In many ways, running a law firm is no different from any other business. In particular, the law firm generates revenue by providing services to its clients and incurs various operating expenses, including payroll and rent, over the year.
There are some significant differences, however. First, legal practice is heavily regulated by states and professional associations. Accordingly, attorneys are bound by certain professional and other ethical obligations that only apply to other types of businesses. Second, some attorneys charge fees, if any, based on certain contingent liabilities, such as the success of litigation in a lawsuit. In other cases, the lawyer can instead opt for a fixed remuneration or a remuneration agreement with the client.
The IRS is well aware of these differences when it comes to auditing law firms and attorneys. In fact, the IRS has its own Attorneys Audit Technique Guide to help its auditors with these issues, including those relating to legal practice. This insight discusses some of the federal tax issues that may arise during an IRS audit of a law firm or attorney.
Bank accounts. Almost every company has at least one operational bank account. However, according to government rules and regulations, attorneys must keep client funds separate from their operational bank account in bank accounts. This rule is intended to ensure that client funds are properly booked and kept safe until they are transferred to the attorney or client.
In most cases, settlement awards and award proceeds are deposited into these escrow accounts (sometimes referred to as IOLTA). In these situations, the attorney generally controls the flow of funds to and from the escrow account. Because the attorney controls the escrow account, the IRS has recognized that attorneys can improperly attempt to move income earned from one tax year to a subsequent tax year. Regardless of when the funds are deposited into the escrow account, however, there is a comprehensive federal tax law that requires the attorney to include attorney fees earned in the year in which the fees are determinable and available. See Isaacson v. Comm’r, TC memo. 2020-17.
Extended customer costs. Personal injury attorneys typically charge their clients with legal costs with the expectation that they will be repaid in the event of a successful litigation. Since lawyers typically also use the accounting cash base, accounting bias would arise if lawyers could deduct litigation costs immediately upon payment. In light of this, the federal courts have generally concluded that these costs should be treated in a manner similar to federal tax loans. See e.g. B. Herrick v. Comm’r, 63 TC 562, 569 (1975). Therefore, with a few exceptions, they cannot be deducted as ongoing business expenses by the attorney. If the attorney is not reimbursed for the customer’s advance costs, the attorney may be able to claim a bad debt loss in the year in which these costs are found to be bad.
Employee versus independent contractor. All companies are required to withhold labor taxes and transfer them to the IRS if an employee is classified as an employee. In these cases, the employee is provided with a W-2 form stating their wages and the amount of withheld and paid labor taxes. Conversely, companies are not required to withhold and pay labor taxes if the employee is classified as an independent contractor. In these cases, the independent contractor will be given a Form 1099 and may be able to pay self employment tax on the compensation.
The IRS and federal courts consider several factors to determine whether a particular worker is an employee or an independent contractor. In general, the most important factor is whether the company has the right to direct and control the worker who provides the services. That is, if the employee is subject to the will and control of the company not just what to do, but also how to do it, the employee is generally characterized as an employee for federal tax purposes.
Because of the nature of their work, lawyers generally have a greater degree of control over their work than other types of workers. As a result, determining whether an attorney is an independent contractor or an employee can be more difficult than that of employees in other companies. However, the federal courts have recognized that the “right to scrutiny” test is generally a lower bar when applied to professional services such as lawyers. See James v. Comm’r, 25 TC 1296, 1301 (1956); Azad v US, 388 F.2d 74, 77 (8th Cir. 1968) (“Given the nature of the services provided by … professionals, it would be totally unrealistic to suggest that an employer should take control over the manner in which the specialist carries out his activities. “).
Attorney-client privilege. In general, lawyers are required to withhold documents and other information under what is known as the “lawyer-client privilege”. The lawyer-client privilege doctrine was originally developed to protect the honor of a lawyer – that is, old common law recognized that clients should be able to tell their attorneys about secrets without the risk of that others know about it. Federal courts today recognize attorney and client law as a necessary means of encouraging clients to provide full information to their attorneys.
When conducting an attorney or law firm exam, the IRS may request fee agreements and client identities. Some federal courts have recognized that such information is not subject to attorney privilege as this information does not constitute confidential communication between attorney and client. See e.g. B. In re Colton, 201 F. Supp. 13, 15 (SDNY 1961), aff’d 306 F.2d 633 (2d Cir. 1962). Therefore, IRS auditors are instructed to issue a subpoena for such information under Code Section 7602 in the event a lawyer or law firm refuses to provide such information during the audit. Of course, the attorney or law firm can bring legal and tenant law and other defensive measures against the subpoena if the IRS tries to enforce it in court.
Conclusion. As shown above, the legal practice – like any other business – is not immune to IRS scrutiny. To the extent that an attorney or law firm is subject to an IRS audit, the attorney or law firm should ensure that they have carefully considered the general audit questions discussed in this insight.