IRS Tax Exams in the Legal Industry

'Accurint' and More

In addition to analyzing the above records, IRS examiners will also perform a thorough search by using Accurint. This is a web-based product that enables the examiner to perform various types of searches based on different criteria. For example, a “People Search” in Accurint will provide address, phone and employment information. This information can be used to verify the size and location of an attorney's office. Searches of attorneys' assets, businesses and licenses will also be performed using Accurint. Furthermore, a complete search of the Internet will be conducted, using the taxpayer's name, firm name and practice area.

Along with analyzing the books and records and performing various Internet searches, the examiner will also interview the taxpayer. This interview process delves into the attorney's business history, payroll, maintenance of books and records, and bank accounts. In addition, specific questions are designed to understand how the attorney accounts for income and expenses.

Payroll

One expense that is commonly examined, not only in law firms, but in every business, is payroll. Here, the IRS is looking for proper classification between employees and independent contractors to make sure that employment taxes have been properly remitted. In short, an employer is required to withhold employment taxes on all employees, where independent contractors are required to remit employment taxes on their own. An employment tax issue may exist where attorneys treat their receptionists, secretaries, paralegals, or law clerks as independent contractors, when in fact they are employees. The IRS basically has three categories it considers when determining employee classification:

• Behavioral Control. Does the company have the right to control what the worker does and how he does his job? If that worker is an employee, the answer is yes.
• Financial Control. Are the business aspects of the worker's job controlled by the payer, including how the worker is paid, and who provides equipment, tools and supplies? If that worker is an employee, the answer is yes.
• Type of Relationship. Are there written contracts? Or employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Obviously, if the worker is an employee, there will be such benefits.

Businesses must weigh all of these categories when determining how to classify a worker as an employee or independent contractor. Please note, it is important to document each of the categories used in coming up with the classification.

Auditing Income

The first step in auditing income is to determine the type of legal work that is handled, and the typical payment arrangements made with clients. The type of legal work performed may affect how and when income is recognized. As most attorneys base their fees on hours worked plus any case-related costs, they will be asked to provide detailed records of their time and direct case costs. These records will be scrutinized and measured against the bills rendered and cash receipts collected.

Those attorneys who do not base their fees on hourly rates may base their fees on a percentage of a settlement, or a contingent fee, plus costs. After a case has been settled, the attorney may attempt to defer income by allowing fees received to remain in the trust account until the subsequent year. Once the new year begins, the attorney will transfer the funds in the trust account into the operating account, in an attempt to establish the fees as received in the subsequent year. However, once the settlement is received in the trust account, the attorney's fee must be recognized for income-tax purposes, and is required to be included in taxable income, as the attorney had constructive receipt of the funds. To uncover any attempt at deferring income, an examiner will analyze the source of funds remaining in the trust account at year's end and the cash received in the operating account in the beginning of the subsequent year, particularly if there is a large balance in either account.

Some attorneys may receive non-cash payments instead of fees for services rendered. For example, an attorney who sets up partnerships or corporations may accept an interest in the newly formed entity as payment for legal services rendered; or an attorney may accept a partial or entire interest in real property as payment for legal fees. Verifying the basis of newer assets, such as partnership interests, stock and real property, may help the examiner reveal non cash payments for services rendered. Although most attorneys are cash-basis taxpayers, non-cash payments for services rendered still constitute taxable income.

In addition to uncovering unreported income, the examiner will also be looking to identify disallowed expenses. Generally speaking, most expenses that are disallowed for attorneys are due to the fact that they are personal in nature and not ordinary business-related expenses. The IRS recognizes that entertaining clients and prospective clients is an ordinary business-related expense. However, since there is a benefit received by an attorney when entertaining (i.e., consumption of food, attending recreational sporting events, etc.), the IRS limits these “meals and entertainment” deductions to 50% of the total cost, as long as the expense is “directly related” to, or “directly associated” with, the attorney's business. Furthermore, the attorney must not only be present at these functions, but must also be engaged in conducting business. The IRS may disallow the 50% deduction if there is little or no possibility that the attorney had any business discussions. The attorney must also substantiate these expenses by documenting who he or she was with and what was discussed.

