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I have a client that is under IRS audit. We did not deduct

Customer Question
I have a client that...
I have a client that is under IRS audit. We did not deduct legal fees associated with one of their investments in an LLC that filed bankruptcy. We did not know if the client would be reimbursed for any legal fees so we decided to capitalize them until the BK process concluded, and then want to deduct them in that period. Is that proper handling of this
JA: The Expert will know how to help. Is there anything else the Expert should be aware of?
Customer: Nope. The LLC our client was a member of filed BK, and we waited until the BK process was over, due to uncertainty of the case, to deduct the legal fees. I just want to give the agent a cite or two if we are correct
Submitted: 2 months ago.Category: Tax
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8/28/2017
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago
Mark Taylor
Mark Taylor, Certified Public Accountant (CPA)
Category: Tax
Satisfied Customers: 2,328
Experience: Certified Public Accountant
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Hi, my name is Mark. I will be happy to help you with your questions. Let me make sure that I understand. You client paid for the legal expenses of the LLC and capitalized these based on the uncertainty as to whether or not these would be reimbursed?

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Customer reply replied 2 months ago
correct
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

Is your client the only member of the LLC or are there multiple members?

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Customer reply replied 2 months ago
Multiple members. The client was trying to recoup the investment in the entity but ended up with very little and a very large legal bill
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

The way that you treated it was very conservative. Was the amount added to the capital account?

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Customer reply replied 2 months ago
We didn't know how much the client spent on this until 2016, so in 2014 and 2015 the fees and capital accounts were not adjusted for the payments.
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

Essentially it is a timing issue of when you deduct the payment.

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Customer reply replied 2 months ago
Correct. All I want to give the agent is a more specific IRS cite (not saying Section 212 or 162) as to our logic
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

I understand. Let me see what I can find. What is the agent's position?

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Customer reply replied 2 months ago
He wants me to tell him in 2014 and 2015, in a detailed schedule with all legal invoices, what expenses I am going to deduct when. During a conference call with him, I specifically told him we would be deducting in 2016 once the BK and legal issues had been settled
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

Section 461 deals with prepaid expenses.

Reg. Section 1.461-1(a)(1) provides the following:

If an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for the taxable year in which made.

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Customer reply replied 2 months ago
Anything else you can think of? The client really thought there was money to collect in the BK, but they ended up with very little
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

Let me keep looking. Please give me a few moments.

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Customer reply replied 2 months ago
ok - thank you
Tax Professional: Mark Taylor, Certified Public Accountant (CPA) replied 2 months ago

If you treat the amount as a loan you would not deduct the bad debt deduction until essentially there is no hope of collection. https://www.law.cornell.edu/uscode/text/26/166

(a)General rule

(1)Wholly worthless debts

There shall be allowed as a deduction any debt which becomes worthless within the taxable year.

(2)Partially worthless debts

When satisfied that a debt is recoverable only in part, the Secretary may allow such debt, in an amount not in excess of the part charged off within the taxable year, as a deduction.

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