Vol. 85, No. 4, April 2012
Out of the blue, an Internal Revenue Service (IRS) agent calls. Or, a letter arrives in a window envelope by regular mail. Your firm has been selected for an IRS examination. The agent's purpose in the first contact is to identify the tax years at issue, discuss the initial issues to be examined and the records needed, and schedule an initial appointment.
You should respect all deadlines and, of course, consider hiring legal counsel. The law firm's goals should be the following: limit the scope of the examination, keep a record of what the agent sees, and move the agent through the process as quickly as possible.1
Beyond these fundamentals, this article will help you prepare for the content of the examination by looking at the audit from the government's point of view. In March 2011, the IRS released a new Attorneys Audit Technique Guide (the Guide) in connection with the examination of lawyers and law firms.2 The Guide is not a call to action: Wisconsin lawyers and law firms likely already have adequate accounting procedures, controls, and record-retrieval functions in place. To be forewarned, however, is to be forearmed. Routine review of firm procedure and practice is a good idea, and the Guide points to areas that lawyers and law firms may want to focus on first.
The Guide directs examiners to conduct a comprehensive precontact analysis. The government's principal tool for this purpose is an Internet-based LexisNexis public-record-search service called Accurint. The Guide recommends that auditors also conduct business filing searches (for example, at the Wisconsin Department of Financial Institutions website), license searches (for example, at wisbar.org), court searches (such as using Wisconsin's Consolidated Court Automation Programs (CCAP) website), nonsubscription-based Internet searches (such as using Yahoo or Google search engines), and a review of the federal government's internal currency and banking-retrieval-system database.
According to the Guide, a thorough understanding of the taxpayer's bookkeeping system and internal controls is necessary. It is important to perform a comparative analysis of at least three years during the pre-audit phase, to determine if there are any unusual changes in income, expenses, and taxes paid. The examiner is directed to request information – including statements and documents – regarding all open and closed checking and savings accounts, bank loan and mortgage documents, certificates of deposit, investment and security custodian accounts, retirement accounts, retained copies of checks, wire-transfer files, safe-deposit-box rental records, credit card statements, currency transaction reports, trust account records, and internal ledger recordation information. The auditor may also ask for client invoices.
The lawyer or law firm should be prepared to provide these documents and thus should, at least for this purpose, save such records in either paper or electronic form going back six years.3
The Guide states that attorneys may refuse to provide documents by invoking the attorney-client privilege. Attorneys may claim the privilege in connection with a client list, general ledger, client ledger cards, invoices, canceled checks, and client trust accounts. The general rule is that a client's identity is not privileged information. This is a fair statement of the law. Courts have consistently held that a lawyer's fee records for a particular client generally are not confidential communications.4 However, an attorney-client communication that reveals the client's motivation for creating the attorney-client relationship or a possible litigation strategy is protected.5 The attorney-client privilege does not protect the disclosure of bank records merely because such records involve a law firm's client-trust-fund bank account.6
If an attorney refuses, based on the attorney-client privilege, to submit documents, the IRS is empowered to issue a summons (an administrative subpoena) pursuant to I.R.C. § 7602. The government can – and often will – petition the federal district court to enforce the summons pursuant to I.R.C. § 7404.
Underreporting of Income
The Guide makes clear that the detection of unreported or improperly deferred income is the primary issue. In this context, keep in mind that most attorneys are on the cash receipt and disbursement method of accounting.7
The auditor is directed to determine whether cash was on hand at the beginning and end of each year (and if so, how much) and to gather information concerning receipt of loan proceeds, receipt of referral fees from other attorneys, compensation in the form of cash or barter (including property interests, services, or other assets in lieu of normal compensation), foreign accounts or offshore interests, interests in other entities, and other income sources, including traditional or online consulting.
The Guide notes that accounting systems vary widely depending on the types of transactions conducted and the types of law practiced. For example, personal injury attorneys seldom receive any fee until a case is resolved, and the fee that is collected is usually a percentage of the amount awarded. Personal injury attorneys often advance client costs related to the litigation, such as court costs. Criminal defense attorneys, on the other hand, usually arrange for clients to pay their own court costs. Criminal defense attorneys, states the Guide, are sometimes paid cash or noncash compensation such as an entity interest, bartering, or other assets.
Primary Examination Areas
The Guide focuses on the following examination areas:
Operating accounts and client trust accounts. Auditors are directed to determine if fees were included in income and if they were included at the proper time. Some attorneys cash fee-payment checks or deposit fee-payment checks directly into personal or investment accounts but report taxable income by totaling deposits made into the general operating account. These misdirected fees would be omitted from income. Thus, states the Guide, attention should be given to checks that either are deposited into accounts other than the general operating account or are cashed. For the same reason, the Guide recommends the inspection of checks written to and from the trust account. For instance, an auditor would want to note if checks written to the trust account were not deposited in the trust account but were endorsed over to the attorney or for the benefit of the attorney. Likewise, an auditor would want to note if checks written from the trust account were not deposited into the operating account but were written out, or endorsed over, to the attorney or for the benefit of the attorney.