Nondeductible Expenses

There are, however, other expenses that on the surface appear to be business-related, but have been deemed by the IRS as nondeductible for attorneys. These expenses are commonly known as advanced client costs or “hard costs.” Attorneys may pay certain costs on behalf of their clients. Expenses such as travel, deposition costs, stenographers, filing fees and expert-witness fees are examples of client costs being paid by the attorney. Depending on the agreement between attorney and client, the costs can be recovered by the attorney. This practice is most often used by attorneys who take cases on a contingency-fee basis. Attorneys who advance client costs cannot deduct the costs as business expenses, as the client is ultimately responsible for the expense. The courts have determined that costs paid on behalf of a client are to be treated as loans for income tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney, since there is an expectation of reimbursement from the client.

Contingency Fees

Attorneys taking cases on a contingency-fee basis generally use two main contractual arrangements with their clients. These are the gross-fee contract and the net-fee contract. The net-fee contract specifically provides that advanced litigation costs are repaid to the attorney before calculating the contingency fee percentage paid from the settlement or judgment proceeds.

In contrast, the gross-fee contract provides that the contingency-fee percentage paid from the settlement or judgment proceeds is calculated without regard to advanced litigation costs. The attorney is only entitled to a percentage of the settlement and is not separately reimbursed for litigation costs advanced. These costs reduce the attorney's net profit. If the case is lost, attorneys usually do not recover their costs from the client under either contingency-fee arrangement. The costs that are not recovered should be taken as a bad-debt expense, as long as they were not deducted when paid.

With each of these contracts, case time is not a factor in determining the amount of the fee. The receipts collected from these contingency-fee cases are derived from the settlement decreed by the court. The examiner will review the settlement in conjunction with the agreement between the attorney and his or her client, to confirm net-fee or gross-fee agreement, and compare the fee income reported by the attorney with the actual settlement from the courts to verify that the correct income was reported.

Gross Fees

Although it is very clear that client costs paid by the attorney are not deductible by the attorney who is either billing his client by the hour or who has a net-fee contract, it is not as clear with a gross-fee contract. However, unless you are willing to enter into a lengthy and costly battle with the IRS, advanced client costs should not be deducted when paid by the attorney. This was
demonstrated in James F. Boccardo v United States, 12 CL. CT. 184(1987) 87-1 US T.C. 9288 (1987), where the Tax Court determined that the gross fee arrangement was non-deductible due to the contingent nature of the reimbursement. On appeal, the Ninth Circuit (James F. Boccardo v United States, 56 F.3d 1016 [9th Cir. 1995]) reversed the Tax Court's decision. However, the IRS takes the position that it will continue to challenge these expenses, except in the Ninth Circuit (IRS FSA 1997 WL 33313738 6-2-97).

Changing Your Accounting Method

If you are an attorney, or work for a firm that is deducting advanced client costs when paid versus treating these costs as loans, there is a way to formally change your accounting method with the IRS and at the same time, provide protection from audits of you or your firm for the years prior to the accounting method change. This is accomplished by filing IRS Form 3115, “Application for Change in Accounting Method.” The default rule is that a taxpayer may not change its method of accounting for tax purposes without IRS approval. However, the IRS will grant an automatic approval for certain predetermined accounting method changes. One of the predetermined automatic accounting method changes is Automatic change number 2, as listed on the instructions to form 3115 (currently there are 180 automatic changes). This change allows lawyers handling cases on a contingent-fee basis and treating advances of money to their clients for litigation costs as deductible business expense to change their method so that those advances are treated as loans.

