Attorneys practice their craft in a variety of ways. It’s their prerogative to charge clients and collect money as they see fit.
They generally use the cash method of accounting, which means they record income when received, and record costs when paid. But their returns must “clearly reflect” income, and the IRS knows how to spot inconsistencies. The bulk of this blog is derived from the IRS’ Attorney Audit Technique Guide, linked below.
First, I present four key ways that lawyers earn income. Following that are four ways that attorneys upset the IRS with various income delaying and avoidance tactics.
4 Common Fee Structures for Attorneys
- Flat fee. The lawyer is hired for a particular matter or a particular purpose. The fee is agreed-upon in advance. The fee may be paid up-front, in installments, or in advance (while billing against it). The attorney must report (and pay) tax on that fee income when the income is received (even if billing against it from a trust account).
- Annual retainer. An agreed, fixed fee covering a specific period of time.
- Contingent fee. An attorney earns an agreed-upon percentage of their client’s recovery. The attorney deposits the total recovery into a trust account from which her fee share is taxable when received, or constructively received, from the trust account.
- Referral fee. A fee generated merely by referring a case to another attorney who is better suited to handle the case.
4 Income Tactics That Distort Income Recognition
1) Not Reporting—or Hiding—Income
- Cashing checks instead of depositing them into an attorney operating account;
- Distributing legal fees directly into personal or investment accounts. The IRS is trained to scrutinize any check not deposited into the attorney’s operating account; and
- Not reporting cash payments in excess of $10,000. See IRS/FinCen Form 8300 as discussed in yesterday’s blog, 6 Common Tax Mistakes of Attorneys Relating to Expenses.
2) Using Trust Accounts to Defer Income
Some attorneys leave earned attorney’s fees in trust accounts until a later tax period. For example, an attorney earns a contingent fee in year 1, deposits it in a trust account, but withdraws the fee in year 2 without reporting the income in year 1. That’s an improper deferral of income, absent a restriction or limitation to the funds. An examining agent may scrutinize any sums left in trust accounts at the end of each tax year.
3) Not Reporting Noncash Payments for Legal Services
Attorneys may receive payment by property or barter. Client “ledger cards” (accounting history for each matter) may show receipt of payments from clients in property instead of cash. For example, an attorney may accept an interest in real estate (i.e. quitclaim deed) as payment for legal fees. Examining agents, called Revenue Agents, may inspect the basis of newer assets (i.e. partnership interests or stock), which may reveal payment in the form of property.
Similarly, an attorney may borrow money from a corporate client but pay it off in legal services. An attorney may record the loan obligation but not the relief of debt after performance of the legal work. Another example is the attorney who sets up a partnership or corporation and accepts an interest in the formed entity as payment for legal services.
Bartering for legal services is a taxable event to the lawyer. Examining agents may compare the attorney’s work schedule with claimed fees to see if the attorney is being paid in services.
4) Not Reporting Income that is Constructively Received
Consistent with deferral of income discussed in point two above, an attorney constructively receives income when she earns it, and has reasonable access to it. Some attorneys may decide to not physically collect the income until the next year. For example, earning the income in year 1, but not billing or collecting it until year 2. That income was constructively received—and therefore reportable—in year 1.
Lawyers are generally cash method taxpayers. “Accrual method taxpayers (i.e. most large corporations) have constructive receipt built into the accrual method,” writes Robert Wood, Esq., is his article, “Lawyers and the Constructive Receipt Doctrine.” With accrual method taxpayers, you book income when you “send the invoice, not when you collect it,” writes Mr. Wood. But since most lawyers already benefit from the cash method of accounting, the IRS is less tolerant of “pay me later shenanigans," says Mr. Wood.
What about contingent-fee lawyers who decide to structure their fee (receive it over time)? The lawyer should place that expectation into the client retainer agreement, and later in the settlement agreement.
General reasons why the IRS may audit anyone (not just lawyers), according to Nerd Wallet (7 Reasons the IRS will Audit You):
- Math errors
- Not reporting income (i.e. 1099’s)
- Claiming too many charitable deductions
- Claiming too many losses on a Schedule C
- Claiming too many expenses on a Schedule C
- Improperly claiming a home office deduction
- Significant rounding up of numbers (expenses)
As an additional resource, here’s a link to the IRS Audits web page. The IRS points out that random selection and computer screening are used, in conjunction with a statistical formula. The IRS compares our tax returns to “norms” of similar taxpayers. Here is the IRS' Attorney Audit Technique Guide.
The IRS may select your return for audit based on related examinations. For example, an audit of a business partner or an investor may lead to an audit of you.
Here is a list of what documents the IRS may request to see.
For IRS’s explanation of accounting methods, including the cash method of accounting discussed here, see Publication 538. Also, here is Investopedia’s description of a Cash Basis Taxpayer.
Feel free to send me a contact form or drop me a call to discuss your tax matter.