Is Your Firm Ready for an IRS Audit?

According to the Training Guide, the first step an agent will take in auditing a law firm is to determine the type of legal work the firm handles and its payment arrangements with clients. The agent will first review the income side of the ledger, analyzing the books and firm records to determine whether income is being properly and timely reported. That may depend upon the type of fees that are received. For example:

Specific Retainer. Many law firms require that new clients make an advance payment to the firm as a retainer, sometimes deposited into a trust account. The firm then transfers part or all of the money from the trust account to its general account as it is earned from the rendition of services. If the firm is on a cash basis of accounting and has free access to the funds, the retainer is taxable when received, not when the services credited against the retainer are performed.

Annual Retainer. Like the specific retainer, an annual retainer should be included in income and reported in the year it is received if the firm is a cash basis taxpayer.

Contingent Fee. Unlike a specific retainer or an annual retainer, a contingent fee may vary according to whether the firm is successful in resolving the client matter. A contingent fee generally is not paid until completion of the matter, when the total settlement amount may be deposited in the firm's trust account. The firm then disburses the funds for items such as medical costs, litigation costs, attorney's fees, and reimbursement to the firm for any advanced costs, with the remaining proceeds distributed to the client. So in those circumstances, although the firm has custody of the total settlement amount, only the amounts payable to the firm from the account (other than for costs advanced by the firm, discussed below) are includable in the firm's gross income at the time received.

There is an important caveat here. An auditing agent may request documentation on a settlement to determine whether the firm attempted to defer earned income, after the case has settled, by allowing the fees to remain in the trust account until the next calendar year. Thus, the auditing agent will want to analyze the funds remaining in the trust account at the end of the year. If there is a large balance, the agent will try to determine whether some or all of the funds may represent fees that have been earned on settled cases and should therefore be included in taxable firm income for the year of settlement.

Non-cash Payments. In the course of an audit, an agent may also request information concerning non-cash income that the firm may have received during the year. For example, did the firm accept a trust deed on a client's property in exchange for legal fees, or perhaps even a quitclaim deed or some other interest in the client's property? The agent will assume that receipt of any such property or interest constitutes taxable income to the firm, includable in its income during the year in which the interest is received. Payment of this type should be distinguished from a mere security interest for a future obligation. Accordingly, firms agreeing to a deferred payment arrangement secured by an interest in a client's property should be certain to document the payment arrangement carefully. Proper documentation should include the execution of an appropriate promissory note and mortgage or security agreement to establish proper timing for inclusion of any amounts to eventually be received.

The Expense Side of the Ledger

The second, and perhaps more fertile, ground an auditor reviews for additional taxes is often found on the expense side of the ledger of a law firm. Has the firm deducted amounts that should have been capitalized, or that should have been treated as client advances rather than expenses? There are several such items that would be prudent for a firm to review before the auditing agent arrives:

Entertainment, Promotion, and Advertising. Entertainment, promotion, and advertising expenses often give rise to audit issues. While client entertainment is a recognized part of law practice, at what point does the entertainment become unreasonable? As an example, the Training Guide refers to an attorney who claimed that by taking doctors, fellow attorneys, and potential clients to concerts with first-class seating, limousine service, dinner, and cocktails, he gained exposure to rock-and-roll groupies, roadies, and stars who might come to him when they needed an attorney. With some restraint, the Guide simple suggests that “[t]he reasonableness of [the attorney's] assertion is arguable.”

The “Directly Related” Test. In order to constitute a valid deductible expense, client entertainment also must be “directly related” and “associated with” the firm's law practice. The test generally cannot be met where there is little or no possibility of engaging in business at the event. This applies, for example, where a representative of the law firm is not present (although such a cost may still constitute a valid promotion of the firm). As an illustration of an extreme case, the Training Guide refers to an attorney who gave a party at a country club attended by some clients and persons who refer clients, but also other business associates, with whom no business was discussed.

Disguised Hobbies. The IRS has alerted agents that hobbies will often turn up on law firm tax returns as some sort of business expense. For example, one attorney and two of his associates had a wine cellar they had built and continually stocked with wines from all over the world. There was no direct correlation, however, between the purchase of the wines and their use exclusively for client purposes. Therefore, the expense was not a valid business expense.

