Addressing Tax Issues Throughout the Year: There Is No Better Time to Start Than Now

Even though 2007 has come and gone, it is not too late ' it is never too late ' to think about tax planning and tax issues affecting your law firm. What still can be addressed now in 2008 that can impact your tax return for 2007? What tax issues can be addressed that can impact 2008? The following is a list of items to review internally with your financial team and externally with your tax adviser.

Potential Tax Deductions for 2007 to Consider After Year End

Accelerated Depreciation Deduction

It is not too late to review your allowable depreciation deductions for 2007.

Summarize all your capital expenditures by major classification: computer software, computer equipment, furniture and fixtures, office equipment, capital leases, leasehold improvements. Different classes of assets have different depreciable lives for tax purposes, so this is an important first step.

Next, categorize each major class of asset additions by date placed in service and paid. Your firm is eligible for a depreciation deduction based on date placed in service, but the asset must have been purchased in 2007. If an asset addition was paid with a credit card, but the credit card bill was not paid until 2008, make sure these additions appear on your 2007 list. Even for a cash basis taxpayer, credit card expenditures are tax deductible in the year charged, not the year paid, similar to a note payable or line of credit.

Review depreciable lives for assets purchased. Generally, computer software is depreciated over three years, computer equipment over five years, furniture and fixtures over seven years, office equipment over seven years, and eligible leasehold improvements over 15 years for 2007.

Review any limitations for depreciation that may affect your law firm. These may include total annual additions to be eligible for a Section 179 deduction, luxury auto rules, and placed-in-service dates mentioned above.

Review whether your firm is eligible for the Section 179 depreciation election. Under this IRS code section, your firm may be allowed to deduct 100% of eligible additions up to $125,000 for 2007, and then use accelerated methods of depreciation for the remaining additions. This optional election can represent an additional tax deduction for your firm. There are some limitations, however. If your firm has more than $500,000 in qualifying additions, then the eligible Section 179 expense deduction gets phased out, dollar-for-dollar, for any additional expenditures. For example, if your qualifying additions are $625,000 ($500,000 + $125,000) or more, your firm will not be eligible to take a Section 179 deduction. In addition, if your firm is a C corporation and has a tax loss, there will be additional limitations.

If your law firm moved in 2007, your firm may be able to take advantage of component depreciation rules. This is a method of breaking down the details of the leasehold improvement project to see whether any individual purchases can be depreciated over a shorter time period than the traditional 15 years (for 2007). There are very specific rules related to this area, so ask your tax adviser. In addition, do not forget that if you moved, your firm will 'write off,' or deduct, the remaining net value of leasehold improvements from your former office space. Sometimes this is a surprise deduction. These assets may have been being depreciated over 39 years and may have a significant net value remaining. The write-off must be taken in the year of the firm's move and termination of the prior lease. This is great news for firms looking for extra tax deductions, but shocking news for firms that are not.

Finally, plan for 2008 project capital expenditure needs and depreciation deductions and see how this may affect your estimated tax profits in 2008.

Pension Plan Deductions

How you can change your firm's taxable income for 2007 using the features that exist in your current pension plan? If your pension plan has a discretionary contribution feature, your firm may be allowed to trigger this feature for an additional tax deduction. The beauty of this is that the contribution may not have to be funded until 2008, but you may still get a deduction for 2007. If your firm has a discretionary 401(k) match or discretionary profit-sharing feature, as stated in the current pension plan documents or adoption agreement, your firm may be able to decide after year-end to make a discretionary contribution for 2007. If you are looking to reduce your pension contribution, you should review the balance of funds in the plan forfeiture account that may be used to offset the required employer contribution for 2007, as defined in the plan documents.

Uncollectible Client Costs

Capitalized, advanced, client costs that are considered not collectible as of year-end can be deducted for tax purposes in 2007 as 'bad debt.' Review your accounts receivable and work-in-process to ensure that your firm deducts any capitalized costs in 2007 if they were deemed uncollectible at that point in time.