Determination of when a case settles. An attorney may attempt to defer income by allowing fees to remain in the trust account until the next year. Once the settlement is received, the attorney's fee is both determinable and available and therefore should be included in income. An effective audit step, states the Guide, is to analyze the source of funds remaining in the trust account at year-end, particularly if there is a large ending balance.
Ownership interest in an entity as payment for professional services. Some attorneys occasionally receive noncash payments instead of fees for services rendered. Examination of an attorney's records may lead to the discovery of noncash payments. Also, the verification of the basis of newer personal assets, such as a partnership interest or stock, may reveal that these items were noncash payment for services. For example, an attorney might accept a partial or entire interest in real property (usually by quitclaim deed) as payment for legal fees. Another example is an attorney who sets up a partnership or a corporation and accepts an interest in the formed entity as payment for legal services.
Unrecorded bartering income. Bartering is another source of noncash income. Attorneys may exchange their legal services for other services but not declare the value of the exchanged service as income. One method for determining the existence of bartering is to compare the attorney's work schedule with his or her claimed fees. If the attorney's workload for a client has increased or remained constant, but fee income from that client has declined, this might suggest the performance of services in exchange for noncash payments.
Cancellation of debt in lieu of payment for legal services. Subject to certain exceptions, cancellation of indebtedness is treated as taxable income to the borrower.8 Consider the lawyer who borrows money from a client. The lawyer performs legal services for the client in exchange for cancellation of indebtedness. Although required to do so, the client may not issue to the lawyer, or file with the IRS, a form 1099-C for the cancellation of indebtedness. Thus, the lawyer does not report the cancellation of indebtedness as income. This is a no-no.
Taxable income sources for bank deposits. Examiners, states the Guide, should seek to identify revenue from sources other than a law practice, such as speaker fees, board-of-directors compensation, and other outside professional activities. This income ordinarily would be subject to tax.
Constructive receipt of fees. The Guide directs examiners to look for the constructive receipt of fees, that is, a receivable that is available at the attorney's demand and on which there are no substantial limitations or limitations concerning the attorney's right of receipt. Holding back on billing for the sole purpose of deferring income is an example.
Overreporting of Expenses
Although the overreporting (or misreporting) of business expenses is not an issue unique to attorneys, the Guide points out areas for examiners to focus on that are somewhat unique to legal practices.
Reimbursement of expenses. Attorneys who take cases on a contingent-fee basis often pay on clients' behalf expenses for which they expect to be reimbursed. The Guide directs examiners to investigate the payment of these "advance client costs" and determine whether such payments are erroneously reported as current expenses. The IRS is concerned with timing issues; namely, the potential time between the year in which an item is deducted and the year payment is received. As a general matter, the timing of the deduction for "advance client costs" should be matched with the receipt (if any) of related client income.9
Deduction taken for personal items. The Guide suggests that examiners look for personal items deducted as business expenses. As an example, the Guide mentions an attorney with an interest in fine wines who deducts the wine purchases as office supplies.
Limitations on deductions. The Guide directs examiners to verify that the attorney maintains proper records that substantiate business travel, meals, entertainment, and gifts. Business meals and entertainment expenses are allowable only if such expenses are "directly related" to or "associated with" the conduct of business and then only at an allowance of 50 percent.10
Misclassification of employees as independent contractors. From time to time, lawyers or law firms misclassify workers as independent contractors when such workers arguably should be classified as employees. This is a long-standing gray area of tax law that is subject to a common law facts-and-circumstances analysis.11 The Guide provides information to help examiners spot the issue. For instance, the Guide notes that if a law firm issues forms W-2 and 1099 to the same individual, a classification issue may exist. The issue sometimes comes up within the context of part-time attorneys or outsourced legal work. The IRS recently has launched an initiative for employers "to come into compliance" by voluntarily reclassifying workers as employees at low cost in connection with covering past payroll-tax obligations.12 Lawyers and law firms that recognize and acknowledge misclassification issues, or are risk adverse, may wish to take advantage of this initiative.
Form 8300 cash receipt requirements. The IRS is taking this issue seriously and has dedicated a revenue agent to conduct Form 8300 audits in Wisconsin. Generally, any person in a trade or business who receives more than $10,000 in cash in a single transaction or in related transactions must file a Form 8300.13 The amount might be received in one lump sum or, if more than $10,000, in a series of payments that cause the total of the cash received within 12 months of the initial payment to total more than $10,000. The Form 8300 asks for the identity of the person from whom the cash was received, including the type of identification (for example, driver's license or passport), document number, date of birth, and taxpayer identification number. The IRS revenue agent will ask to see copies of the Form 8300 and evidence that the Form 8300 was timely filed with the IRS.
