## Facts

- Hughes & Luce, L.L.P., a Texas law firm and cash-method taxpayer, routinely advanced litigation-related out-of-pocket amounts for clients (e.g., filing fees, expert fees, travel, phone, delivery) (“Service Costs”).
- From 1976 through 1989, the firm deducted Service Costs when paid as ordinary and necessary business expenses and reported client reimbursements as income when received.
- On its 1989 return, the firm deducted about $2.37 million in Service Costs and reported about $2.40 million in reimbursements as income.
- Included in 1989 reimbursements was $490,766 attributable to Service Costs that had been deducted in earlier years that were closed by the statute of limitations.
- After auditing 1989, the IRS determined Service Costs should have been treated as loans to clients and reimbursements as loan repayments, and it included the $490,766 in 1989 income under the tax benefit rule or, alternatively, the duty of consistency.
- The firm argued that, under the IRS’s “loan” characterization, reimbursements were non-income loan repayments.

## Issues

1. Whether reimbursements received in 1989 for Service Costs deducted in closed prior years must be included in 1989 income under the tax benefit rule.
2. Whether an “erroneous deduction exception” bars application of the tax benefit rule when the original deductions were improper, and whether the Tax Court properly relied instead on the duty of consistency.

## Decision

- The Fifth Circuit affirmed the judgment requiring inclusion of the $490,766 in 1989 income.
- The court applied the tax benefit rule as the controlling doctrine and rejected any “erroneous deduction exception.”
- The court deemed reliance on the duty of consistency unnecessary because the tax benefit rule directly addressed the distortion created by prior deductions followed by later recovery.

## Legal Principles

- Under the tax benefit rule, if a taxpayer obtains a tax benefit from a prior-year deduction and a later event occurs that is fundamentally inconsistent with the premise of that deduction, the later recovery must be included in gross income in the year of recovery to correct distortion caused by annual accounting.
- The tax benefit rule applies even if the original deduction was erroneous; there is no “erroneous deduction exception” that would allow a taxpayer to retain a permanent tax advantage when earlier years cannot be reopened.
- The expiration of the statute of limitations for the years of the deductions does not prevent application of the tax benefit rule; it supports using the recovery year to restore proper income measurement.
- Where the tax benefit rule governs, courts need not rely on equitable doctrines such as the duty of consistency to reach the same inclusion result.

## Conclusion

The Fifth Circuit held that reimbursements received for amounts previously deducted must be included in income under the tax benefit rule, even if the earlier deductions were improper and earlier years are closed, and it rejected an “erroneous deduction exception” as inconsistent with the rule’s function in the annual accounting system.


Hughes & Luce, L.L.P. v. Commissioner, 70 F.3d 16 (5th Cir. 1995)