Tax Checklist for 2008 Planning

Entity Selection

Is your law firm's selection of a legal entity the most appropriate? If your firm is a sole proprietorship, what are the advantages to incorporating? If your firm is a C corporation, what are the advantages and planning necessary to elect S corporation status? If your firm is a partnership, can it benefit from becoming a Limited Liability Corporation ('LLC') or a Limited Liability Partnership ('LLP')? These are all questions that your firm should consider, as an appropriate entity selection can have tremendous impact on tax liability.

Fiscal Year End

If your law firm is organized as a corporation and has a tax year-end other than Dec. 31, the firm must meet certain minimum distribution rules, or certain payments for shareholder compensation may not be tax deductible as incurred. If your firm fails to meet these minimum distribution requirements, it could trigger unwanted taxable income. You should calculate your firm's minimum distribution requirements well in advance of Dec. 31 in order to form a game plan of compliance early on in the year.

Accounting Method Changes

Is your firm compliant with the tax laws surrounding accounting for advanced client costs? If so, how can you 'increase' your tax deductions and reduce cash flow for funding client costs? Your firm should only be capitalizing 'hard costs' advanced. If your firm is capitalizing soft costs, or postponing write-offs of uncollectible accounts receivable or non-billable expenses paid, your firm could be missing important tax deductions. If your firm is not capitalizing advanced client costs, see the 'Managing Advanced Client Costs and Complying with IRS Rules' article on page 3 of this issue regarding the best way to plan and change to the correct method of accounting before the Internal Revenue Service does it for you.

Cash Payments Received

If your firm has received any currency cash payments in excess of $10,000 from a client, have you met your reporting obligations to the IRS with the filing of Form 8300?

Form 1099 Compliance

By Jan. 31, 2008, your firm must prepare and send Form 1099 MISC to eligible recipients to notify them and the IRS of payments made to them. Eligible recipients include unincorporated vendors who were paid for providing personal services in excess of $600 during 2007 to your firm. In addition, law firms are singled out as the only incorporated businesses required to receive 1099s for payments received. If you are unsure whether a vendor is incorporated or not, you should send the vendor Form W-9 to complete. Completion of a W-9 should be made mandatory for all vendors before their invoices are paid, in order to streamline the process of completing Form 1099s each year. This way, your firm can flag all potential 1099 recipients as soon as they become vendors.

Revenue Recognition

One would think that revenue recognition in a law firm that is a cash basis taxpayer is pretty simple. If the cash came in before year-end, whether it were deposited or not, it is a taxable cash receipt. However, there are a few instances when it is not so clear until later. The existence of client fund accounts and the prudent practice of accepting retainers for work not yet performed complicate this matter ' so does accepting property, an investment interest, or a note receivable in payment of fees.

As fees are earned and billed to clients, authorized payments should be transferred from a client fund retainer account to the firm's operating account, and recognized as taxable revenue. If this is not done in a timely manner, two problems may arise. Your firm may be underreporting taxable income, and your firm is commingling client funds with firm assets, which is prohibited. Make sure you, your financial staff, and other employees of the firm that handle client fund accounts are aware of the federal and local bar association rules surrounding the accounting for client funds.

If the firm has received property in lieu of cash payment for fees, what is the value of the property? If the property received is an investment interest in an unrelated business that operates as a 'flow through entity,' such as a partnership or an S corporation, the firm could have additional tax income or loss associated with the investment. In order to decrease the chances of unexpected taxable income, it is wise to request estimates of what taxable income may be generated and allocated to your firm from these outside investments. That way it is not a surprise when Form K-1 comes in and the firm's taxable income changes unexpectedly at the last minute.

Signed Ownership and Buy/Sell Agreements

If your firm does not have signed shareholder agreements, partnership agreements, or buy-sell agreements, make this a priority in 2008. Unfortunately, these agreements are often put on the back burner when firms are first created. It is too late when a business dispute arises, the resolution of which should be spelled out in the buy/sell agreement. Make sure all important shareholder matters are documented and agreed upon while everyone is working amicably together.

