The Trial Bar’s Tax Break

Lindsey Graham preserves a carve-out for his plaintiff pals.


Senator Lindsey Graham

Lindsey Graham appears to work for the trial bar on political retainer, and last week the South Carolina Republican stripped the Senate tax bill of a provision that eliminated a contingency-fee carve-out for plaintiff attorneys on the West Coast.

The IRS has long held that legal expenses incurred by attorneys in contingency-fee lawsuits are loans and thus not deductible. Attorneys front the costs for depositions, expert witnesses and discovery in expectation that they’ll recoup their expenses when cases settle or their clients win. On the rare occasion with no recovery, attorneys may deduct expenses as they would a bad loan.

Tax courts have consistently upheld this interpretation, as have federal appellate courts dating to the 1930s. But in 1995 the Ninth Circuit Court of Appeals indulged a creative California lawyer who sought to reduce his tax bill by drawing a dubious distinction between contingency net-fee and gross-fee lawsuits. 

In net-fee arrangements, attorneys are first reimbursed for their expenses from their client’s recovery and then receive a share of the remainder. Gross-fee contracts merely entitle attorneys to a percentage of the recovery, which is supposed to cover litigation expenses. This is a distinction without a legal or pecuniary difference since both arrangements allow attorneys to recoup expenses.

The Ninth Circuit in Boccardo v. Commissioner of Internal Revenue (1995) broke with precedent and allowed attorneys to immediately deduct expenses they incur in gross-fee, but not net-fee, contingency contracts. “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 ruled. But the IRS instructed staff to apply Boccardo only in the Ninth Circuit, reinforcing that gross-fee contracts are structured “to provide the attorney with a percentage of recovery sufficient to cover advanced expenses.” No other circuit has adopted the Ninth’s opinion, and other tax courts have sustained the IRS position.

The Ninth Circuit’s tax dispensation subsidizes litigation and can reduce legal costs by up to 40%. Plaintiff attorneys are more likely to file dubious lawsuits—and drag out cases—when they can immediately deduct expenses. Democrats unsuccessfully sought to extend the Ninth Circuit’s contingency-fee tax break nationwide in 2008 with legislation and later petitioned the Obama IRS to do so by fiat. But businesses howled, so the plaintiff attorney carve-out is still limited to Ninth Circuit states.

The House tax bill includes a provision that would codify the IRS’s interpretation of advanced fees as loans, which would create parity throughout the U.S. and yield $500 million in revenues over the next decade. While the original Senate bill included a similar provision, Mr. Graham pulled some strings and got it removed in the final manager’s amendment.

A spokesperson for Mr. Graham says that “disallowing a deduction for those expenses disincentivizes equal access to justice for those of limited financial means.” Does the Senator really believe that individuals in Florida or New York have less access to the justice system than they do in California and Hawaii?

The House-Senate tax conference committee should adopt the House provision, which is likely to be the most significant tort reform that Republicans pass this Congress.

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