Depreciable Books and Periodicals. An agent may review the general ledger to determine whether the firm is expensing publications in the year of acquisition. Generally, periodicals and loose-leaf services that are purchased annually can be expensed, but permanent volumes may have to be depreciated over five years.

Advanced Client Costs. This is an area where many firms trip up. Firms often automatically deduct currently all disbursements incurred on behalf of clients and include the amounts in income when paid by the client pursuant to monthly or other periodic invoicing. Unfortunately, the courts have determined that advances to and costs paid on behalf of clients must be treated as loans to the clients for tax purposes, not deductible as a current cost of conducting business. Simply put, the costs are those of the client and not the firm, since there is an expectation of recovery. If the client fails to pay the disbursement, the firm may claim a bad debt deduction. The IRS does recognize that certain expenses otherwise classified as disbursements should be excepted from this general deferral rule. Thus, it generally allows a current deduction for client reimbursed costs that are allocated to normal operating expenses. Included in this category are secretarial costs, copying costs, and transportation costs. The test is whether the expenses would be incurred even if not charged to a particular client.

Employment Taxes

The final major area to review before an IRS agent visits is employment tax issues. In most cases, the auditing agent will ask to see Forms W-2 and 1099 to determine whether any of the firm's service providers are being misclassified as independent contractors rather than common law employees. Here, the 20 common law factors contained in Rev. Rul. 87-41 will come into play.

According to the Training Guide, an employment tax problem exists when attorneys treat their receptionists, secretaries, paralegals, or law clerks as independent contractors. The issue is one of control. While some firms may argue that their paralegals operate independently and not under the direct supervision and control of attorneys or others in the office, the agent will view such a claim with skepticism and likely classify the clerk or paralegal as an employee.

The determination is more difficult when attorney classification is at issue. The IRS concedes that in limited situations attorneys may be properly treated as independent contractors rather than common law employees, but that is principally where the attorney's services are offered to the general public or other law firms as well. Where the attorney is comparable to an associate working with partners in the firm, it will be a hard sell to convince the agent that the attorney should be treated as an independent contractor rather than a common law employee, even if the retention of the attorney is on a part-time basis.

If a firm's classification of any of its workers is challenged by the auditing agent, the firm may want to consider raising section 530 of the Revenue Act of 1978. Under section 530, the IRS cannot reclassify workers as employees for purposes of federal employment tax obligations if the employer had a “reasonable basis” for not treating the workers as employees. Section 530 provides three safe havens for showing a “reasonable basis”: 1) a judicial precedent, published rulings or a technical advice memorandum, or letter ruling with respect to the employer (unlikely in most cases); 2) a prior IRS audit of the employer in which the employment deficiencies were not assessed for amounts paid to the workers holding positions substantially similar to that held by the worker in question (again, unlikely); or 3) a long-standing, recognized practice of a significant segment of the industry in which the worker was engaged. The latter may hold the most promise for a law firm, but even then the firm may have difficulty producing sufficient evidence of any “long-standing, recognized practice” with respect to the affected employees.

Dealing with an Auditing Agent

Finally, a few points for dealing with an auditing agent when he or she arrives.

• Provide the agent a comfortable, but not overly pleasant, place to work while on site. The location should provide privacy for both the agent and the firm, meaning that it should be away from the active business areas of the firm including, particularly, the accounting function.
• Have firm records (and backup) ready, but provide the agent only what he or she asks for, and not more.
• Have the agent prepare a list of questions to which responses can be provided in one meeting rather than try to deal with each issue as it arises.
• Appoint one person to deal with the agent and instruct other employees not to engage in any substantive conversations with the agent.

Conclusion

An IRS audit may not be a near-term eventuality for your firm, but keeping it in the back of your mind and planning accordingly as you manage your firm, can be your best defense should that unanticipated IRS letter arrive.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the Managing Partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].

The phone call or letter may come when you least expect it. The Internal Revenue Service has selected your firm for audit. Are you ready? As a service-oriented business typically using the cash receipts and disbursements method to determine income for tax purposes, you may feel the IRS has little to find. When you receive legal fees, you include them in income. When you pay expenses, you deduct them. That's pretty straightforward. However, you may be in for a surprise if you ever accept retainers, accept payment for services in kind, accept client trust funds, advance client costs in connection with matters you are handling, or have any service providers not on the regular payroll.