Owner Benefits

Are officers' life, disability, health benefits, and other taxable fringe benefits or nondeductible personal expenses summarized and being handled properly from a tax point of view at your firm? To find out the answer, summarize all owner benefits and review them with your tax adviser for compliance. Some benefits may not be deductible by the firm, but can be deducted individually by the owner. Do not miss the opportunity for a proper tax deduction regarding benefits paid to owner/employees. In addition, do not fall short of tax requirements in the treatment of employer-owned vehicles, or stock given in lieu of compensation.

Shareholder Loans

If a shareholder loaned the law firm money, are the terms compliant with IRS requirements? The loan should be documented in the form of a note, and bear interest at a reasonable rate. The 'safe harbor' practice is that loans more than $10,000 should be handled in this manner. Otherwise the 'loan' may be construed as a capital contribution and the 'repayment of the loan' may be considered a taxable distribution in certain circumstances for corporations. Although this characterization may not matter to a partner in a partnership, there is a risk in a corporation of a future taxable distribution if the funds are not properly documented and treated as a loan at the time of origination. A reasonable rate of interest can be prevailing rates paid by the law firm in other instances or, at a minimum, those published monthly and referred to as 'applicable federal rates.'

Employee Benefit Reporting Requirements

Review and summarize all employee benefit plans and reporting requirements. Are all Form 5500 annual reports for employee benefit plans completed for the year? If not, form a plan to get in compliance. Review these issues with your employee benefit consultant.

While reviewing reporting compliance, also review how you may maximize your pension benefits. There is an ever-growing trend for sponsors of defined benefit plans to freeze or terminate these pension vehicles and replace them with defined-contribution plans such as 401(k) plans and discretionary employer contributions.

An audit by an independent certified public accountant may be required to be filed along with the Form 5500 for certain employer-sponsored pension plans with greater than 100 participants. If your plan will require an audit for 2007, you should plan accordingly with your CPA firm now to meet the filing deadlines.

Deferred Compensation Plans

Are all of the firm's deferred-compensation plans compliant with the operational and documentation requirements of Section 409(A)? You may help clients with these issues; why not make sure you are addressing the same concerns at your firm to avoid any penalties for noncompliance.

Depreciation Deductions

Budget your capital expenditure needs so you can determine how much depreciation you may deduct in 2008 for tax purposes. We recommend not only recording a monthly depreciation entry for depreciation that existed as of Dec. 31, 2007, but to also factor in expected purchases in 2008 so that your firm does not record a large depreciation adjustment at the end of the year. Not only does budgeting capital expenditures help your firm estimate future depreciation expense, but it also helps with cash flow requirements and possible financing needs. Keep in mind that certain states have depreciation rules that differ from federal rules.

Sale and Use Tax Compliance

Although most states do not require sales tax to be charged on professional services, in particular law firms, they may require your firm to pay a use tax on qualified purchases of tangible property. If your firm makes purchases of tangible property out of state or online, and the vendor does not charge your firm sales tax, you may be required by your state to file a use tax return and voluntarily pay the equivalent rate of sales tax in the form of a use tax. If your firm has not been filing state use tax returns, you should perform a self-audit and plan to be compliant with your state law by filing delinquent use tax returns.

Multi-State Tax Issues

Is your firm filing income tax returns in all required states? Consider where attorneys are licensed in other states, maintain an office in other states, have property or equipment in other states, or are paying payroll taxes in other states. Determine what your obligation is to pay income taxes in other states, based on the activity your firm has in these states.

Conclusion

Use the above tax issues as a guide to see whether your firm can impact its 2007 tax results and to plan for any opportunities for 2008.

K. Jennie Kinnevy is the director of the Law Firm Services Group at Feeley & Driscoll, P.C. (http://www.fdcpa.com/). The Law Firm Services Group provides tax, accounting, business advisory, and consulting services to law firms. Based in Boston, Kinnevy can be reached at [email protected] or by phone at 617-456-2407.

