Why You Should Stop Self-Funding Case Costs
(And Increase Your Firm’s Profits)
All lawyers know that contingency-based fee arrangements can be quite profitable in the right circumstances. But the obvious downside is that the firm must also take on most, if not all, of the expenses of a case – often before it really has a chance to really dig into the merits of the case. And those costs are hardly minimal. They frequently account for nearly a quarter of a contingency-based firm’s expenditures.
Even worse, if the case fails, the firm is left empty-handed to absorb these losses. Yet most contingency firms take as a given the need to self-fund their case costs and expenses. They dutifully pay for them upfront as a matter of course, deducting the costs from any eventual settlement or fee award.
This mindset requires a fundamental shift. There simply is no financial benefit to a firm in shouldering the burden of case costs through its own capital. It unnecessarily bootstraps a firm’s profitability. That’s because the costs of fronting litigation costs for a client are not tax deductible as a business expense under the current tax laws. Those costs must instead be considered a “loan” to your client. Regardless of the method of accounting your firm uses, the costs must be reflected as an asset on your firm’s books. The implications cannot be overemphasized: a firm must front the costs of case expenses for your clients, which means that those costs come out of the firm’s after-tax dollars, directly reducing profits. The result is purely a drag on the bottom line.
To make matters worse, it can be a significant amount of time before those expenses are offset – if ever. In the case of more complex torts, they can take years to materialize. The bad debt can be written off only once it is determined that the debt is uncollectable. When and if those amounts are eventually recovered (or deemed uncollectable), they offset the initial loan amounts. In the worst-case scenario, no recovery is realized. They are simply written off as bad debt. The impact is that the law firm partners are forced to pay taxes on money they have not, and may never, realize. They are essentially paying for it out of profits.
It’s the equivalent of providing your clients with an interest-free loan which they may, nor may not, ever repay. This situation can go on for years. In this day and age of high interest rates, those free interest payments can be a significant tax advantage to your clients (and distinct disadvantage to your firm). At the end of the day, your firm is covering these costs through after-tax dollars, which further reduces your firm’s profits. This means that your firm carries an outsized risk with all contingent cases, oftentimes for a period of years.
What’s The Solution? This is where strategic capital can come into play. You should certainly consult your accounting and tax advisers for your particular situation. But when you deploy capital to advance litigation costs, the interest payments generally can be deducted as business expenses, allowing you to offset annual expenditures. Increasingly, in many jurisdictions, you can also offset those interest costs from client recoveries, allowing for even greater economic gains. This simple switch in focus from a self-funding model to maximizing deductions allows for a healthier bottom line.
While it seems simple, when multiplied over a number of cases, the difference can be hugely significant. And those profits can then be plowed right back into the firm, allowing it to invest in much needed revenue-generating items, such as marketing and lead generation. Alternatively, you can invest those funds in efficiency drivers, such as software and technology.
Have questions about how to solve your law firm’s financing needs, contact Bridgehead Legal Capital today. Our sole purpose is to partner with law firms to make them stronger.