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Tax Break for Trial Lawyers Moving Toward a Vote

Senate Majority Leader Harry Reid on Friday filed cloture on the motion to proceed to H.R. 6049, the Renewable Energy and Job Creation Act, i.e., the tax extenders bill, which includes in it the $1.6 billion tax break for trial lawyers. The bill could be voted on this upcoming week. (Previous post here.)

The Examiner editorialized on the measure today, accurately describing the way it's been shoved down the throat of legislators and the public -- no usual Treasury analysis, no committee hearings on the bill in the Senate.

The lawyers' payoff was slipped into a large bill with all sorts of other provisions such as extensions of a tax credit for research and development and of an optional deduction for individuals for their state sales tax payments. While those provisions would extend current law, the lawyers' payoff would change long-existing policy that already made good sense. At an estimated cost to the Treasury of $1.575 billion, the provision would encourage class-action plaintiff lawyers to file dubious long-shot, big-money cases. It does so simply by letting the attorneys deduct fees and expenses up-front. Existing law rightly treats such expenses as loans to their clients, to be repaid from ultimate awards if they win or deducted on their income reports at case's end if they lose.

Republicans plan to raise a ruckus about the measure, largely on procedural grounds. Given the many popular provisions in the measure -- extending the R&D tax credit, for example -- a procedural fight may be the best approach.

More from Lisa Rickard, president of the U.S. Chamber Institute for Legal Reform, in a Townhall.com column, "Trial Lawyer Tax Break."

We've put the relevant portions of the Ways & Means committee report -- written by the majority -- on the provisions in the extended entry below.

From the Ways & Means committee report on H.R. 6049, the Renewable Energy and Job Creation Act of 2008. The passage starts on page 172.

1. Uniform treatment of attorney-advanced expenses and court
costs in contingency fee cases (Sec. 311 of the bill and new sec.
162 of the Code)
In general, a deduction is allowed for ordinary and necessary expenses
paid or incurred during the taxable year in carrying on any
trade or business.214 For advanced litigation costs in contingency
fee cases, the tax treatment is determined based on the type of arrangement
that exists between the attorney and client. The contingent
fee arrangements generally take two forms: (1) net fee ar-

215 Burnett v. Commissioner, 356 F.2d 755 (5th Cir. 1966); Hearn v. Commissioner, 309 F.2d
431 (9th Cir. 1962); Canelo v. Commissioner, 447 F.2d 484 (9th Cir. 1971); Boccardo v. United
States, 12 Cl. Ct. 184 (1987).
216 Boccardo v. Commissioner, 56 F.3d 1016 (9th Cir. 1995).

rangements, whereby the attorney's compensation is based on a
percentage of the gross recovery net of the advanced litigation
costs, and (2) gross fee arrangements, whereby the attorney's compensation
is based on a percentage of the gross recovery without
regard to the amount of advanced litigation costs. The advanced
litigation costs typically include travel expenses, witness fees, deposition
costs, court filing fees, expert witness fees, and other case related
costs. When these costs are paid by the attorney, effectively
on behalf of the client, they are generally considered to be advanced
litigation costs.

The advanced litigation costs incurred as part of net fee arrangements
have been viewed by the IRS and the courts as a loan from
the attorney to the client. A current deduction under section 162
is not permitted; however, the attorney may claim a bad debt deduction
under section 166 at such time as the loan becomes worthless.
215 This conclusion has primarily been reached based on the
attorney's expectation of reimbursement based on the screening
process used to accept cases with a high probability of victory (e.g.,
the rate of collection on the advances is typically in excess of 90%).
In the case of a gross fee arrangement, the Ninth Circuit Court of
Appeals has ruled that the costs are deductible by the attorney in
the year incurred and the payment of such costs cannot be described
as an advance or a loan when there is no obligation on the
part of the client to repay the money expended.216

The Committee believes that uniform treatment of attorney-advanced
expenses and court costs in contingency fee cases is an
issue of tax fairness. A large number of attorneys are small business
owners and many frequently work under contingency fee arrangements.
Under present law, these expenses are deductible as
paid or incurred in gross fee arrangements, but not in net fee arrangements.
The average contingency fee case lasts two and onehalf
years, which leads to an extended deferral of these expenses.
Additionally, while attorneys are required to capitalize these costs
until the case is resolved in a net fee arrangement, similar expenditures
are currently deductible when paid or incurred in other businesses.
The provision eliminates this disparity.

The provision ensures a uniform set of rules for attorney-advanced
expenses and court costs in contingency fee cases by providing
that in the case of any expense or court cost which is paid
or incurred in the course of the trade or business of practicing law
and the repayment of which is contingent on a recovery by judgment
or settlement in the action to which such expense or cost relates,
the deduction of an ordinary and necessary business expense
is determined as if such expense or cost is not subject to repayment.
Thus, the amounts paid or incurred by the attorney are not
considered to be a loan to the client, and the attorney is entitled

217 See Treas. Reg. section 1.181-2T for rules on making an election under this section.n in the taxable year in which
the expense or cost is paid or incurred.
The provision applies to expenses and costs paid or incurred in
taxable years beginning after date of enactment.

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Rafael Mangual
Project Manager,
Legal Policy

Manhattan Institute


Published by the Manhattan Institute

The Manhattan Insitute's Center for Legal Policy.