Even though 2007 has come and gone, it is not too late ' it is never too late ' to think about tax planning and tax issues affecting your law firm. What still can be addressed now in 2008 that can impact your tax return for 2007? What tax issues can be addressed that can impact 2008? The following is a list of items to review internally with your financial team and externally with your tax adviser.

Potential Tax Deductions for 2007 to Consider After Year End

Accelerated Depreciation Deduction

It is not too late to review your allowable depreciation deductions for 2007.

Summarize all your capital expenditures by major classification: computer software, computer equipment, furniture and fixtures, office equipment, capital leases, leasehold improvements. Different classes of assets have different depreciable lives for tax purposes, so this is an important first step.

Next, categorize each major class of asset additions by date placed in service and paid. Your firm is eligible for a depreciation deduction based on date placed in service, but the asset must have been purchased in 2007. If an asset addition was paid with a credit card, but the credit card bill was not paid until 2008, make sure these additions appear on your 2007 list. Even for a cash basis taxpayer, credit card expenditures are tax deductible in the year charged, not the year paid, similar to a note payable or line of credit.

Review depreciable lives for assets purchased. Generally, computer software is depreciated over three years, computer equipment over five years, furniture and fixtures over seven years, office equipment over seven years, and eligible leasehold improvements over 15 years for 2007.

Review any limitations for depreciation that may affect your law firm. These may include total annual additions to be eligible for a Section 179 deduction, luxury auto rules, and placed-in-service dates mentioned above.

Review whether your firm is eligible for the Section 179 depreciation election. Under this IRS code section, your firm may be allowed to deduct 100% of eligible additions up to $125,000 for 2007, and then use accelerated methods of depreciation for the remaining additions. This optional election can represent an additional tax deduction for your firm. There are some limitations, however. If your firm has more than $500,000 in qualifying additions, then the eligible Section 179 expense deduction gets phased out, dollar-for-dollar, for any additional expenditures. For example, if your qualifying additions are $625,000 ($500,000 + $125,000) or more, your firm will not be eligible to take a Section 179 deduction. In addition, if your firm is a C corporation and has a tax loss, there will be additional limitations.

If your law firm moved in 2007, your firm may be able to take advantage of component depreciation rules. This is a method of breaking down the details of the leasehold improvement project to see whether any individual purchases can be depreciated over a shorter time period than the traditional 15 years (for 2007). There are very specific rules related to this area, so ask your tax adviser. In addition, do not forget that if you moved, your firm will 'write off,' or deduct, the remaining net value of leasehold improvements from your former office space. Sometimes this is a surprise deduction. These assets may have been being depreciated over 39 years and may have a significant net value remaining. The write-off must be taken in the year of the firm's move and termination of the prior lease. This is great news for firms looking for extra tax deductions, but shocking news for firms that are not.

Finally, plan for 2008 project capital expenditure needs and depreciation deductions and see how this may affect your estimated tax profits in 2008.

Pension Plan Deductions

How you can change your firm's taxable income for 2007 using the features that exist in your current pension plan? If your pension plan has a discretionary contribution feature, your firm may be allowed to trigger this feature for an additional tax deduction. The beauty of this is that the contribution may not have to be funded until 2008, but you may still get a deduction for 2007. If your firm has a discretionary 401(k) match or discretionary profit-sharing feature, as stated in the current pension plan documents or adoption agreement, your firm may be able to decide after year-end to make a discretionary contribution for 2007. If you are looking to reduce your pension contribution, you should review the balance of funds in the plan forfeiture account that may be used to offset the required employer contribution for 2007, as defined in the plan documents.

Uncollectible Client Costs

Capitalized, advanced, client costs that are considered not collectible as of year-end can be deducted for tax purposes in 2007 as 'bad debt.' Review your accounts receivable and work-in-process to ensure that your firm deducts any capitalized costs in 2007 if they were deemed uncollectible at that point in time.

