He ain't heavy, he's my client

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Published on 5/26/08

Client costs that are advanced is a major issue for a number of law firms, particularly those that focus on intellectual property law and are often required to pay thousands of dollars in fees for patent and other filings before being reimbursed by the client.

This is in essence an interest-free loan to the client that can stay on the books for several months, eating up considerable cash flow — not to mention partner compensation.

Some firms try to address this issue by taking a retainer in advance of the fees. This is problematic for two reasons.

One, anticipated expenses might not come in as expected, the retainer may prove inadequate and the client may be reluctant to pay a retainer that is too large.

And two, if you take a retainer in advance, whether the fee is called refundable or not, and work is promised in exchange for that fee, then failure to perform the work requires a refund.

In addition to the problems of cash flow and refundable fees, there's another issue involved in carrying client expenses. The Internal Revenue Service is training auditors to examine law firms to see how advanced costs are treated. As a result, many law firms now find themselves facing serious tax liabilities for their tax treatment of advanced client costs.

For the cash-basis law firm, advanced costs have usually been deducted in the year paid as ordinary business expenses, with the law firm taking repayment of the costs as ordinary income. The second approach used by many law firms is to treat such advanced costs as a loan to the client.

Commentators have indicated the IRS is increasingly rejecting the tax-deductibility of both approaches, taking instead the position that advanced costs can only be deducted on the law firm's tax returns as a bad debt.

One way to handle this issue, without straining either the firm's finances or the patience of the IRS, is to use what is termed a Dedicated Hard Disbursement Line of Credit (DLOC).

Checks for client expenses are paid from the DLOC. The hard disbursement amounts and interest and audit fees are automatically added to the client's next invoices by software that integrates with the firm's accounting system.

The firm simply passes on the carrying cost to their clients without added markups. Such an approach must be squared with ethical requirements relating to client trust funds.

Another option is a software package marketed to IP firms. The firm using it obtains "instant retainers" for payment of out-of-pocket expenses, collecting fees from clients the same day these payments are made by electronic collection from either a client credit card or checking account. The firm gets the full cost of the out-of-pocket fee and clients pay only when the fees are actually due.

Either way, the bottom line is the same — law firms should not be banks that carry their client's expenses.

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