Introduction

Contingency fee law firms face unique challenges when managing litigation expenses, especially when it comes to how these costs are taxed. One critical, yet often misunderstood, IRS guideline is Revenue Ruling 75-120, which outlines the tax treatment of litigation costs advanced on behalf of clients. If your firm regularly dips into its operating account to front litigation expenses, you may be inadvertently increasing your tax burden.

In this article, we break down the key takeaways from this IRS ruling, explain how these rules impact your firm’s financials, and explore smarter funding strategies that could improve your tax position.

Key Takeaways from Revenue Ruling 75-120

  1. Advanced Costs Are Considered Loans, Not Expenses
    Under Revenue Ruling 75-120, when a law firm pays litigation costs on behalf of a client in a contingency fee case, the IRS views those payments as loans not deductible business expenses. Why? Because the firm typically expects to be reimbursed from a successful settlement or judgment.
  2. No Immediate Tax Deduction
    Because these costs are treated as loans, they are not deductible under IRC § 162 at the time they are paid. Instead, they must be recorded as receivables (assets)on the firm’s balance sheet. The tax deduction only comes if the expense becomes uncollectible(i.e., the case is lost, and the client cannot repay the advance). In that instance, the firm may claim a bad debt deduction under IRC § 166.
  3. Gross Fee Arrangement Exception
    There is an important caveat. If your firm operates under a gross fee arrangement, where the firm pays litigation expenses and does not expect reimbursement, those costs can be deducted immediately. This setup, however, is less common and riskier, since the firm absorbs all costs regardless of case outcome.

Practical Impact: Why Using Your Operating Account Can Hurt

Let’s say your firm fronts $250,000 in litigation costs for a major case using your operating funds. Here’s how the accounting and tax treatment breaks down:

  • Cash Flow Hit: You’ve significantly reduced liquidity without any current tax benefit.
  • No Deduction: Despite spending the money, your taxable income stays the same because the IRS treats the payment as a client loan.
  • Balance Sheet Expansion: That $250,000 becomes a receivable, increasing your firm’s assets and possibly complicating financial ratios used by lenders or investors.
  • Tax Timing Mismatch: You incur the cost today but only get a potential deduction years later, and only if the case fails and collection is impossible.

This tax treatment can create a significant financial strain, especially for smaller firms or those handling multiple high-cost cases simultaneously.

Strategic Consideration: Litigation Financing as a Solution

Instead of using your operating account, consider leveraging litigation financing a solution that aligns with IRS guidelines while protecting your working capital. Here’s how it helps:

  • Preserve Operating Cash: Keep your internal funds focused on firm operations, not case costs.
  • Avoid Asset Build-Up: The financing company records the litigation costs, not your balance sheet.
  • Consistent Tax Positioning: You’re not tying up assets in receivables, minimizing mismatch between cash outflow and tax deductions.

While financing fees are an added cost, the improved liquidity, financial clarity, and potentially reduced tax exposure often outweigh the expense.

Final Thoughts

Revenue Ruling 75-120 highlights a critical reality for contingency-based law firms: the IRS doesn’t treat advanced litigation costs the way many firms assume. By fronting these expenses through your operating account, you may be inflating your balance sheet, delaying deductions, and exposing your firm to unnecessary financial stress.

Understanding these rules and exploring smarter financing solutions can help you maintain healthier cash flow, simplify your tax filings, and ultimately support the growth and sustainability of your firm.

Need Help Navigating Litigation Financing?

Speak with a financial advisor or legal finance expert who understands both the legal and tax implications for contingency fee practices. A well-structured litigation funding strategy could be the key to optimizing your firm’s financial and tax position.

If you would like to learn about alternatives to your firm financing litigation case expenses, contact Capital Financing at 404-348-4475 and info@injuryfinancing.com.