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Attorneys Audit Technique Guide - Chapter 3

NOTE: This document is not an official pronouncement of the law or the position of the Service and cannot be used, cited, or relied upon as such. This guide is current through the publication date. Since changes may have occurred after the publication date that would affect the accuracy of this document, no guarantees are made concerning the technical accuracy after the publication date.

 


Table of Contents

 


Chapter 3 - Audit Issues

Gross Income

Introduction

Audit techniques are described in IRM 4.10.4, “Examination of Returns, Examination of Income.” These techniques are also summarized on the Examiner’s Mandatory Lead Sheet Work Paper #400 “Minimum Income Probe Lead Sheet.” The following provides information specific to this industry to assist in performing the various income analyses.

As with any audit, it is essential to understand the accounting method used by the taxpayer. Law firms typically use the cash receipts and disbursements method to determine income for tax purposes. Generally, the calendar year is used as their reporting period.

The first step in auditing income is to determine the type of legal work that is handled and the typical payment arrangements made with clients. Attorneys who do not specialize in one particular field may handle many different types of cases. Other attorneys may engage in one or more specialties such as corporate law, bankruptcy, criminal law, personal injury, real estate, or estate planning. The type of legal work performed may affect how and when income is recognized.

Some attorneys base their fees on a percentage of the settlement (contingent fee) plus costs. Most attorneys, however, base their fees on hours worked plus any case-related costs. These attorneys should be able to provide detailed records of their time and direct case costs because this is how they calculate their clients’ bills.

State licensing agencies and/or the state bar associations generally establish accounting rules for attorneys. These rules usually describe the type of books and records an attorney must maintain and the record retention period. Examiners should review any relevant regulatory websites to gain an understanding of these accounting and recordkeeping requirements.

Gross Income Types

In addition to billing clients based upon time expended, attorneys also use a number of other fee arrangements. The following is a summary of the most common types.

Specific Retainer

This is an agreed fee to perform services for a particular case or matter. The attorney typically sends an engagement letter to the client explaining the terms of the fee arrangement. The fee arrangement may be based on an hourly fee plus costs or for a set amount irrespective of how many hours the matter takes. The attorney may also request that the client prepay a portion of their fees before the matter is accepted. This advance payment may be deposited into a trust account with transfers made for part or all of the money to the general account as it is earned. Generally, if the attorney is on a cash basis of accounting, the retainer is taxable when received.

The client is normally given a periodic accounting of the time and costs spent on the case. If the prepaid funds are exhausted, the client is billed for any balance due. Typical cases involving this type of arrangement are divorces, traffic violation cases, business incorporations and immigration cases.

Annual Retainer

This is also an agreed and fixed fee, but it covers services over a specified period of time. This agreement may include terms for supplementary fees for special or unusual services. The parties usually sign a written contract for annual retainer agreements. This arrangement is often used for corporate clients. Supplemental fees are earned if the attorney has to perform unexpected services. Again, a cash basis taxpayer should report this as income when received.

Contingent Fee

In this type of fee arrangement, the attorney earns an agreed upon percentage of the amount of their client’s recovery (either in settlement or awarded in litigation), plus costs. Case time is not a factor in determining the amount of the fee. The focus is on the ultimate amount recovered for the client and what percentage the client agrees to pay the attorney. This type of arrangement is common in personal injury cases. Attorneys typically receive one-third of the recovery, but the contingency amount may vary according to whether the case is settled or resolved through litigation. The total settlement is deposited into the attorney's trust account. The attorney then has the responsibility of disbursing the funds. The disbursements may include litigation costs, the attorney's fee, and reimbursement to the attorney of any advanced costs. The remaining proceeds are distributed to the client. Amounts paid to the attorney from the trust account that do not represent advanced costs are includible in the attorney's gross income. Net fee and gross fee contingency arrangements are discussed in more detail under advanced client costs, below. A review of the books and records is necessary to determine if a reimbursement payment needs to be included in gross income or if it is an offset to actual expenses incurred.

The appropriate state licensing agency may have specific limits or guidelines regarding the amount of contingency fees an attorney may charge. Check the appropriate licensing agency’s website to see if there are any applicable guidelines or limitations. Variations from these limitations should be questioned and investigated.

Referral Fee

This is a fee paid to an attorney who refers a case to another attorney. This generally occurs when an attorney receives a case that could be better handled by another attorney due to his area of specialty or because of his geographic location. A portion of the ultimate award is generally remitted back to the attorney that originated the case or referred the client. Examiners should ask an attorney whether or not they have referred any cases to another attorney. These fees represent recognizable income when received.