The Income Side of the Ledger

As early as 1993, the IRS issued guidelines for a nationwide audit program of attorneys as part of its Market Segment Specialization Program (“MSSP”). These audit guidelines (the “Training Guide”) are included today in the Internal Revenue Manual to assist agents in their review of law firm practices.

According to the Training Guide, the first step an agent will take in auditing a law firm is to determine the type of legal work the firm handles and its payment arrangements with clients. The agent will first review the income side of the ledger, analyzing the books and firm records to determine whether income is being properly and timely reported. That may depend upon the type of fees that are received. For example:

Specific Retainer. Many law firms require that new clients make an advance payment to the firm as a retainer, sometimes deposited into a trust account. The firm then transfers part or all of the money from the trust account to its general account as it is earned from the rendition of services. If the firm is on a cash basis of accounting and has free access to the funds, the retainer is taxable when received, not when the services credited against the retainer are performed.

Annual Retainer. Like the specific retainer, an annual retainer should be included in income and reported in the year it is received if the firm is a cash basis taxpayer.

Contingent Fee. Unlike a specific retainer or an annual retainer, a contingent fee may vary according to whether the firm is successful in resolving the client matter. A contingent fee generally is not paid until completion of the matter, when the total settlement amount may be deposited in the firm's trust account. The firm then disburses the funds for items such as medical costs, litigation costs, attorney's fees, and reimbursement to the firm for any advanced costs, with the remaining proceeds distributed to the client. So in those circumstances, although the firm has custody of the total settlement amount, only the amounts payable to the firm from the account (other than for costs advanced by the firm, discussed below) are includable in the firm's gross income at the time received.

There is an important caveat here. An auditing agent may request documentation on a settlement to determine whether the firm attempted to defer earned income, after the case has settled, by allowing the fees to remain in the trust account until the next calendar year. Thus, the auditing agent will want to analyze the funds remaining in the trust account at the end of the year. If there is a large balance, the agent will try to determine whether some or all of the funds may represent fees that have been earned on settled cases and should therefore be included in taxable firm income for the year of settlement.

Non-cash Payments. In the course of an audit, an agent may also request information concerning non-cash income that the firm may have received during the year. For example, did the firm accept a trust deed on a client's property in exchange for legal fees, or perhaps even a quitclaim deed or some other interest in the client's property? The agent will assume that receipt of any such property or interest constitutes taxable income to the firm, includable in its income during the year in which the interest is received. Payment of this type should be distinguished from a mere security interest for a future obligation. Accordingly, firms agreeing to a deferred payment arrangement secured by an interest in a client's property should be certain to document the payment arrangement carefully. Proper documentation should include the execution of an appropriate promissory note and mortgage or security agreement to establish proper timing for inclusion of any amounts to eventually be received.

The Expense Side of the Ledger

The second, and perhaps more fertile, ground an auditor reviews for additional taxes is often found on the expense side of the ledger of a law firm. Has the firm deducted amounts that should have been capitalized, or that should have been treated as client advances rather than expenses? There are several such items that would be prudent for a firm to review before the auditing agent arrives:

Entertainment, Promotion, and Advertising. Entertainment, promotion, and advertising expenses often give rise to audit issues. While client entertainment is a recognized part of law practice, at what point does the entertainment become unreasonable? As an example, the Training Guide refers to an attorney who claimed that by taking doctors, fellow attorneys, and potential clients to concerts with first-class seating, limousine service, dinner, and cocktails, he gained exposure to rock-and-roll groupies, roadies, and stars who might come to him when they needed an attorney. With some restraint, the Guide simple suggests that “[t]he reasonableness of [the attorney's] assertion is arguable.”

The “Directly Related” Test. In order to constitute a valid deductible expense, client entertainment also must be “directly related” and “associated with” the firm's law practice. The test generally cannot be met where there is little or no possibility of engaging in business at the event. This applies, for example, where a representative of the law firm is not present (although such a cost may still constitute a valid promotion of the firm). As an illustration of an extreme case, the Training Guide refers to an attorney who gave a party at a country club attended by some clients and persons who refer clients, but also other business associates, with whom no business was discussed.

Disguised Hobbies. The IRS has alerted agents that hobbies will often turn up on law firm tax returns as some sort of business expense. For example, one attorney and two of his associates had a wine cellar they had built and continually stocked with wines from all over the world. There was no direct correlation, however, between the purchase of the wines and their use exclusively for client purposes. Therefore, the expense was not a valid business expense.

