Finance: Client Cost Advances: The Best Things in Life Are Free … Plus Tax, of Course!

The last several columns have addressed time entry, billing, collection, realization and applying process improvement for maximum profitability. Law firms focus on generating and collecting fees that fall to the bottom line—all essential ingredients for profitability. However, equally important is how law firms manage client cost advances from both an accounting and tax perspective. With year-end 2022 fast approaching, housekeeping exercises are not limited to boosting collections efforts and writing off old time and receivables. Work in process and accounts receivable not only focuses on fee generation and collection, but also includes client cost advances, both billed and unbilled. How client costs are treated is equally important because there are tax implications to the law firm if not managed and recorded properly.

Many law firms incur expenses on behalf of clients. But there is often confusion about the proper tax treatment. Several court cases and Internal Revenue Service rulings have helped to clarify the issue, but many law firms are still not in compliance. The IRS is aware that client cost advances in law firms are different when compared to other industries. Accordingly, the IRS developed a publication known as the Attorneys Audit Technique Guide, which devotes an entire section to client costs. An understanding of the basic principles underlying the IRS’ position can mean avoidance of audits, penalties and noncompliance.

Law firms typically incur two types of expenses on behalf of clients: hard and soft costs. The tax treatment of each is based on the type of expense incurred.

Hard costs. Hard costs are reimbursable client costs that can be directly attributed to a matter. Hard costs are a pass-through item, meaning they are not treated as an expense on the firm’s profit/ loss statement. Firms will advance the costs when received on an invoice and then pass the cost directly on to the client. This includes advance payment of such things as deposition fees, witness fees, filing fees, court reporters, medical records and other related costs. Hard costs are considered a loan to the client and are not deductible as a business expense. This is true whether the firm reports on a cash or accrual basis for tax purposes. If the client does not reimburse the costs advanced, the firm can write off the expense and take the tax deduction. Because the hard costs are considered a loan, the costs would be reflected on the balance sheet as an asset. Most firms will set up a balance sheet account called “Client Costs Advanced.” When these costs are recovered (paid), even if years after the original date incurred, they then offset the amounts previously advanced, resulting in no impact to the firm’s income.

Soft costs. Soft costs are those office-type expenses that are incurred on behalf of a matter. Examples include in-house photocopying, postage, faxing (yes, faxing!) and word processing, as well as other clerical services and expenses that would have been paid regardless of whether they are being billed to the client.

With an understanding of hard and soft costs, we can explore some of the potential problems with incorrectly tracking and recording client costs and how to avoid them.

“I didn’t know.” If the IRS identifies errors during an audit, not knowing the guidelines for client cost advances will not excuse a law firm for incorrectly managing client costs. Law firms must understand how they are recording and tracking client cost advances on their financial statements. When in doubt, refer to the IRS publication Attorneys Audit Technique Guide and/or contact your firm’s accounting firm to ensure the law firm is tracking client costs correctly.

“We didn’t have the right tool for the right job.” For proper client cost advance tracking and reporting, law firms should be looking for accounting software that makes recording and tracking client costs easy. Not only should the software track client costs recorded, but it should also reconcile these costs. Client cost advance ledgers must reconcile to the firm’s financial statements. If they do not reconcile and if audited by the IRS, this could result in penalties and interest. Reconciliation issues often occur when firms are using different software packages for time and billing and a different package for the accounting. The key is to make sure that the software packages are integrated properly and that client costs are reconciled monthly.

“Our staff is not trained.” You might have accounting software that tracks and records client costs to perfection, but staff must understand how to enter these costs and also understand how they flow through your accounting and billing software. Training is essential. Without proper understanding, law firms run the risk of making material errors on their financial statements, which could result in the IRS assessing penalties and interest if audited. It is well worth the investment to provide thorough training. Many firms rely solely on the accounting software and assume the information produced is correct. If you do not understand the client cost mapping and treatment guidelines, how can you determine if the reporting generated is correct?

Hard costs: Treat them right.

Some law firms make the error of expensing hard costs and then reimbursing the expenses when payment is received, keeping all the activity on the income statement. This recording methodology makes sense to many law firms, but the hard cost accounting is incorrect and could potentially trigger an IRS audit. Remember, hard costs go on the balance sheet!

Soft costs: Track the income.

Law firms operating on a cash basis can deduct soft costs when they are paid. Any reimbursements should be included as income in the year they are received. Be sure to map soft costs in your time and billing systems so receipts from clients for these soft costs are recorded on the income statement. You may track soft cost income separately, or you may offset the original expense account to reduce the expense on the income statement. However, while soft cost expense net reimbursements work, it is recommended that income for each soft cost designation be tracked separately. Most accounting software packages can accommodate this mapping—the benefit of which is, if ever audited, the firm can produce the reimbursement detail supporting the soft cost reimbursement income.

Is Your Law Firm in Compliance?

If your law firm should discover that it is not fully compliant with the IRS guidelines for recording client costs, the firm may need to file Form 3115, Application for Change in Accounting Method to change the firm’s accounting method for the treatment of client cost advances. The resulting increase in income from treating client cost advances as client loans, rather than as a deductible expense, could potentially be recognized over a four-year period, rather than a single year. Take the time necessary to understand the client cost accounting guidelines and review your accounting and billing software to be sure proper mapping and safeguards are in place to prevent costly errors. Investing the time now to identify and correct any problems is far better than waiting for the IRS to find them—and less expensive!