When the IRS examines returns of attorneys, there are specific issues they look for. Thus, if you should be chosen for an audit, it’s important that we appropriately document your compliance with these issues. This will help reduce additional costs to you in the future should an audit arise.

1. IRS prior 3 year analysis

If you are chosen for an audit, the IRS will perform a comparative analysis of at least three years during the pre-audit planning phase. During this phase, they will determine if there are any unusual changes in income, expenses and taxes paid for those prior years. Thus, it is important that I review your last three year tax returns so we can document any unusual changes such as I just described.

2. Attorney Specialties

The IRS will also build its audit around an attorney’s specialty. For example, criminal and immigration attorneys may receive more cash for services than other types of lawyers, as their clients may not use U.S. banks. Thus, the IRS will look at Currency Transaction Reports posted to the Information Returns Program (IRP) transcripts to see if an attorney has received large cash payments. They will then track those payments back to the attorney’s tax return. IRP transcripts provide information about payments an attorney receives that are reported to the IRS. For example, these transcripts provide information about reported Forms 1099, Currency Banking Retrieval System report summaries, social security payments, rental income, property sales, and interest and dividend payments.

3. Costs Advanced on Client Behalf

If you pay litigation expenses on behalf of your clients, the IRS will verify whether or not these payments have been deducted. Courts have determined that costs paid on behalf of a client are to be treated as in the nature of loans for tax purposes. They are not deductible as a current cost of conducting business. The costs are those of the client and not the attorney since there is an expectation of reimbursement. A bad debt deduction may be taken in the year that any costs are determined to be uncollectible.

4. Bookkeeping System Review and Analysis

The IRS will also want a thorough understanding of your bookkeeping system and internal controls, especially as they relate to any trust accounts that you control. Your business should have a written accounting manual which describes these procedures. If you have one, I will want to review it. If you do not have one, I can help you prepare one.

5. Earned Income Contained in Trust Accounts

If you control trust accounts into which settlement and award proceeds have been deposited, the IRS will check to see if you have attempted to defer earned income by allowing fees to remain in the trust account until the following year. Generally, once a settlement is received, the attorney’s fee is both determinable and available and therefore includible in income. However, if there are some extenuating circumstances which preclude income recognition, we need to appropriately document those circumstances.

6. Non cash Transactions

If you receive noncash compensation, for example in a bartering transaction, the IRS will want to see documentation of how such compensation has been valued and recorded in income.

7. Entertainment and Meals Deductions

The IRS pays particular attention to deductions for entertainment and meals. Generally, to be deductible, entertainment must meet either a “directly related” or “associated with” test. The “directly related” test generally cannot be met where there was little or no possibility of engaging in the active conduct of trade or business. This would apply, for example, in situations where you were not present. However, even if you were present, the rules state that there is little or no possibility of engaging in business where distractions are substantial, such as when the meetings or discussions occur at nightclubs, theatres, sporting events, cocktail parties, or social gatherings. In one instance, an attorney gave a party at a country club that was attended by some clients, persons who referred clients, and other business associates. The attorney could not deduct the expense incurred for the party because no business was discussed. The business purpose and business discussions must be properly substantiated. Any expenses rejected by the IRS because of improper, ill-kept, or non-existent records can result in substantial penalties.

8. Personal Service Corporations (PSCs)

When an attorney works for a personal service corporation, the IRS will scrutinize whether or not there are any constructive dividends or additional wages as a result of the corporation paying the attorney’s travel, meal, entertainment, and other personal expenses. If you have received a lot of reimbursements of such expenses, we need to ensure that the business purpose is appropriately documented.

9. Employee Status of Independent Contractors

Finally, if you treat receptionists, secretaries, paralegals, or law clerks as independent contractors, there may be some potential employment tax exposure. If this is the situation in your case, we need to document the facts that support such treatment.