Client Trust Accounts

Most attorneys will have one or more trust accounts under their control (see Chapter 1 on "Bank Accounts" for a discussion of trust accounts). Careful reconciliation of the trust account(s) to the attorney’s other bank accounts are necessary to determine if there is additional unreported income.

Unreported Income

Generally, an attorney will deposit settlement and award proceeds to their trust account. Settlement and award checks are usually made out to both the attorney and the client. After depositing the funds to their trust account, the attorney must distribute the proceeds. Frequently, the attorney will draw a portion of these funds to cover their fees and case costs. This occurs when a case is taken on a contingency basis.

It is important to determine if fees were included in income at the proper time. Some attorneys may cash fee payment checks or deposit them directly into personal or investment accounts. If they determined taxable income by totaling deposits made into the general operating accounts, these fees are omitted from income.

Inspecting the endorsements on checks written to or on behalf of the attorney from trust accounts is one important auditing procedure. These checks are income or expense reimbursements. Special attention should be given to all checks that either are deposited into accounts other than the general operating account or are cashed.

Deferral of Income

After a case has been settled, the attorney may attempt to defer earned income by allowing fees to remain in the trust account until the next year. Once the settlement is received, the attorney's fee is both determinable and available and therefore should be included in income. An effective audit step is to analyze the source of funds remaining in the trust account at year-end, particularly if there is a large ending balance.

Noncash Sources

Some attorneys may receive noncash payments instead of fees for services rendered. Examination of the client ledger cards will many times lead to the discovery of noncash payments. Also, verifying the basis of newer assets, such as partnership interests or stock, may reveal that they were non cash payments for services.

For example, an attorney may accept a partial or entire interest in a property (usually by a quitclaim deed) as payment for legal fees.

Another example, an attorney borrowed a large sum of money from a corporate client and then paid it off by performing legal services. The loan was shown on the attorney's books, but not the income resulting from the relief of the debt. When no loan repayments were noted, the lender was contacted. They confirmed the loan and the credits against the outstanding balance posted when the attorney rendered legal services.

As another example, an attorney who sets up partnerships or corporations may accept an interest in the formed entity as payment for legal services rendered.

Bartering is another source of noncash income. Attorneys may exchange their legal services for other services. An effective audit tool would be to compare the attorney’s work schedule with their claimed fees. If the attorney’s workload has not decreased, but their claimed fees from one or more clients has, that may indicate they are performing services in exchange for noncash payments. These variations should be noted and questioned, as deemed appropriate.

Cash Payments

Cash payments for legal services may be diverted to other accounts or to other entities under the control or for the benefit of the attorney. Some attorneys may offer substantial legal service discounts for currency payments. The IRP report summarizes Cash Transaction Reports (CTRs). Details of each report should be examined. They can be obtained from the Web CBRS. Refer to Chapter 2 of this audit technique guide for more information on Cash Transaction Reports. Additionally, if an examiner believes that the attorney enters into a number of cash transactions, then a review of Suspicious Activity Reports available on Web CBRS may be warranted.

The examiner should also be aware of cases where an indirect method may be needed to determine income. Indirect methods are discussed in IRM 4.10.4.6.

Constructive Receipt

Income may be earned under the doctrine of constructive receipt. This is an exception to the general rule that taxpayers on the cash basis of accounting must have actual receipt of income before it is taxable. Income is constructively received if it is subject to the demand of a taxpayer and there are no substantial limitations or conditions on the right to receive it. (Treas. Reg. section 1.451-2.)

For example, a criminal defense attorney was acting as a public defender and was paid an hourly rate plus any costs incurred. The attorney was required to submit a billing statement to the county government on a monthly basis to receive payment. At the end of the year a Form 1099 was issued to the attorney for the income that was actually paid. To defer income, the attorney did not bill the county for services rendered for the second half of the year. Since billings were submitted only for the first half of the year, the attorney's gross income was considerably understated.

Expenses

Entertainment, Promotion and Advertising

Entertainment expenses should be examined to ensure they meet the requirements under IRC §§ 162 and 274. The taxpayer should substantiate such expenses in accordance with the rules under IRC § 274(d). In general, to be deductible, entertainment expenses must also meet the "directly related" or "associated with" tests as outlined in Treas. Reg. §§ 1.274-2(a),(c), and (d). Even if they meet these tests, expenses for meals and entertainment are also subject to a 50 percent disallowance under IRC § 274(n).

