The IRS over the years has gained considerable experience and expertise in how to screen for audit and conduct audits of attorneys. In March, 2011, IRS issued a revised Attorneys Audit Technique Guide (Guide) for use by its field agents and office audit examiners. The IRS says of these guides in general:
“…Audit Techniques Guides … help IRS examiners during audits by providing insight into issues and accounting methods unique to specific industries…. (The Guides) 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, interview techniques and evaluation of evidence.”
The Guide in an introductory note also states: “This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relief upon as such.” Nonetheless, the revised guide for attorneys is helpful to tax lawyers and attorney clients in that it offers and insight into what IRS is looking for and how it goes about finding what it is looking for. The Guide should not be viewed as the final word on any tax matter, however; it mostly presents the IRS side of the story which often is not the whole story for any tax issue.
Attorneys are likely candidates for audit due in part to their occupation, high earnings and occasional receipt of cash in payment of fees, more common in some practice areas such as criminal and immigration law. Lawyers also attract attention when unreasonably low wages are paid by Professional Associations or LLCs that have elected S Corporation status.
The Guide has three fairly comprehensive chapters covering:
Overview of Attorney Returns
Chapter 1, Overview of Attorney Returns
The Guide discusses:
How lawyers operate and get paid including advance fees, cash fees and contingent fees.
Typical books and records and methods of accounting for law firms
Structure of law firm accounts and general and segregated trust accounts.
Other revenue sources attorneys may have
Client related expenses and costs.
IRS view of impact of attorney client privilege on audits. The Guide states that the attorney client privilege will not shield the identity of a client or how many hours have been charges or how much he has paid. The IRS acknowledges that the privilege may apply where documents sought would reveal the client’s motive in seeking counsel or litigation strategy, and nature of services provided. The burden of proof is on the attorney arguing that the material is privileged.
IRS successful use of its summons power to obtain fee ledgers, fees and expenses but overly broad or vague requests can be challenged.
Information required to be reported on Forms such as Form 8300, Report of Cash Payments Over $10,000, is generally not viewed as privileged by IRS unless the “last link” doctrine applied.
The Guide contains a listing of cases supporting its views on these matters.
Chapter 2: Audit Steps
Prior to the first meeting, IRS searches all available public and IRS data bases to inquire about the practice, licenses, assets, other businesses, and income of the selected attorney or firm. The agent will conduct Accurint® (a suite of Lexis Nexis® locate and research tools available to government, law enforcement, and commercial customers) searches and search the internet and the Web Currency and Banking Retrieval System for CTRs, for example, regarding International Transportation of Currency (FinCEN Form 104) and Currency Transaction Report by Casinos (FinCEN Form 103).
IRS conducts a comparative analysis of at least 3 years looking for unusual fluctuations in income.
At the initial interview, IRS asks questions designed to probe for possible unreported income, including:
o How much cash was n hand at the beginning of the year? This is a trick question because some may answer none even if they have a cash horde, which may be asserted as a defense should IRS attempt to reconstruct income of the attorney under the “net worth method.”
o Were loan proceeds received?
o Were referral fees received?
o Were any fees paid other than with cash (bartering)?
o Are there any foreign accounts, interests in other business?
o What websites does the attorney have, what on-line sources of income and are other on-line services provided?
The Guide provides in Exhibits 2-1 and 2-2, a Sample Information Document Request and Bank Document Request List for the agent to use which is quite comprehensive and may shock the attorney who is not a tax practitioner.
The Guide has an Initial History and Business Overview checklist for the agent to use in interviewing the selected attorney. The interview covers: Practice History, Payroll Functions, Practice Operational Matters, Forms 8300 Compliance, Books and Records, Internal Controls, Bank Accounts, Income Probe (previously mentioned), and Questions Regarding Specific Expenses.
