Tax Audits of Attorneys and Law Firms
The IRS releases Audit Technique Guides (ATGs) that explain and provide tips on how to navigate unique issues IRS auditors may come across when examining a business in a particular industry, including the legal field. As attorneys are well aware, knowing what information the opposing party has in their arsenal can be very important in disputes.Pre-Contact Analysis and interview
Prior to contacting a taxpayer, the ATG instructs auditors to conduct a pre-contact analysis. The ATG recommends IRS auditors use Accurint, which is a tool created by LexisNexis that allows users to identify and locate people, businesses, and assets. IRS agents also have access to the Web Currency and Banking Retrieval System that provides information disclosed on the following reporting forms:
- FinCEN Form 104, Currency Transaction Report, must be filed by financial institutions, including check cashers and wire transfer companies, to report cash transactions (deposits and withdrawals) greater than $10,000.
- FinCEN Form 105, Report of International Transportation of Currency and Monetary Instruments, must be filed by individuals who carry more than $10,000 in cash and/or monetary instruments into or out of the U.S. Form 105 must also be filed if an individual physically sends or receives, through the mail or otherwise, more than $10,000 in cash and/or monetary instruments.
- FinCEN Form 8300, Report of Cash Payments Over $10,000 Received in a Trade or Business, must be filed by businesses that receive more than $10,000 in cash and/or monetary instruments. The form requires identification of the customer, description of the transaction, and method of payment.
- FinCEN Form 103, Currency Transaction Report by Casinos, must be filed by casinos to report cash received or disbursed that exceed $10,000 in one day.
- FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), must be filed by individuals and entities that have a financial interest or signature authority over foreign financial accounts with an aggregate value of more than $10,000.
The ATG explains, attorneys that are more likely to be paid directly by their clients are more likely to receive cash. According to the ATG, these attorneys include criminal defense attorneys, estate and trust attorneys, real estate attorneys, and tax attorneys.
IRS agents also have access to Return Preparer Coordinators that maintain lists of tax returns completed by a particular preparer, and Information Returns Processing transcripts that identify payments made to a taxpayer that are reported to the IRS. Attorneys and law firms should keep in mind IRS agents may gather and use any information they find on the Internet as well.
After gathering as much information as possible, the ATG instructs IRS agents to conduct a comparative analysis of at least three years to identify any unusual changes in income, expenses and taxes paid. The pre-contact analysis also enables IRS agents to adjust sample Information Document Requests and interview questions accordingly.Attorney-Client Privileged Documents
The ATG warns IRS examiners that attorneys may refuse to provide documents and other information by claiming attorney-client privilege. The ATG explains in detail when and how the attorney-client privilege applies, and provides the following examples from case law:
- Fee arrangements are not privileged because they do not constitute a confidential communication between an attorney and a client. In re Colton, 201 F. Supp. 13, 15 (S.D. N.Y. 1961), aff’d. 306 F.2d 633 (2nd Cir. 1962).
- A client’s identity is not privileged information unless disclosure of the client’s identity is “in substance a disclosure of the confidential communication in the professional relationship between the client and the attorney.” In re Osterhoudt, 722 F.2d 591, 593 (9th Cir. 1983).
- A client’s reason for retaining an attorney is privileged. See In re Grand Jury Proceedings (Jones), 517 F.2d 666, 674-75 (5th Cir. 1975).
- Bank records are not privileged just because they involve a client trust account. Gannet v. First National State Bank of New Jersey, 546 F.2d 1072 (3rd Cir. 1976).
- Documents and information required to be kept by statutes are not privileged. United States v. Goldberger & Dublin, P.C., 935 F.2d 501 (2nd Cir. 1991).
The ATG states that if an attorney continues to refuse providing documents, a summons may be issued pursuant to IRC § 7602, unless the case has been referred to the Department of Justice.Gross Income
When auditing an attorney’s gross income, the ATG instructs IRS examiners to pay particular attention to client trust accounts and to reconcile such accounts with any other bank accounts of the attorney. IRS examiners are advised that disbursements from client trust accounts to the attorney and/or law firm are income or expense reimbursements. Additionally, the ATG explains that IRS agents should analyze the source of any funds remaining in a client trust account at year-end to determine if the attorney is attempting to defer recognition of income.
Attorneys should also be aware that the ATG advises IRS agents to review the basis (or cost) of relatively new assets, because some attorneys may receive such noncash payments for services rendered. Therefore, an IRS examiner auditing an attorney or law firm may inquire into property interests, partnership interests, and shares in a corporation. In addition, the ATG states repayment of loans may be unreported income as some attorneys and law firms borrow from their clients and perform legal services to repay such loans.Expenses
To drum up business, many attorneys entertain clients at restaurants, golf clubs, and similar businesses. Such entertainment expenses were deductible if the expense was directly related to the taxpayer’s trade or business, or if the expense was incurred before or after a business discussion for a clear business purpose. Unfortunately, section 13304 of the Tax Cuts and Jobs Act (TCJA) eliminated the deduction for entertainment expenses that are directly related to a taxpayer’s business or have a business purpose. They are, however, still deductible if they fall under the one of the nine exceptions under IRC § 274(e):
- Food and beverage expenses for employees;
- Expenses treated as compensation;
- Reimbursed expenses;
- Recreational expenses for employees;
- Expenses directly related to employee or stockholder business meetings;
- Expenses directly related and necessary to attendance at a business meeting or convention of business leagues, chambers of commerce, real estate boards, and other IRC § 501(c)(6) organizations;
- Expenses for goods and services made available by the taxpayer to the general public;
- Expenses for goods and services that are sold by the taxpayer to customers in a bona fide transaction; and
- Expenses includible in income of persons who are not employees, unless the amount must be included in any information return filed by such taxpayer. (This includes amounts that would be required on an information return had the amount been at least $600.)
Fifty percent of food and beverage expenses are still deductible under the TCJA if the expense is not lavish or extravagant and the food or beverage is provided to the taxpayer or a business associate. Meals provided during an entertainment activity are also deductible as long as the food or beverages are purchased separately from the entertainment, or the cost is stated separately from the cost of the entertainment on an invoice/receipt. However, pursuant to the IRS’ Notice 2021-25, business meal expenses paid or incurred after December 31, 2020 and before January 1, 2023 are fully deductible if purchased from a business that sells food and beverages for immediate consumption.
Attorneys should be aware that advanced client costs are not deductible because they are intended to be recovered from the settlement or award. Therefore, courts treat these expenses as loans. Costs paid on behalf of clients that may not be deducted include travel expenses, costs of medical records, expert witness fees, filing fees, and deposition costs. If it is determined that the costs are unrecoverable, attorneys and law firms may then deduct such costs as bad debt.
What if an attorney or law firm improperly deducts advanced client costs in a tax year for which the statute of limitations on assessment has expired? A judicially created doctrine called the tax benefit rule provides, “a taxpayer who deducts an expenditure in one year resulting in a reduction of taxable income must include in income any recovery of that expenditure in a later year.” Unvert v. Commissioner, 656 F.2d 483 (9th Cir. 1981). Therefore, instead of making an adjustment that disallows the deduction, the IRS may make a corresponding adjustment that increases your taxable income in another year.
As attorneys, we understand you have enough on your plate. Let the Ben-Cohen Law Firm handle your tax issues. Your matter will be handled by a tax controversy attorney and CPA who has practiced tax law for over two decades. Call us now at (310) 272-7600 or send us a message.