law firm shall pay all preparation and trial costs.
The law firm’s fee shall be 33-1/3% of the gross sum recovered in the event that said claim is settled before said suit is filed, otherwise 40% of said gross sum.
The fee herein provided shall be a lien upon the cause of action in the recovery.
That no settlement shall be made without consent of the parties hereto.
In the event there is no recovery in said claim, said law firm shall receiving nothing for its services, or for costs paid.
Should client discharge such said law firm for any reason, client, upon demand, shall pay to said law firm reasonable value for its services to date of discharge.”
The Boccardo firm then proceeded to again currently deduct its client costs and advances. Subsequently, the Tax Court again reviewed cost deductions within a net fee agreement.
In Clifton A. Hodges vs. Commissioner, 1993 TCM 316, the issue again arose of whether the petitioner, an attorney, was entitled to a deduction for fees advanced on for costs and expenses incurred regarding litigation costs. The petitioner testified that amounts claimed as fee advances represented costs for either transcripts, filing fees or other expenses advanced on behalf of contingency clients. The counsel at issue conceded that he would recover the amounts advanced when the cases were successfully settled. The Tax Court, citing Canelo and Boccardo, held that they had previously ruled that fees advanced were not deductible. Accordingly, the court ruled against the taxpayer, and litigation costs advanced were not deductible when paid.
The Tax Court again ruled against deductibility in Boccardo vs. Commissioner, 56 F.3d 1016 (9th Cir. 1995) upon two premises. The first premise was the substance over form doctrine. This doctrine provides the form of an agreement, or the form of a transaction does not control its substance. To permit the nature of a transaction to be disguised by mere formalisms, which exists solely to alter tax liabilities, would seriously impair the effective administration of the tax policies of Congress. The court cited Commissioner vs. Court Holding, 34 U.S. 331, 334 (1945). Additionally, the court cited the California Rules of Professional Conduct, pursuant to IRC §162.
The California rules, Rule 5-104, prohibit an attorney from paying, agreeing to pay, guaranteeing, representing or sanctioning the representation that he\she will pay such costs incurred by or for a client, except (1) with the consent of the client, that the costs be repaid from funds collected or to be collected for the client, or (2) that the costs be advanced in prosecuting or defending a claim or action or otherwise protecting or promoting the client’s interest. The recovery, according to the court belongs to the client not the firm. Therefore, the reimbursement of costs come from the client recovery.
The decision by the Tax Court in effect ruled that under IRC §162, a business expense deduction was not allowed for advanced client litigation costs incurred by the firm pursuant to its fee agreement in the year paid. The fees and costs would only be deductible in the year the case was settled, or otherwise disposed of.
The 9th Circuit Court of Appeals, reversed the Tax Court and held that litigation costs and advances could be deducted when paid in a gross fee agreement. The court initially cited the favorable United State Supreme Court ruling of Gregory vs. Helvering, 293 U.S. 465, 469, 55 S.Ct. 266, 267 (1935). It has long been established that the taxpayer has a right to arrange his affairs so as to minimize the taxes he pays. The court noted the firm, on advice of tax counsel, adopted different contractual terms which resulted in a different economic effect for the law firm under the net fee contracts, rather than gross fee contracts. The court further discussed that the case cannot be governed by automatic application of the prior cases which were decided on net fee contracts, not gross fee contracts.
The 9th Circuit Court noted that the Tax Court’s analysis of the California Rules of Professional Conduct, 5-104, now 4-210 (A), was inappropriate relative to an analysis of federal law. Federal law provides pursuant to IRC §162(a) the allowance of a deduction for all ordinary and necessary business expenses paid or incurred during a taxable year in carrying on any trade or business. Whereas, Internal Revenue Code §162(c)(2) disallows any deduction if such payment is illegal under any law of the United States, or any law of a State (but only if such State law is generally enforced), which subjects the payor to criminal penalty or the loss of license or privilege to engage in a trade or business.
On appeal the plaintiff argued that gross fee contracts do not “violate a law of the United States or a State law that is generally enforced which subjects the payor to a criminal penalty, or the loss of a license, or takes away the privilege of engaging in a trade or business”. This created a perplexing issue as Mr. Boccardo was licensed both in the District of Columbia, as well as the State of California. The District of Columbia, did not have any ethical issue relative to the fee agreement. The California Rules of Professional Conduct did, however, retain the rule related to and enunciated by the Tax Court.
The Appellate Court cited the California statute and noted the statute does nothing to prohibit a lawyer from paying expenses, and it does allow an attorney to advance funds if they will ultimately be collected from the client, or as a result of the representation. The court noted that the rule against an attorney bearing the cost of litigation was a relic of old English rules against barratry, champerty and maintenance. Further, a federal class action suit, Rand vs. Monsanto Company, 926 F.2d 596,600 (7th Cir. 1991) held that state ethics rules against attorneys picking up the costs in litigation had been invalidated as frustrating the Federal Rules of Civil Procedure. Id at 600,601. Therefore, the 9th Circuit ruled that the firm’s arrangement does not violate a law of the United States and that the Rules of Professional Conduct approved by the California Supreme Court may be treated as a State law though the characterization would be arguable. Further, no criminal penalty for rules violation was present. Theoretically, the court conceded that the contract could result in an attorney’s license being revoked, but there was no evidence presented that the California Attorney’s Commission was attempting to move forward with such argument, nor was there any general enforcement of this prohibition. Thus, the payments were not illegal, and the court was not prohibited by IRC §162(c) of eliminating the payment’s deductibility.
The federal rules had not been violated Boccardo’s firm paying such fees and costs. The court stated, “the line of ethical inquiry pursued by the Tax Court ends when it becomes apparent that the criteria set by §162(c) for the elimination of deduction have not been met. Therefore, the court held that Boccardo incurred ordinary and necessary business expenses in the payment of costs and charges in connection with the client’s litigation. The Tax Court judgment was reversed, with judgment entered for the taxpayer.
Prior Illinois rules, 5-103(b), provides while representing the client in connection with a contemplated or impending litigation, a lawyer shall not advance nor guarantee financial assistance to his client, except that a lawyer may advance or guarantee the expenses of litigation, including court costs, expenses of investigation, expenses of medical examination and costs of obtaining and presenting evidence, provided the client remains ultimately liable for such expenses. This rule was repealed August 1st, 1990 and the subsequent Rule 1.8, Conflict of Interest(d), reads: ... a lawyer shall not advance or guarantee financial assistance to the client, except that a lawyer may advance or guarantee the expenses of litigation, ... if (1) the client the remains ultimately liable for such expenses, or (2) the repayment is contingent on the outcome of the matter, or (3) the client is indigent. Therefore, Illinois law seems to be in conformance with California law. Thus, if an attorney properly restructures his contracts, it would appear that the 9th Circuit ruling would be on point. There is an important caveat. The ruling was in the 9th Circuit, not the 7th Circuit. So far, no other circuit has ruled in favor of an attorney regarding these tax ramifications. It is, however, expected that another case will be forthcoming. If the case is not determined in favor of the taxpayer, it would appear to present an ideal case for writ of certiorari to ultimately be decided by the U. S. Supreme Court.
Richard M. Colombik, JD, CPA, former chairman, ISBA Federal Taxation Council, elected representative in the ISBA Assembly, liaison to the IRS district director, Vice President of the American Association of Attorney-CPAs and Treasurer of the Northwest Suburban Bar Association. Richard is also a published author and frequent lecturer at various bar associations, civic groups, professional organizations, radio and TV.