Hughes & Luce, L.L.P. v. Commissioner

Hughes & Luce, L.L.P. (the law firm) (plaintiff) paid for certain expenses on behalf of its clients, such as court costs and other fees, and later billed the clients for reimbursement of those costs. The law firm’s practice was to deduct client expenses when they were paid and then include the reimbursements as income once received. In 1992, the Internal Revenue Service (IRS) audited the law firm’s 1989 tax return. On that return, the law firm deducted $2,367,535 in client expenses and reported $2,398,825 in reimbursement of client expenses as income, of which $490,766 had been deducted in prior tax years as expenses. During the audit, the IRS determined that the law firm should have treated the payment of client expenses as loans (and reimbursement as loan repayment), meaning that it should not have deducted the expenses or reported income upon reimbursement from the clients. The IRS could not seek an adjustment to disallow the previous deductions due to the statute of limitations, but its ultimate adjustment of the law firm’s income for 1989 included the $490,766 as income under the tax-benefit rule. The law firm petitioned the United States Tax Court for review, arguing that client reimbursements were not income due to the IRS’s determination that they were in the nature of loan repayments, not income. The tax court upheld the IRS’s adjustment, but not on the basis of the tax-benefit rule. The law firm appealed.