This change in method results in an increase to taxable income in the year of the change. However, this increase will be picked up equally over a four-year period beginning with the year of the change. This is another benefit to coming forward to the IRS, as it allows the taxpayer to spread the tax liability over several years. Another positive outcome to requesting the automatic change is that the IRS will not impose interest and penalties on the tax generated by the additional income. However, if the IRS determines that theses costs are nondeductible before Form 3115 is filed, three years of amended returns must be filed. This means that for law firms that operate as pass-through entities, such as Partnerships or S Corporations, each partner or shareholder will also be required to file three years of amended returns.

To review, the benefits of applying for the automatic change are three-fold: 1) audit protection for prior years; 2) additional income spread equally over four years, thus spreading the tax liability on that income over the same four-year period and; 3) no interest or penalties calculated on the tax generated from the additional income. Not to mention the countless hours of carefree sleep the attorneys will be getting, knowing that they are in full compliance with income tax accounting principles.

Conclusion

IRS Examinations can be tedious and frustrating. It would behoove any law firm and law firm owner selected for an IRS audit to retain an experienced tax practitioner to assist them in navigating through the process. The absence of qualified representation in this matter could result in lost time and money.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner in the New York accounting firm of Anchin, Block & Anchin LLP. He can be reached at 212-840-3456 or via e-mail at rstieg
[email protected].

Ever wonder what the IRS looks for when auditing tax returns of law firms and their owners? The IRS has developed Audit Technique Guides (ATGs) to assist their agents during audits by providing insight into issues and accounting methods unique to specific industries. ATGs explain industry-specific examination techniques and include common, as well as unique, industry issues, business practices, and terminology. Guidance is also provided on the examination of income, expenses, interview techniques, and evaluation of evidence. And yes, the IRS has developed an ATG for the legal industry.

A Guide for the Legal Industry

Within this past year, the IRS updated the “Attorneys Audit Technique Guide.” Included in this update are key items that the IRS is looking for during the course of an examination. Attorneys can expect to have their appointment books, disbursements, receipts and accounts receivable journals, time summary reports and other client and financial data scrutinized and reconciled to their tax returns to ascertain the validity of both income and expenses. In addition, the auditors will be examining attorney/client trust accounts to determine if there is any unreported income contained within these accounts. Since many attorneys compute gross income based on withdrawals from the client trust account, analysis of these accounts is usually the first step in the audit process. Preparing for and providing all of the above information can be daunting and time-consuming. Attorneys have tried to refuse access to these records by claiming attorney-client privilege, which basically means that any information relating to an attorney's client is privileged and shall remain confidential to any third party. This privilege, however, generally does not apply to the Internal Revenue Service. The ATG states that “As a 'general rule,' where a party demonstrates that there is a legitimate need for a court to require disclosure of such matters, the identity of an attorney's clients and the
nature of his or her fee arrangements with his or her clients are not confidential communications protected by the attorney-client privilege.”

'Accurint' and More

In addition to analyzing the above records, IRS examiners will also perform a thorough search by using Accurint. This is a web-based product that enables the examiner to perform various types of searches based on different criteria. For example, a “People Search” in Accurint will provide address, phone and employment information. This information can be used to verify the size and location of an attorney's office. Searches of attorneys' assets, businesses and licenses will also be performed using Accurint. Furthermore, a complete search of the Internet will be conducted, using the taxpayer's name, firm name and practice area.

Along with analyzing the books and records and performing various Internet searches, the examiner will also interview the taxpayer. This interview process delves into the attorney's business history, payroll, maintenance of books and records, and bank accounts. In addition, specific questions are designed to understand how the attorney accounts for income and expenses.

Payroll

One expense that is commonly examined, not only in law firms, but in every business, is payroll. Here, the IRS is looking for proper classification between employees and independent contractors to make sure that employment taxes have been properly remitted. In short, an employer is required to withhold employment taxes on all employees, where independent contractors are required to remit employment taxes on their own. An employment tax issue may exist where attorneys treat their receptionists, secretaries, paralegals, or law clerks as independent contractors, when in fact they are employees. The IRS basically has three categories it considers when determining employee classification:

• Behavioral Control. Does the company have the right to control what the worker does and how he does his job? If that worker is an employee, the answer is yes.
• Financial Control. Are the business aspects of the worker's job controlled by the payer, including how the worker is paid, and who provides equipment, tools and supplies? If that worker is an employee, the answer is yes.
• Type of Relationship. Are there written contracts? Or employee-type benefits (i.e., pension plan, insurance, vacation pay, etc.)? Obviously, if the worker is an employee, there will be such benefits.