Treas. Reg. § 1.274-2(b)(1)(i) defines "entertainment" as any activity which is generally considered to constitute entertainment, amusement, or recreation. Included is entertaining at nightclubs, cocktail lounges, theatres, country clubs, golf and athletic clubs, sporting events, and on hunting, fishing, vacation, and similar trips. This definition also includes payment of an individual’s personal, living, or family needs, unless those expenses are clearly not entertainment (such as paying an employee’s meal while they are working overtime).

Generally, to be deductible, entertainment must meet either the "directly related" or "associated with" tests. 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 clearly applies where the taxpayer is not present. However, even if the taxpayer is present, the Regulations 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 Israelson v. United States, 367 F. Supp. 1104 (D. Md. 1973), an attorney gave a party at a country club. Although the party was attended by some clients, persons who refer clients, and other business associates, no business was discussed. Therefore, no deduction was allowed.

The following cases denied deductions for entertainment where the taxpayer failed to meet the "directly related" and "associated with" tests:

  • Walliser v. Commissioner, 72 T.C. 433 (1979)
  • Flaig v. Commissioner, T.C. Memo. 1984-150; 47 T.C.M. (CCH) 1361 (1984)
  • St. Petersburg Bank & Trust v. United States, 362 F. Supp. 674 (M.D. Fla. 1973), aff'd. 503 F.2d 1402 (5th Cir. Oct 30, 1974) (Table, NO. 73-3762)
  • Gardner v. United States, T.C. Memo. 1983-171; 45 T.C.M. (CCH) 1116 (1983)

The following cases also denied deductions for promotion expenses based on lack of proof:

  • Roumiguire v. Commissioner, T.C. Memo. 1980-356; 40 T.C.M. (CCH) 1137 (1980)

Travel

Travel expenses are another area where audit issues may arise. Taxpayers must meet the substantiation requirements of IRC §274. Some attorneys are licensed to practice in other states or travel to other parts of the state and must travel for work. However, they are still required to provide proper substantiation.

For example, one attorney substantiated airfare and lodging for several ski trips. When asked the business purpose he refused to answer, claiming the attorney-client privilege (refer to "Attorney-Client Privilege" in Chapter 1). The examiner questioned the documents provided because they included the names of his children and wife. 

Disguised Hobbies

The attorney should be asked about hobbies during the initial interview. Attorneys may attempt to claim an expense deduction for their hobbies. For example, one attorney said his hobby was fine wines. He and two other associates had a wine cellar they had built and stocked with wines from all over the world. The attorney deducted wine purchases as office supply expenses.

Corporate Expenses

Constructive dividend issues are often present when auditing personal service corporations. For example, one attorney reported earning $11,000 in income from his corporation. Upon further examination of the corporation, the examiner discovered the corporation paid all of his personal living expenses. The examination resulted in a constructive dividend to the attorney shareholder of over $200,000 per year.

Attorneys who are corporate shareholders may use a company credit card for travel, entertainment, or other personal expenses. Constructive dividends or additional wages for personal expenses paid by the corporations should be considered when auditing attorneys who are corporate shareholders.

Depreciable Books and Periodicals

If the attorney maintains a hardcopy library of research material, depreciation of the permanent volumes may be an issue. The general rule for depreciating property is found in IRC §167. It allows for recovery of the costs of any asset used in a trade or business if it has a useful life of more than one year and its value decreases with time. The cost of technical books and services which have a useful life of one year or less (including periodicals and loose-leaf services which are purchased on an annual basis), is deductible currently as a business expense. Permanent volumes are in asset class 57.0 and can be depreciated on MACRS over 5 years (Rev. Proc. 87-56)

Advanced Client Costs

Attorneys commonly pay litigation expenses on behalf of their clients. The costs are then recovered by the attorney out of the settlement or award. This practice is most often used by attorneys who take cases on a contingency fee basis. These attorneys generally use a cash basis of accounting and may deduct those expenses when paid, and the recovered costs are included in income when received. This causes a distortion of income since it can take years to resolve these cases. 

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 by the attorney 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. Cases supporting this position appear in Exhibit 3-1.

The typical expenses included in this category are listed in Canelo v. Commissioner, 53 T.C. 217, 219 (1969), aff’d 447 F.2d 484 (9th Cir. 1971):

The types of costs advanced by petitioners' law firm include travel expenses, costs of medical records, reports, interpreters' fees, witness fees, deposition costs, filing fees, investigation costs, photographs, laboratory tests, and sheriff's fees for service …. Petitioners ordered the services of process servers, shorthand reporters, investigators, doctors, and expert witnesses to whom litigation costs were paid.

