IRS Attorneys Audit Technique Guide – IRS Focuses on Attorney Audits

THOMAS E. PIERCE, CPA

The IRS recently released an updated Attorneys Audit Technique Guide to help its examiners effectively audit attorneys. While no one enjoys being the subject of an audit, the guide provides some valuable insights into the areas that auditors are likely to focus on, which, in turn, can help law firms avoid costly missteps.

Related Read: Don’t Panic: How to Prepare for an IRS Audit

Areas of interest

The revised guide identifies several issues that merit examiner attention, including the following:

Segregated Client Trust Accounts
The guide instructs examiners that attorneys should be able to provide an accounting of any amounts in segregated trust accounts. They should keep detailed schedules with the client’s name, the type of asset held in trust and its value. The balance sheet should reflect a liability equal in value to the total amount of the schedules and trust account balances.

The guide also notes that attorneys may deposit fees into a personal or business account or bypass bank accounts entirely. Because many attorneys compute their gross income based only on withdrawals from the client trust account, auditors will examine deposits into all bank accounts, personal living expenses and other cash expenditures for signs of unreported income.

Deferred Income
The guide suggests examiners stay on the alert for attempts by attorneys to defer income. For example, after a case has been settled,  an attorney may leave the related fees in the trust account until the next tax year.

But the attorney’s fee is both determinable and available once the settlement is received and therefore, should be included in income for that tax year. Auditors are advised to analyze the sources of funds remaining in the trust account at year-end, particularly if the account has a large ending balance.

Advanced Client Costs
Attorneys, especially those who work on a contingency basis, may advance costs and expenses for clients. If they use the cash basis method of accounting, they might deduct these expenses when paid and include the recovered costs in income on receipt. This can distort income, as it can take years to resolve the related cases.

The guide points out that courts have found that costs paid on behalf of a client should be treated as loans for tax purposes — and not deducted as business expenses. You are generally allowed a current deduction only for those client-reimbursed costs that are allocated to normal operating expenses that would reasonably be incurred even if not charged to a specific client. The subsequent reimbursement should be treated as income in the year of reimbursement.

Employee Misclassification
Attorneys may improperly treat their receptionists, secretaries, paralegals or law clerks as independent contractors for tax purposes. Although the guide directs examiners to refer this issue to the Employment Tax Specialist Group, it devotes several pages to providing background to help examiners identify it.

An employer-employee relationship exists when the business for which services are performed has the right to direct and control the worker. The “control” refers to both the work to be done and how it must be done. The employer does not need to actually direct or control how the services are performed if it has the right to do so. According to the guide, paralegals and clerks under an attorney’s close supervision and control generally should be classified as employees. And close scrutiny will be given in cases where the same party receives both W-2 and 1099 forms.

Get Ahead of the Game

You may not be able to avoid an IRS audit, but you can take steps to reduce the risk of negative outcomes. As the guide notes, “A good accounting system for attorneys will include strong internal controls to monitor both fees billed and costs and expenses advanced for clients.” ORBA can help you establish the strong and effective controls you need.

Sidebar: Preparation can go a long way

Providing the IRS with the necessary documentation upfront can both expedite the audit process and demonstrate a commitment to transparency. The new Attorneys Audit Technique Guide has a nonexclusive list of documents that the auditors will need, including:

• All books and records (for example, appointment books, cash receipts and disbursements journals);
• Bank statements, canceled checks and deposit slips for all personal, business and trust accounts, including reconciliation statements for the last month of the calendar year for all business and trust accounts;
• Investment records, account statements and other investment information;
• Work papers associated with the tax return;
• Client listing;
• Forms 1040 (U.S. Individual Income Tax Return);
• Forms 8300 (Report of Cash Payments Over $10,000 Received in a Trade or Business);
• Quarterly tax returns;
• Forms W-2 (Wage and Tax Statement), W-4 (Employee’s Withholding Certificate) and 1099 (Miscellaneous Income) received and issued;
• Invoices for acquisitions and dispositions of capital assets and verification of basis for depreciation purposes; and
• Records substantiating travel and entertainment expenses.

The auditors will inform you in advance of the periods for which they require each type of document.

For more information, contact Tom Pierce at [email protected] or 312.670.7444. Visit ORBA.com to learn more about Law Firms and Lawyers Group.

What Is It Worth? Understanding Valuations in Law Firm Acquisitions

ROBERT G. SWENSON, CPA, MST

Merger and acquisition activity remains steady in the legal industry. If your firm is targeting another, you have many questions to ask and avenues to pursue as part of due diligence. Among the most important is the value of the other firm, taking into account such factors as its assets, liabilities and ability to generate revenues in the future.

Related Read: Merger Fever: Should Your Firm Get Hitched?

Law firms versus other businesses

Attorneys often work with valuation professionals to obtain appraisals of businesses for clients, whether for divorce proceedings, shareholder lawsuits, buy-sell agreements or other purposes. But valuing law firms can prove trickier than valuing typical businesses. For example, a widget factory can typically be expected to continue to generate a certain level of revenue after it is sold. That is not necessarily the case with law firms.

Clients (and referral sources) tend to be more loyal to their specific attorneys than to the actual firms. In addition, the merger with or acquisition of another law firm could lead to conflicts of interest that limit — or even lead to the loss of — revenues. For these reasons, you must choose an appraiser who has extensive experience valuing law firms.

Valuation methods

The legal industry does not have a long history of valuing individual firms, meaning valuators cannot just turn to a comprehensive database to “plug and play” the numbers and reach a reasonable, supportable estimate. Instead, they generally apply one or more of the following four valuation methods:

1. Asset-Based
   This approach has the benefit of being straightforward — the appraiser deducts a firm’s liabilities from its assets to arrive at a net value. But it ignores earnings and cash flow, two critical indicators of a law firm’s financial health.
2. Comparable Transactions
   The appraiser looks to sales of similar firms in terms of geography, practice areas, size and financial performance to estimate value. It is usually difficult to access the necessary data, though, and even harder to uncover behind-the-scenes circumstances that can affect sales prices. However, comparable transactions can be helpful to back up or contradict values produced by other valuation methods.
3. Rule of Thumb
   The rule-of-thumb method applies a multiplier (generally, 0.5 to 3.0) to average gross fee revenues or net income over the past five years or so. The multiplier figure reflects the likelihood of revenues remaining steady or increasing going forward, as determined based on factors such as the number of clients, transferability of client relationships, amount of repeat business and reliance on large clients. The approach is a bit simplistic, though. For example, if the appraisal focuses solely on revenues, it does not reflect how well the firm is managed, which will affect profits.
4. Discounted Cash Flow
   Appraisal experts frequently favor this method, which is based on the targeted firm’s future financial performance. It uses historical financial data to predict future cash flows and applies a growth rate (or expected rate of return) to them, discounting the result to net present value.

Firm-specific adjustments

Law firms have individual characteristics that will not easily fit into a valuation formula. For example, a firm’s brand identity, growth potential, fee structures, client satisfaction and non-attorney staff all have the power to boost or undermine its value.

A qualified appraiser will make adjustments for such factors. The appraiser will also adjust for unusual or nonrecurring items such as professional fees, non-arm’s length transactions and capital projects.

Related Read: Law Firm Mergers: Once the Deal Closes, the Hard Work Begins

Choose wisely

An attorney would not hire just any appraiser to conduct a client’s business valuation. You should exercise equal care when hiring for your firm’s purposes.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about Law Firms and Lawyers Group.