Businesses must weigh all of these categories when determining how to classify a worker as an employee or independent contractor. Please note, it is important to document each of the categories used in coming up with the classification.

Auditing Income

The first step in auditing income is to determine the type of legal work that is handled, and the typical payment arrangements made with clients. The type of legal work performed may affect how and when income is recognized. As most attorneys base their fees on hours worked plus any case-related costs, they will be asked to provide detailed records of their time and direct case costs. These records will be scrutinized and measured against the bills rendered and cash receipts collected.

Those attorneys who do not base their fees on hourly rates may base their fees on a percentage of a settlement, or a contingent fee, plus costs. After a case has been settled, the attorney may attempt to defer income by allowing fees received to remain in the trust account until the subsequent year. Once the new year begins, the attorney will transfer the funds in the trust account into the operating account, in an attempt to establish the fees as received in the subsequent year. However, once the settlement is received in the trust account, the attorney's fee must be recognized for income-tax purposes, and is required to be included in taxable income, as the attorney had constructive receipt of the funds. To uncover any attempt at deferring income, an examiner will analyze the source of funds remaining in the trust account at year's end and the cash received in the operating account in the beginning of the subsequent year, particularly if there is a large balance in either account.

Some attorneys may receive non-cash payments instead of fees for services rendered. For example, an attorney who sets up partnerships or corporations may accept an interest in the newly formed entity as payment for legal services rendered; or an attorney may accept a partial or entire interest in real property as payment for legal fees. Verifying the basis of newer assets, such as partnership interests, stock and real property, may help the examiner reveal non cash payments for services rendered. Although most attorneys are cash-basis taxpayers, non-cash payments for services rendered still constitute taxable income.

In addition to uncovering unreported income, the examiner will also be looking to identify disallowed expenses. Generally speaking, most expenses that are disallowed for attorneys are due to the fact that they are personal in nature and not ordinary business-related expenses. The IRS recognizes that entertaining clients and prospective clients is an ordinary business-related expense. However, since there is a benefit received by an attorney when entertaining (i.e., consumption of food, attending recreational sporting events, etc.), the IRS limits these “meals and entertainment” deductions to 50% of the total cost, as long as the expense is “directly related” to, or “directly associated” with, the attorney's business. Furthermore, the attorney must not only be present at these functions, but must also be engaged in conducting business. The IRS may disallow the 50% deduction if there is little or no possibility that the attorney had any business discussions. The attorney must also substantiate these expenses by documenting who he or she was with and what was discussed.

Nondeductible Expenses

There are, however, other expenses that on the surface appear to be business-related, but have been deemed by the IRS as nondeductible for attorneys. These expenses are commonly known as advanced client costs or “hard costs.” Attorneys may pay certain costs on behalf of their clients. Expenses such as travel, deposition costs, stenographers, filing fees and expert-witness fees are examples of client costs being paid by the attorney. Depending on the agreement between attorney and client, the costs can be recovered by the attorney. This practice is most often used by attorneys who take cases on a contingency-fee basis. Attorneys who advance client costs cannot deduct the costs as business expenses, as the client is ultimately responsible for the expense. The courts have determined that costs paid on behalf of a client are to be treated as loans for income tax purposes. They are not deductible by the attorney as a current cost of conducting business. The costs are those of the client and not the attorney, since there is an expectation of reimbursement from the client.

Contingency Fees

Attorneys taking cases on a contingency-fee basis generally use two main contractual arrangements with their clients. These are the gross-fee contract and the net-fee contract. The net-fee contract specifically provides that advanced litigation costs are repaid to the attorney before calculating the contingency fee percentage paid from the settlement or judgment proceeds.

