IRS Audit Guides on Attorneys and Consultants

By Sidney Kess, CPA, J.D., LL.M

The IRS has about four dozen guides for its examiners to use when auditing tax returns. The guides are instructions to auditors, but are very instructive to taxpayers who want to know what the IRS is looking for. Being forewarned is forearmed in auditing-proofing a return to the extent possible. Here are some of the key points found in these two new audit guides.

Audit guide on attorneys

In March of this year, the IRS released a new guide entitled Attorneys Audit Technique Guide (3/11). The guide explains to auditors how lawyers operate and what to look for in income and expenses. The guide is employed regardless of the entity that is used to provide the services (e.g., sole proprietorship, partnership, corporation, limited liability partnership). However, different entities present unique issues to be considered, such as whether adequate compensation is taken by owners from practices that are S corporations.

Records. The guide tells auditors the type of attorney records to review in order to find information about income and expenses. These include:

• Appointment book
• Client card index
• Receipts journal or Daily log
• Disbursements journal, book, petty cash journal, or other record showing a breakdown of regular expenses paid from bank accounts, as well as disbursements made from client trust funds. These disbursement records should provide a mechanism from which disbursements chargeable to a specific client can be noted on their records for billing purposes.
• Accounts Receivable journal showing billed receivables.
• Individual client accounts including a description of services rendered, charges and credits, a summary of unbilled charges and work in progress, and final invoices.
• Case time records for each client.
• Register of cases in progress (typically organized by client’s name).
• Time summary reports, sorted by attorney and by client, listing the time, dates of work, billings and/or charges.

The guide instructs auditors on how to deal with claims of attorney-client privilege in looking at attorneys’ records. As a general rule, the attorney-client privilege protects disclosures of confidential communications but does not protect the identity of a client and the nature of a fee arrangement. Usually, attorneys cannot refuse to provide information required by information reporting statutes based upon the attorney-client privilege (see, e.g., Goldberger & Dublin, P.C., (CA-2) 935 F.2d 501 (1991).

Trust bank accounts. The auditor is also advised that attorneys typically have a main bank account for the firm. They also have one or more trust accounts, which may be interest-bearing; these accounts are unique to attorneys. There are two types of trust accounts: the General Trust Account and Segregated Trust Accounts. The General Trust accounts (called “Interest on Lawyer Trust Account” (IOLTA)) are administered under the direction of the program for IOLTA accounts, which are created by state legislation or the state’s court system. Therefore, these bank accounts may show either the identification number of the Bar Association, the IOLTA Program recipient or the client. The auditors are advised to contact the appropriate State Bar Association to determine the proper handling of these accounts and their earnings. Some states, including New York, have a statute detailing the disposition of interest paid on IOLTA accounts.

Client-related expenses. Attorneys, especially those working on a contingency basis, may pay expenses for their clients. Auditors are instructed to check whether attorneys properly reflect reimbursements from clients, either as gross receipts or as offsets to actual expenses.

Audit steps. The guide tells auditors how to conduct an examination. They have access to Accurint, which provides information on a person, their business, their professional standing, their assets, pending or resolved litigation, and other matters; this is the first thing that auditors are supposed to check. They are also advised to check the Internet for additional information.

Initial interview questions. The auditors are looking for income. Here are some suggested questions from the guide:

• How much cash was on hand at beginning and end of year?
• Were any loan proceeds received?
• Were referral fees received from other attorneys?
• Was compensation received in forms other than cash? Define bartering and use examples such as property interests, services, other assets received from a client in lieu of normal compensation.
• Are there any foreign accounts or offshore interests?
• Are there any interests in other entities?
• What Internet sites are maintained by the taxpayer?
• Online income sources including consulting, online bartering?
• Other online services provided?

The guide also contains lists of questions about the firm’s history, payroll, method of operation, and internal controls.

Key audit issues. In addition to probing about income, the auditors are looking at various expenses, including travel and entertainment costs, promotion and advertising, and advanced client costs. They also investigate the issue of employee versus independent contractor and corporate officers who are employees (if the firm is incorporated).

Bottom line. Any attorney or firm under examination should review this audit guide to anticipate what is to come. Those who are not under examination may want to review the guide as well to see where records, operations, or other matters can be changed to better withstand an audit.

Business Consultants

Last month, the IRS posted the Business Consultants Audit Techniques Guide (Rev. 7/11). According to the guide, business consulting is one of the fastest growing industries in the world today, and for many displaced workers, consulting is something they say they are doing while searching for a job. The guide attempts to identify audit issues unique to this market segment. Again, the guide applies to all consultants regardless of the entity used to run the activity.

Audit issues. Obviously, auditors are looking to find income that is not reported (or reported incorrectly) and expenses that should not have been deducted. Some of the income-related issues that the auditors are looking for include:

Bartering income that is not reported.

Shifting or assigning income between the consultant and his/her corporation in order to reduce income and/or self-employment taxes

Some of the expense-related issues that the auditors are looking for include:

Compensation for labor (whether workers are employees or independent contractors)

Meals and entertainment (to determine whether deductible items were for personal rather than business purposes; whether amounts were reimbursed by clients)

Travel both domestically and abroad

The auditors are also instructed to look for personal service corporations (PSCs). These C corporations pay a flat 35% tax rate on their taxable income. PSCs are also subject to certain restrictions. Consulting businesses that operate as C corporations usually are PSCs.

Another key audit issue concerns the hobby loss rule (Code Sec. 183). If the activity shows a loss, auditors are instructed to determine whether the activity is engaged in with a profit motive so that losses are deductible. If there is no profit motive, losses are not business losses; they are deductible only to the extent of income from the activity, and only as a miscellaneous itemized deduction (in excess of 2% of adjusted gross income).

Conclusion

There are many other audit technique guides for different industries. For example, the most recently posted guide is for the wine industry. This guide covers vineyards, wineries, and marketing and sales of wine. There is also a guide for the retail industry that came out two years ago. Tax professionals should check the list of audit guides so they can better advise clients about IRS-identified issues for their industries.