At the WSJ Law Blog:

The U.S. Chamber of Commerce’s Legal Newsline reported on Wednesday that the U.S. Department of Treasury may be about to grant plaintiffs’ attorneys long-sought tax write-offs for the costs associated with fronting contingency-fee lawsuits.

Apparently at the heart of the matter is an April letter Sens. Max Baucus (D., Mont.) and Richard Durbin (D., Ill.) sent to Michael Mundaca, assistant secretary for tax policy seeking clarity on the 9th Circuit ruling in the 1995 case of Boccardo v. Commissioner.

In the Boccardo case, the IRS asserted that out-of-pocket expenses incurred by attorneys on behalf of clients while prosecuting contingency cases are not deductible because the law firm expects reimbursement upon getting a settlement or judgment. The Tax Court agreed.

The 9th Circuit took up the matter. The letter sums up the ruling like this:

The court “held that attorneys who represent clients in contingency fee cases may treat litigation costs that are paid by the attorneys, such as filing fees and witness expenses as deductible ordinary and necessary business expenses . . . when the attorney and client agree to a specific fee arrangement known as a gross fee contract.”

The IRS issued a memo saying that the ruling applied only to attorneys in the 9th Circuit. But the Tax Court has since recognized the validity of the decision in at least one other case, according to the letter.

Of course, every other business in American gets to deduct its expenses. Some favored industries, like oil companies, get to deduct more than just their expenses:

Percentage depletion allows an independent oil company to deduct from its taxes about 15 percent from the revenue generated from a well, even if that amount exceeds the well’s total value. This means that oil companies take a deduction as long as a well is producing oil, without regard to how much, or whether, the well is still declining in value. Companies in other industries are only allowed to deduct an amount that represents the decline in their investment’s value that year. The administration expects that eliminating this subsidy to produce budget savings of about $10 billion over 10 years.

That’s just one of the goodies Congress doles out to upstanding corporate citizens like BP, which will pay at least $10 billion less in taxes as the result of its own oil spill, since it gets to deduct all of the cleanup costs, the compensation it pays out to victims, and the loss in value of the well.

But not plaintiff’s lawyers. The IRS requires that we treat expenses on our cases as actually being profits, since we might, years down the road, recover those costs. (Nevermind that, even then, it’s not profit, it’s just a recovery of expenses.)

Since small businesses (like law firms) have an effective tax rate around 20-25%, such disparate tax treatment ends up making the costs on plaintiff’s litigation one-fifth to one-quarter more than the costs of any other business, including the business of defending the exact same lawsuit.

A little over a year ago I posted about Contingent Fee Business Lawyers As Venture Capitalists, giving a few sample numbers:

A large-damages personal injury / product liability / medical malpractice lawsuit can be done by one or two attorneys and costs below $250,000, with recovery of $5-$10m within 1.5-3 years. That’s a big win: you put in $250k out of pocket, likely didn’t impair bandwidth, and recovered $2-$4m in attorneys’ fees.

The numbers aren’t too much different for most small business cases, with breach of contract, unfair competition, etc.

A regional-market antitrust / mid-sized patent infringement case can be done with 3-6 attorneys, $1-$5m in costs, with a recovery of $15-$50m in 2-4 years. Another big win: you put in $1-$5m out of pocket, moderately impaired bandwidth, and recovered $7-$20m in attorneys’ fees.

A massive shareholder class action / national antitrust / large patent infringement case can be done with 10-40 attorneys, $10-40m in costs, and a recovery of >$100m in 4-10 years. Think of the Blackberry patent infringement case, which ended with a $612m settlement and over $200m in fees (resulting in profits-per-partner than year over $4m).

As I wrote then, day in and day out, the primary thing a contingent fee law firm does is spend lots of money. In addition to all the normal costs of a business (rent, staff, etc.), you have to pay your attorneys salaries which are competitive in the market, even against hourly billing firms, and you have to dump loads of money and time into cases for experts, motions, discovery, trials, appeals and negotiations, none of which earn you a dime until the very end.

The Duck Boat accident, for example, was a major maritime accident with two wrongful deaths and more than two dozen personal injury claims that will involve two primary defendants (K-Sea and Ride The Ducks) and a handful of their employees. Litigating the Limitation of Liability Act issues like "seaworthiness" will probably take at least a year or two, after which the litigation will begin in earnest, probably lasting another two-to-five years (though possibly more), with costs of at least $1,000,000. Those costs could be doubled or tripled if there’s a need to do extensive testing on the seaworthiness of the tugboat or the duck boat. Some sample potential costs:

  • renting an identical tugboat and barge to do visibility tests;
  • buying a duck boat and then ramming it to see how easily it sinks; and,
  • buying a dozen duck boat engines and running them day and night to see how long it takes for them to overheat.

None of that would be unusual or unexpected. Cases against car manufacturers that allege inadequate "crashworthiness" routinely require the destruction of a few identical cars to see how they holdup and how alternative designs would have worked better.

That’s where the lack of a tax deduction has a big bite: when most businesses think of "$1 million in costs," they think of them in terms of deductible costs. For a plaintiff’s lawyer, then, they have to see "$1 million in costs" as being more like "$1.25 million in costs" to any other business, since the plaintiff’s lawyer will be taxed on the costs. Given the time value of money, if we assume the case takes five years, and that the taxes paid could have been invested at a modest 5% annual return, then the lack of a tax deduction adds an additional $320,000 in costs to that $1 million in expenses. If the case costs $3 million on paper, it’ll cost $4 million once the lack of a tax deduction is figured in.

In contrast, the defendants and their insurers will be able to immediately deduct every penny they spend on their defense.

Is that fair? Of course not, but it’s been the law for years, just another way in which the deck is stacked against plaintiff’s lawyers, another reason why we have to be so selective about cases and charge such a large contingent fee.