Tax Checklist for 2008 Planning

Entity Selection

Is your law firm's selection of a legal entity the most appropriate? If your firm is a sole proprietorship, what are the advantages to incorporating? If your firm is a C corporation, what are the advantages and planning necessary to elect S corporation status? If your firm is a partnership, can it benefit from becoming a Limited Liability Corporation ('LLC') or a Limited Liability Partnership ('LLP')? These are all questions that your firm should consider, as an appropriate entity selection can have tremendous impact on tax liability.

Fiscal Year End

If your law firm is organized as a corporation and has a tax year-end other than Dec. 31, the firm must meet certain minimum distribution rules, or certain payments for shareholder compensation may not be tax deductible as incurred. If your firm fails to meet these minimum distribution requirements, it could trigger unwanted taxable income. You should calculate your firm's minimum distribution requirements well in advance of Dec. 31 in order to form a game plan of compliance early on in the year.

Accounting Method Changes

Is your firm compliant with the tax laws surrounding accounting for advanced client costs? If so, how can you 'increase' your tax deductions and reduce cash flow for funding client costs? Your firm should only be capitalizing 'hard costs' advanced. If your firm is capitalizing soft costs, or postponing write-offs of uncollectible accounts receivable or non-billable expenses paid, your firm could be missing important tax deductions. If your firm is not capitalizing advanced client costs, see the 'Managing Advanced Client Costs and Complying with IRS Rules' article on page 3 of this issue regarding the best way to plan and change to the correct method of accounting before the Internal Revenue Service does it for you.

Cash Payments Received

If your firm has received any currency cash payments in excess of $10,000 from a client, have you met your reporting obligations to the IRS with the filing of Form 8300?

Form 1099 Compliance

By Jan. 31, 2008, your firm must prepare and send Form 1099 MISC to eligible recipients to notify them and the IRS of payments made to them. Eligible recipients include unincorporated vendors who were paid for providing personal services in excess of $600 during 2007 to your firm. In addition, law firms are singled out as the only incorporated businesses required to receive 1099s for payments received. If you are unsure whether a vendor is incorporated or not, you should send the vendor Form W-9 to complete. Completion of a W-9 should be made mandatory for all vendors before their invoices are paid, in order to streamline the process of completing Form 1099s each year. This way, your firm can flag all potential 1099 recipients as soon as they become vendors.

Revenue Recognition

One would think that revenue recognition in a law firm that is a cash basis taxpayer is pretty simple. If the cash came in before year-end, whether it were deposited or not, it is a taxable cash receipt. However, there are a few instances when it is not so clear until later. The existence of client fund accounts and the prudent practice of accepting retainers for work not yet performed complicate this matter ' so does accepting property, an investment interest, or a note receivable in payment of fees.

As fees are earned and billed to clients, authorized payments should be transferred from a client fund retainer account to the firm's operating account, and recognized as taxable revenue. If this is not done in a timely manner, two problems may arise. Your firm may be underreporting taxable income, and your firm is commingling client funds with firm assets, which is prohibited. Make sure you, your financial staff, and other employees of the firm that handle client fund accounts are aware of the federal and local bar association rules surrounding the accounting for client funds.

If the firm has received property in lieu of cash payment for fees, what is the value of the property? If the property received is an investment interest in an unrelated business that operates as a 'flow through entity,' such as a partnership or an S corporation, the firm could have additional tax income or loss associated with the investment. In order to decrease the chances of unexpected taxable income, it is wise to request estimates of what taxable income may be generated and allocated to your firm from these outside investments. That way it is not a surprise when Form K-1 comes in and the firm's taxable income changes unexpectedly at the last minute.

Signed Ownership and Buy/Sell Agreements

If your firm does not have signed shareholder agreements, partnership agreements, or buy-sell agreements, make this a priority in 2008. Unfortunately, these agreements are often put on the back burner when firms are first created. It is too late when a business dispute arises, the resolution of which should be spelled out in the buy/sell agreement. Make sure all important shareholder matters are documented and agreed upon while everyone is working amicably together.

