Correctly allocating advanced client costs to ensure the appropriate tax impact is applied is critical in order to avoid the Internal Revenue Service (IRS) audits and violations.
These costs need to be allocated directly as hard (direct expenses) or soft costs (support expenses), with the tax treatment being applied differently to each. Hard costs as those associated with payments for items such as expert witnesses, court fees and witness fees. Soft costs, on the other hand, are those typically associated with the overhead of running a law firm, such as copying costs.
Hard costs are generally considered a loan to the client and are not deductible as a business expense when the client repays them. The IRS considers these a loan, as they are not a necessary business expense and expects them to be listed on the balance sheet as such.
Because this cost is a loan, it is reflected as an asset and once recovered is offset by the same amount, resulting in no taxable impact for the firm. However, if the costs are not reimbursed then they can be written off.
There is typically no reimbursement for soft costs as they as not usually passed along to the client, so these tend to be deductible items.