Depreciable Books and Periodicals. An agent may review the general ledger to determine whether the firm is expensing publications in the year of acquisition. Generally, periodicals and loose-leaf services that are purchased annually can be expensed, but permanent volumes may have to be depreciated over five years.

Advanced Client Costs. This is an area where many firms trip up. Firms often automatically deduct currently all disbursements incurred on behalf of clients and include the amounts in income when paid by the client pursuant to monthly or other periodic invoicing. Unfortunately, the courts have determined that advances to and costs paid on behalf of clients must be treated as loans to the clients for tax purposes, not deductible as a current cost of conducting business. Simply put, the costs are those of the client and not the firm, since there is an expectation of recovery. If the client fails to pay the disbursement, the firm may claim a bad debt deduction. The IRS does recognize that certain expenses otherwise classified as disbursements should be excepted from this general deferral rule. Thus, it generally allows a current deduction for client reimbursed costs that are allocated to normal operating expenses. Included in this category are secretarial costs, copying costs, and transportation costs. The test is whether the expenses would be incurred even if not charged to a particular client.

Employment Taxes

The final major area to review before an IRS agent visits is employment tax issues. In most cases, the auditing agent will ask to see Forms W-2 and 1099 to determine whether any of the firm's service providers are being misclassified as independent contractors rather than common law employees. Here, the 20 common law factors contained in Rev. Rul. 87-41 will come into play.

According to the Training Guide, an employment tax problem exists when attorneys treat their receptionists, secretaries, paralegals, or law clerks as independent contractors. The issue is one of control. While some firms may argue that their paralegals operate independently and not under the direct supervision and control of attorneys or others in the office, the agent will view such a claim with skepticism and likely classify the clerk or paralegal as an employee.

The determination is more difficult when attorney classification is at issue. The IRS concedes that in limited situations attorneys may be properly treated as independent contractors rather than common law employees, but that is principally where the attorney's services are offered to the general public or other law firms as well. Where the attorney is comparable to an associate working with partners in the firm, it will be a hard sell to convince the agent that the attorney should be treated as an independent contractor rather than a common law employee, even if the retention of the attorney is on a part-time basis.

If a firm's classification of any of its workers is challenged by the auditing agent, the firm may want to consider raising section 530 of the Revenue Act of 1978. Under section 530, the IRS cannot reclassify workers as employees for purposes of federal employment tax obligations if the employer had a “reasonable basis” for not treating the workers as employees. Section 530 provides three safe havens for showing a “reasonable basis”: 1) a judicial precedent, published rulings or a technical advice memorandum, or letter ruling with respect to the employer (unlikely in most cases); 2) a prior IRS audit of the employer in which the employment deficiencies were not assessed for amounts paid to the workers holding positions substantially similar to that held by the worker in question (again, unlikely); or 3) a long-standing, recognized practice of a significant segment of the industry in which the worker was engaged. The latter may hold the most promise for a law firm, but even then the firm may have difficulty producing sufficient evidence of any “long-standing, recognized practice” with respect to the affected employees.

Dealing with an Auditing Agent

Finally, a few points for dealing with an auditing agent when he or she arrives.

• Provide the agent a comfortable, but not overly pleasant, place to work while on site. The location should provide privacy for both the agent and the firm, meaning that it should be away from the active business areas of the firm including, particularly, the accounting function.
• Have firm records (and backup) ready, but provide the agent only what he or she asks for, and not more.
• Have the agent prepare a list of questions to which responses can be provided in one meeting rather than try to deal with each issue as it arises.
• Appoint one person to deal with the agent and instruct other employees not to engage in any substantive conversations with the agent.

Conclusion

An IRS audit may not be a near-term eventuality for your firm, but keeping it in the back of your mind and planning accordingly as you manage your firm, can be your best defense should that unanticipated IRS letter arrive.

Michael E. Mooney, a member of this newsletter's Board of Editors, is the Managing Partner of Nutter McClennen & Fish, LLP, in Boston. His firm maintains an active tax and business practice, representing and advising domestic and international corporations in a broad range of tax issues, reorganizations, business combinations, and divestitures. He can be reached at [email protected].