Practice Management: Attorneys and the IRS: Are You in the Audit Cross Hairs?

7/7/2015 - By Zachary Farrington

Don’t look now, but you may have a target on your back. The legal profession is one of several industries the IRS has singled out for special scrutiny as part of its Examination Specialization Program (formerly known as the Market Segment Specialization Program).

In fact, the feds have released a revised Attorneys Audit Technique Guide that specifically identifies the accounting, banking and record-keeping practices used in the profession and highlights issues that revenue agents should focus on in examining a lawyer or law firm.

Who Gets Hit?
According to the guidelines, solo practitioners face the highest potential for an audit. The IRS also considers attorneys who practice in the following areas to have higher potential for noncompliance:

Criminal law
Real estate law
Immigration law

The audit guide identifies the records and documents typically kept by attorneys that IRS agents should request and review — everything from appointment books and client card indexes to disbursement ledgers and time reports. As they sift through these records, agents are advised to look for these common areas of noncompliance:

• Unreported income — Personal bank accounts will be analyzed to determine whether any client fees were deposited directly into a personal account instead of a business account. Particular attention will be paid to withdrawals from client trust accounts.

Agents will also scrutinize attempts by attorneys to defer income. As cash basis taxpayers, attorneys are required to recognize income in the year it is received. So, retainers and prepaid fees must be reported as income in the year received even if the services will not be performed until a later year.

Contingency fee cases also come under scrutiny. When a settlement or judgment is received and deposited into a client trust account, the contingency fee amount is typically includable in income for the year in which it is received (because it is determinable and available as soon as a client’s settlement or judgment is received).

• Non-cash income — The Audit Technique Guide also directs IRS agents to look for situations in which an attorney receives non-cash payment. Examples include when an attorney performs legal services to pay back a loan, trades legal services for other services or accepts stock in lieu of cash (as discussed in this issue’s lead article).

• Employment practices — Agents are also advised to check for employment tax issues, such as treating secretaries, paralegals and clerks as independent contractors when they in fact meet the IRS definition of an employee. See IRS Publication 1779, Independent Contractor or Employee, for more details on this important distinction.

• Advanced client costs — The IRS takes the position that advanced client costs should be treated as loans to clients if the attorney expects to later be reimbursed for the costs. A classic example is the attorney in a contingency fee case who covers litigation expenses on behalf of the client with the agreement that the amounts will be recovered out of a future settlement or judgment.

Problems arise when attorneys deduct these costs instead and are later reimbursed. If the costs are never reimbursed, the attorney may deduct the amount as bad debt. To determine whether there is an expectation of reimbursement, IRS agents are advised to look at an attorney’s case selection, fee advancement processes and success rate.

Watch Your Back
With the IRS arming agents with specific tools for auditing attorneys and law firms, it is critical to check for potential areas of noncompliance. Make sure your accounting practices and tax filings comply with the Internal Revenue Code and corresponding regulations.

Protecting Attorney-Client Privilege During an Audit
When the IRS comes knocking, it’s important to consider that fee arrangements and the identity of clients are generally not considered to be protected communications. However, while the specific fee arrangement is not protected, any portions of an engagement letter, retainer agreement or any other correspondence that reveals the client’s motivation for creating the relationship, the nature of legal services provided or the attorney’s litigation strategy is protected.

If an attorney invokes attorney client privilege and refuses to provide documents, IRS agents are advised that it may be necessary to issue a summons for the documents. The attorney may then challenge the validity of the summons on the basis that the documents requested are protected by privilege.