Certified Specialist In Taxation Law
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Certified Specialist In Taxation Law |
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ARE YOU PREPARED FOR AN AUDIT BY THE IRS ? ?
Procedures contained in an audit manual (IRS Market Segment Specialization Paper for Attorneys, "the manual") are used by the groups in the conduction of their audits. It addresses a wide variety of items, including how returns are identified, record keeping, pre-audit analysis, audit of gross income and expenses, employment tax issues, and how to conduct an interview with an attorney. Referrals, both in-Service and out-Service, and self-generated work provide the best leads for audits, as the manual suggests. Audits of other individuals, third party information, and public records, such as disciplinary actions, magazines, periodicals and other media will be used as leads for audits. Sole proprietorships are at a greater risk for selection. High income attorneys who file late tax returns may also be increasing their audit risk. The auditor will conduct a pre-audit analysis. Resources the auditor will use to discover information include the Department of Motor Vehicles, U.S. Coast Guard, Fictitious Names Filings, County tax records, Court Records, Federal Aviation Agency (FAA) records on aircrafts, and the Department of Corporations. These searches may show a higher economic standing than has been disclosed. Bartering transactions may also be uncovered. Court Records of divorces can be especially useful because of the financial information filed with the court. The auditor will also utilize certain tracking mechanisms which track cash transactions (ie., form 8300). 1099 information returns will point out details about interest and dividend paying accounts, rental income and property sales, and 1099s issued by payees, all which can lead to the discovery of unreported income or assets. Attorneys should pay close attention to all 1099s received. Four main areas will be the subject of the audit. The auditor will examine the trust accounts, travel and entertainment expenses, employment issues, and client advances. The auditor will also take a look at all other expenses. The auditor will always ask for the bank statements and canceled checks on all trust accounts to 1) determine whether personal expenses have been paid through the account, 2) whether fees held in the trust account are being held to avoid reporting of income, 3) whether payments from the client trust account have been reported on a 1099, 4). whether the attorney is attempting to avoid involuntary collection action, and 5) whether fees earned have been transferred into the operating account and reported as income. The auditor will inspect the endorsements on checks written out of the trust account. Special attention will be given to checks that are deposited into non-business accounts or that are cashed. Inspection of disbursements to other attorneys from the client trust account can lead to the examination of other payees. The auditor will give close scrutiny to all funds entering and leaving the trust account. Abuses can be discovered during the examination of the trust account, such as prepayments deducted by clients which are not included in the attorney's income or deductible prepayments which are used for the client's personal benefit rather than for legal services. Travel and entertainment will be examined. Extensive documentation should be kept on these expenses, including calendars, receipts, itineraries, and well documented and detailed receipts to avoid an audit adjustment. The agent will segregate checks to individuals to ascertain the nature of their services to determine whether persons classified as independent contractors should be classified as employees. Severe payroll taxes and penalties can result when someone treated as an independent contractor is reclassified as an employee. When an attorney treats receptionists, secretaries, paralegals, or law clerks as independent contractors an employment tax issue will certainly exist. The auditor will treat paralegals and clerks under an attorney's close supervision and control as employees. When other attorneys provide services, the issue will be less clear. If the agent reclassifies an independent contractor or contractors as employees, section 530 of the Revenue Act of 1978 may relieve the employer of employment tax burdens. Generally, the relief may be available if 1) the employer had a "reasonable basis" for not treating the workers as employees, 2) all relevant Federal 1099 forms were filed timely ("reporting consistency rule"), and (3) the employer has not treated any individual holding a substantially similar position as an employee for employment tax purposes ("substantive consistency rule"). See Rev. Proc. 85-18, 1985-1 C.B. 518, for guidance in implementing the provisions of section 530. Attorneys doing business through a professional corporation cannot pay themselves as an independent contractor. Under IRC sections 3121(d) and 3401(c), an officer of a corporation is an employee. Consequently, the corporation can be liable for employment taxes on an officer even if a salary was not paid. Attorneys who take cases on a contingency basis will be subjected to an adjustment for costs and loans advanced if they take a current deduction for them. Frequently, attorneys deduct these expenses and loans when paid, and recover the costs and loans as income when reimbursed. This is an incorrect manner of handling these expenditures. Courts have determined that advances and costs paid on behalf of clients are to be treated as loans for tax purposes, deductible when recovered or uncollectible. Expenses subject to deferment include costs advanced on ongoing cases (ie., medical records, reports, interpreters' fees, witness fees, deposition costs, filing fees, and investigation costs). An interesting case discussing the complexities and vagaries of deducting client costs is Boccardo v. Commissioner, KTC 1995-690 (9th Cir. 1995). The case discusses the difference between "gross fee" contracts and "net fee" contracts. The Ninth circuit, reversing the Tax Court, allowed Boccardo a current deduction for amounts advanced under Gross fee contracts. Most personal injury attorneys deduct the costs advanced on cases when paid. Resistence to deferment occurs because of the perceived accounting burden and because deferring the deduction of cash paid on cases in process may leave the attorney without cash to pay the taxes on the money advanced. Actually, with an accounting program, such as QuickBooks Pro, tracking advanced costs is not difficult. QuickBooks Pro has a knowledge base on accounting for legal firms. Criminal and immigration attorneys often receive fees in cash. The auditor will utilize different methods designed to uncover unreported income in these cases. The auditor will be interested in the attorney's life style and use methods such as pre-contact analysis and an extensive interview of the attorney. Such techniques tend to disclose the existence of assets or of spending that would be inconsistent with the income shown on the return. The use of third-party contacts and information will also be utilized. Real estate attorneys will be examined for the possibility of bartering transactions because they may receive an ownership interest or a second trust deed for services rendered. Attorneys who continue to do business through a regular C corporation should determine whether or not conversion should be made to an S corporation. Audit adjustments when the attorney does business through a C corporation can result in more tax than had the attorney been an S corporation. Attorneys in private practice should have an adequate accounting system with good internal controls. It would also be wise for the attorney to address issues discussed above and in the manual to determine areas of potential non-compliance and corrective action that may need to be taken. The attorney should also bear in mind that the auditor may refer matters to the State Bar or criminal division of the IRS if warranted.
Michael D. Daniels
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