In contrast, the gross-fee contract provides that the contingency-fee percentage paid from the settlement or judgment proceeds is calculated without regard to advanced litigation costs. The attorney is only entitled to a percentage of the settlement and is not separately reimbursed for litigation costs advanced. These costs reduce the attorney's net profit. If the case is lost, attorneys usually do not recover their costs from the client under either contingency-fee arrangement. The costs that are not recovered should be taken as a bad-debt expense, as long as they were not deducted when paid.

With each of these contracts, case time is not a factor in determining the amount of the fee. The receipts collected from these contingency-fee cases are derived from the settlement decreed by the court. The examiner will review the settlement in conjunction with the agreement between the attorney and his or her client, to confirm net-fee or gross-fee agreement, and compare the fee income reported by the attorney with the actual settlement from the courts to verify that the correct income was reported.

Gross Fees

Although it is very clear that client costs paid by the attorney are not deductible by the attorney who is either billing his client by the hour or who has a net-fee contract, it is not as clear with a gross-fee contract. However, unless you are willing to enter into a lengthy and costly battle with the IRS, advanced client costs should not be deducted when paid by the attorney. This was
demonstrated in James F. Boccardo v United States, 12 CL. CT. 184(1987) 87-1 US T.C. 9288 (1987), where the Tax Court determined that the gross fee arrangement was non-deductible due to the contingent nature of the reimbursement. On appeal, the Ninth Circuit (James F. Boccardo v United States, 56 F.3d 1016 [9th Cir. 1995]) reversed the Tax Court's decision. However, the IRS takes the position that it will continue to challenge these expenses, except in the Ninth Circuit (IRS FSA 1997 WL 33313738 6-2-97).

Changing Your Accounting Method

If you are an attorney, or work for a firm that is deducting advanced client costs when paid versus treating these costs as loans, there is a way to formally change your accounting method with the IRS and at the same time, provide protection from audits of you or your firm for the years prior to the accounting method change. This is accomplished by filing IRS Form 3115, “Application for Change in Accounting Method.” The default rule is that a taxpayer may not change its method of accounting for tax purposes without IRS approval. However, the IRS will grant an automatic approval for certain predetermined accounting method changes. One of the predetermined automatic accounting method changes is Automatic change number 2, as listed on the instructions to form 3115 (currently there are 180 automatic changes). This change allows lawyers handling cases on a contingent-fee basis and treating advances of money to their clients for litigation costs as deductible business expense to change their method so that those advances are treated as loans.

This change in method results in an increase to taxable income in the year of the change. However, this increase will be picked up equally over a four-year period beginning with the year of the change. This is another benefit to coming forward to the IRS, as it allows the taxpayer to spread the tax liability over several years. Another positive outcome to requesting the automatic change is that the IRS will not impose interest and penalties on the tax generated by the additional income. However, if the IRS determines that theses costs are nondeductible before Form 3115 is filed, three years of amended returns must be filed. This means that for law firms that operate as pass-through entities, such as Partnerships or S Corporations, each partner or shareholder will also be required to file three years of amended returns.

To review, the benefits of applying for the automatic change are three-fold: 1) audit protection for prior years; 2) additional income spread equally over four years, thus spreading the tax liability on that income over the same four-year period and; 3) no interest or penalties calculated on the tax generated from the additional income. Not to mention the countless hours of carefree sleep the attorneys will be getting, knowing that they are in full compliance with income tax accounting principles.

Conclusion

IRS Examinations can be tedious and frustrating. It would behoove any law firm and law firm owner selected for an IRS audit to retain an experienced tax practitioner to assist them in navigating through the process. The absence of qualified representation in this matter could result in lost time and money.

Richard H. Stieglitz, CPA, a member of this newsletter's Board of Editors, is a Tax Partner in the New York accounting firm of Anchin, Block & Anchin LLP. He can be reached at 212-840-3456 or via e-mail at rstieg
[email protected].