Chapter 3: Audit Issues
Gross Income: The Guide in detail covers the various kinds of fees attorneys may receive and possible tax consequences, including specific matter and annual retainers, contingent and referral fees. IRS will examine billings and client ledger cards to ascertain if there is an unexplained discrepancy between time charges and billings. IRS may compare bank deposits with gross fees reported. Generally, IRS views retainers as income when received. But a client’s separate check for costs made payable to and deposited into a lawyer trust account, contractually to be used exclusively for non-overhead client costs, with unexpended funds being returned to the client, should be treated as the client’s funds and not as income to the lawyer.
Trust Accounts: The Guide covers at length attorney trust accounts and how client costs and receipts should be handled for tax purposes. The agent will review all trust account deposits and disbursements. IRS will treat advanced client costs as non-deductible loans (most common for PI lawyers), except for costs properly allocated to general overhead or where nominal or advanced on quick turnover cases, or when the attorney can prove low likelihood of recovery. The Guide covers how some lawyers will use the trust account to camouflage deferred or unreported income or as a “rainy day savings account.”
Entertainment Expenses: The Guide admonishes agents to review required documentation for all travel and entertainment expenses and make sure that documented expenses are directly related to or associated with the attorney’s practice as required by the cited provisions of the Internal Revenue Code and Regulations. Further, the Guide stresses that actual business must be discussed at events or lunches in an environment suitable for business discussions.
Personal Expenses: the Guide admonishes agents to look for the payment of personal expenses by the attorney’s professional corporation or partnership.
Not discussed at length in the Guide but a prime issue for IRS now, is the use of S Corporations (whether corporation or LLC) by professionals to escape payroll taxes by paying unreasonably low compensation and taking distributions not subject to Social Security and Medicare taxes. This practice welcomes audit, may result in harsh civil penalties and could lead to criminal charges in egregious cases.
Conclusion: What’s a busy lawyer to do?
Use the Guide before being selected for audit to organize your attorney accounting records and back up documentation and trust accounting procedures (a good idea to avoid problems with the Florida Bar as well).
File your returns on time as delinquent returns invite audit and habitual late filing can lead to criminal charges and disbarment.
When audited, seek tax representation. Only a fool self-represents and only a mad fool self-represents in a tax case. If you do chose to represent yourself stay calm, answer only questions asked and don’t try to bully the agent. Bullying may work with a weak opposing counsel but will get you into deep trouble with IRS. When seeking representation consider whether the likely audit issues are more accounting or legal in deciding to employ a CPA, tax lawyer or both. Discuss privilege issues only with an attorney.
Don’t inadvertently become subject to the jurisdiction of the IRS Office of Professional Responsibility. For example a divorce lawyer who writes into a Martial Settlement Agreement that husband will pay former wife’s post divorce auto expenses from his company that he get a deduction and she supposedly avoid paying tax is possibility running afoul of Circular 230 Section 10.8 which provides in part:
(c) Application of rules to other individuals. Any individual who for compensation prepares, or assists in the preparation of, all or a substantial portion of a document pertaining to any taxpayer’s tax liability for submission to the Internal Revenue Service is subject to the duties and restrictions relating to practice in subpart B, as well as subject to the sanctions for violation of the regulations in subpart C.
Sanctions from IRS are serious because the violation could be viewed by the Florida Bar as an ethical violation. Even worse, an indiscretion of this sort could be viewed by the Department of Justice as violating 18 U.S.C. 371 (often called a Klein Conspiracy after the name of the infamous case) or as aiding and abetting under Internal Revenue Code Section 7206(2).
Generally, IRS has become more intrusive into the lives of all taxpayers. The following parody song lyric explains the strategy:
GETTING TO KNOW YOU AT IRS
(To tune of “Getting to Know You,” by Rodgers and Hammerstein, from Broadway musical “The King and I”).
Getting to know you,
Getting to know more about you
Letting you know you
Are in our view
Getting to know when
You earn a nice fee or interest
With a keen interest
We’re watching you
When you are filing
Making you feel quite uneasy
Doing it so you
Pay more not less
Haven’t you noticed?
Everything you do is noticed
We have computers humming a wry song
Tracking you in the tax throng