Generally, a taxpayer must file Form 8300 within 15 days after receiving a payment that triggers the filing requirement. If the first payment is not more than $10,000, the attorney is required to add the first payment and any later payments made within 12 months of the first payment. When the total cash payments add up to more than $10,000, the attorney must file Form 8300 within 15 days of the payment that brings the total over the $10,000 threshold. After the attorney files Form 8300, the attorney must start a new count of cash payments received from the client.
The attorney is required to issue a written statement to each person named on a Form 8300 that the attorney files. The statement must show the name and address of the legal practice, the name and phone number of a contact person at the firm, and the total amount of reportable cash the attorney received from the client during the year. The statement must indicate that this information is being reported to the IRS. The attorney is required to issue the statement by January 31 of the year after the year in which the cash is received that caused the Form 8300 filing requirement. The penalties for disregarding these requirements can be civil (including large monetary fines) or criminal.
State Taxation Issues
The IRS and the Wisconsin Department of Revenue (DOR) share audit determinations. If the IRS has audited first, the DOR likely will seek to "piggy-back" off the IRS adjustments. The DOR, moreover, may also seek to review purchase records to identify out-of-state purchases. If the out-of-state vendor has not charged sales tax, a use tax likely exists – and the DOR will have found a new adjustment.
Douglas H. Frazer, Northwestern 1985, is a shareholder in the Metro Milwaukee office of DeWitt Ross & Stevens S.C. He focuses his practice on tax litigation and controversy.
At the end of the examination, the IRS agent will issue a report. A "no-change" report, or a report with minor adjustments, is the document that the law firm would hope to receive. Absent that, or agreement with the adjustments, an appeal can be taken to the IRS Office of Appeals. After administrative remedies are exhausted, and depending on the procedural posture, a taxpayer can further contest the matter by filing suit in the U.S. Tax Court, the federal district court, or the Court of Federal Claims.
The best outcome, of course, is a speedy examination and an early conclusion. IRS examinations can be time and resource consuming. In defending examinations, a law practice, like any other taxpayer, should attempt to answer only the question asked – and in such a way as not to invite further questions. Law practices might try to keep records with this goal in mind. Although the initiation of an IRS examination is, by and large, out of taxpayers' hands, the expeditious conclusion of such an examination may be fully within our reach.
1 Saltzman, IRS Practice and Procedure ¶ 8.11 (revised 2d ed. 2003).
2 The Guide is available at http://www.irs.gov/businesses. The IRS closely protects the formula it uses to select returns for examination. As a general matter the IRS audits Schedule C sole proprietorships at a higher rate than entities. See, e.g., www.treasury.gov/tigta/auditreports/2010reports/201030105fr.pdf, and, generally, postings at the Transactional Records Access Clearinghouse (TRAC) sponsored by Syracuse University.
3 The statute of limitation for assessments is three years after the return was filed, I.R.C. § 6501(a), or six years in the case of a substantial omission of items. I.R.C. § 6501(e).
4 Matter of Grand Jury Proceeding, Cherney, 898 F.2d 565, 567 (7th Cir. 1990).
5 Id. at 568. An attorney should be able to redact such information from client invoices otherwise subject to disclosure.
6 Clarke v. American Commerce Nat'l Bank, 974 F.2d 127, 130 (9th Cir. 1992); Gannet v. First Nat'l State Bank of N.J., 546 F.2d 1072, 1076 (3d Cir.1976).
7 The cash and disbursements method of accounting treats income as recognized when received and expenses as recognized when paid.
8 I.R.C. § 108.
9 Generally, costs paid on behalf of a client are treated as a loan for tax purposes. Such costs are not deductible currently as a cost of conducting business. Recognition of such costs would be paired with the recognition of fee income or written off in the year the debt is deemed uncollectible. Hughes & Luce LLP v. Commissioner of Internal Revenue, 70 F.3d 16, 19-20 (5th Cir. 1995).
10 I.R.C. § 274(n).
11 See IRS Pub. 15A, Employer's Supplemental Tax Guide.
12 2011-41 I.R.B. 503-04.
13 These instructions are set forth in IRS Pub. 1544 (March 2009). Similarly, a person who deposits cash in amount of $10,000 or more is required to file a Form 4789 Currency Transaction Report. The government prosecutes attorneys who "structure" deposits to avoid this requirement. See, e.g., United States v. Needleman, No. 11 CR 449 (D. Md. Sept. 1, 2011) (guilty plea entered Sept. 1, 2011).