The tax treatment by law firms of disbursements advanced by them on behalf of litigation clients has been an ongoing source of controversy with the Internal Revenue Service. Some of the rules are fairly clear. For example, if a disbursement is made on behalf of a client and the client is unconditionally obligated to pay the disbursed amount to the firm regardless of the outcome of the matter, the disbursement is viewed as a loan. Accordingly, the firm cannot claim a deduction for that amount unless and until it becomes apparent that payment will not be made by the client; if and when that occurs, a bad debt deduction may be available.
In many contingency fee litigation matters, however, the client has no obligation to pay the disbursements unless and until there is a recovery in the underlying matter (in which case the disbursements are paid from the amount recovered through payment of a judgment, settlement, or otherwise). In those cases, it has been argued that the conditional nature of the obligation to repay converts the disbursements from loans to the client into expenses of the firm, generally deductible at the time they are paid or incurred.
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