Owner Benefits

Are officers' life, disability, health benefits, and other taxable fringe benefits or nondeductible personal expenses summarized and being handled properly from a tax point of view at your firm? To find out the answer, summarize all owner benefits and review them with your tax adviser for compliance. Some benefits may not be deductible by the firm, but can be deducted individually by the owner. Do not miss the opportunity for a proper tax deduction regarding benefits paid to owner/employees. In addition, do not fall short of tax requirements in the treatment of employer-owned vehicles, or stock given in lieu of compensation.

Shareholder Loans

If a shareholder loaned the law firm money, are the terms compliant with IRS requirements? The loan should be documented in the form of a note, and bear interest at a reasonable rate. The 'safe harbor' practice is that loans more than $10,000 should be handled in this manner. Otherwise the 'loan' may be construed as a capital contribution and the 'repayment of the loan' may be considered a taxable distribution in certain circumstances for corporations. Although this characterization may not matter to a partner in a partnership, there is a risk in a corporation of a future taxable distribution if the funds are not properly documented and treated as a loan at the time of origination. A reasonable rate of interest can be prevailing rates paid by the law firm in other instances or, at a minimum, those published monthly and referred to as 'applicable federal rates.'

Employee Benefit Reporting Requirements

Review and summarize all employee benefit plans and reporting requirements. Are all Form 5500 annual reports for employee benefit plans completed for the year? If not, form a plan to get in compliance. Review these issues with your employee benefit consultant.

While reviewing reporting compliance, also review how you may maximize your pension benefits. There is an ever-growing trend for sponsors of defined benefit plans to freeze or terminate these pension vehicles and replace them with defined-contribution plans such as 401(k) plans and discretionary employer contributions.

An audit by an independent certified public accountant may be required to be filed along with the Form 5500 for certain employer-sponsored pension plans with greater than 100 participants. If your plan will require an audit for 2007, you should plan accordingly with your CPA firm now to meet the filing deadlines.

Deferred Compensation Plans

Are all of the firm's deferred-compensation plans compliant with the operational and documentation requirements of Section 409(A)? You may help clients with these issues; why not make sure you are addressing the same concerns at your firm to avoid any penalties for noncompliance.

Depreciation Deductions

Budget your capital expenditure needs so you can determine how much depreciation you may deduct in 2008 for tax purposes. We recommend not only recording a monthly depreciation entry for depreciation that existed as of Dec. 31, 2007, but to also factor in expected purchases in 2008 so that your firm does not record a large depreciation adjustment at the end of the year. Not only does budgeting capital expenditures help your firm estimate future depreciation expense, but it also helps with cash flow requirements and possible financing needs. Keep in mind that certain states have depreciation rules that differ from federal rules.

Sale and Use Tax Compliance

Although most states do not require sales tax to be charged on professional services, in particular law firms, they may require your firm to pay a use tax on qualified purchases of tangible property. If your firm makes purchases of tangible property out of state or online, and the vendor does not charge your firm sales tax, you may be required by your state to file a use tax return and voluntarily pay the equivalent rate of sales tax in the form of a use tax. If your firm has not been filing state use tax returns, you should perform a self-audit and plan to be compliant with your state law by filing delinquent use tax returns.

Multi-State Tax Issues

Is your firm filing income tax returns in all required states? Consider where attorneys are licensed in other states, maintain an office in other states, have property or equipment in other states, or are paying payroll taxes in other states. Determine what your obligation is to pay income taxes in other states, based on the activity your firm has in these states.

Conclusion

Use the above tax issues as a guide to see whether your firm can impact its 2007 tax results and to plan for any opportunities for 2008.

K. Jennie Kinnevy is the director of the Law Firm Services Group at Feeley & Driscoll, P.C. (http://www.fdcpa.com/). The Law Firm Services Group provides tax, accounting, business advisory, and consulting services to law firms. Based in Boston, Kinnevy can be reached at [email protected] or by phone at 617-456-2407.