The Tax Court explains in Herrick v. Commissioner, 63 T.C. 562, 569 (1975) (discussing Burnett v. Commissioner, 356 F.2d 755 (5th Cir. 1966)) that:

In our view the clear inference of the Fifth Circuit’s opinion in the Burnett case is that if the amounts deducted were advances by the attorney to his clients whether for living expenses or other expenses normally paid by the clients and there was an agreement or understanding that the attorney would be repaid, the advances are in the nature of loans and were not deductible business expenses.

Therefore, attorneys on the cash method of accounting may not take a current deduction for client expense advancements for which an attorney expects to be reimbursed. However, attorneys on the cash method of accounting are generally allowed a current deduction for client reimbursed costs which are allocated to normal operating expenses, (for example, secretarial costs or copying costs). These are general office type expenses which would reasonably be incurred even if not charged to a particular client. Of course, if a current deduction is taken, any subsequent reimbursement from the client would be treated as income in the year of reimbursement under the tax benefit rule of IRC §111.

There is typically a prearranged agreement with the client regarding the payment of case-related costs. Attorneys who advance client costs keep careful records of these expenses to ensure that they are recovered out of the settlement. Generally, a ledger card or other accounting record is maintained for each client detailing the expenses paid. When the recovery is included on the cash receipts journal, it is usually shown separately from the fee income associated with the case.

Attorneys taking cases on a contingency fee basis generally use two main contractual arrangements. These two contractual arrangements are the gross fee contract and the net fee contract.

The net fee contract specifically provides that advanced litigation costs are repaid to the attorney before calculating the contingency fee percentage paid from the settlement or judgment proceeds. 

In contrast, the gross fee contract provides that the contingency fee percentage paid from the settlement or judgment proceeds is calculated without regard to advanced litigation costs. The attorney is only entitled to a percentage of the settlement or judgment and is not separately reimbursed for litigation costs advanced. These costs reduce the attorney’s net profit. If the case is lost, attorneys usually do not recover their costs from the client under either contingency fee arrangement.

Examiners should ask questions regarding the types of contingency fee contracts the taxpayer-attorney uses, if applicable to the audit. Examiners should ask whether the attorney includes a provision in their contingency fee contracts that they are repaid their advanced litigation costs even if they lose a case. 

It should be noted that a common argument used by attorneys taking cases on a contingent fee basis to claim advanced litigation costs are currently deductible is that there is no guarantee they will recover these costs. In the cases where that argument was presented, courts specifically look at the attorney’s case selection and fee advancement processes. For example, if an attorney has a high rate of recovery for advanced expenses, this would indicate that the attorney is likely to be reimbursed. Examiners should look at the attorney’s success rate for recovering advanced litigation costs as a factor showing that the attorney has an expectation of reimbursement for these costs.

Advanced client costs may appear on the tax return in various places. Generally, the deduction will be taken under "other expenses" and will be labeled as "client costs" or some similar name. The deduction may also be claimed as a cost of sales. Some attorneys net these costs against gross receipts and show only the netted amount on the return. Therefore, the advanced costs may not be apparent when the return is inspected.

It is important to determine whether client costs are being advanced. This issue is frequently encountered with personal injury attorneys. It can take years to reach a settlement in this type of case. The attorney typically pays all costs incurred on the case and does not expect to recover any of his or her costs until the case is resolved in the client’s favor. This can result in sizable adjustments if costs are recovered over an extended period of time. Conversely, if an attorney is turning over his or her cases quickly or is asking their clients to pay costs up front, this may not be a material issue that requires adjustment.

Although the court cases strongly support treating advanced client costs as in the nature of loans, there are some opposing arguments presented by the taxpayers and their representatives.

The argument most frequently raised is that if the advanced costs are to be treated as being in the nature of loans, then the recovery of these "loans" does not create taxable income. This issue was raised in the Canelo case, 53 T.C. 217, (1970). In Canelo, the Government relied upon the tax benefit rule, IRC § 111, arguing that the attorney’s recovery of costs deducted in prior years, in which the statute of limitations had expired, was includible in income. The Tax Court held that an “erroneous deduction exception” applied to the tax benefit rule and determined that the tax benefit rule could only be used in cases in which a proper deduction was originally taken. There are several Actions on Decision which address this issue. A revised Action on Decision, CC-1981-175, explains the Commissioner’s position:

The erroneous deduction exception is inequitable. A person who benefits from a proper deduction is taxed on the recovery in a subsequent year of the amount deducted while a person who benefits from an improper deduction is not taxed on the recovery of the amount deducted. Thus, the exception rewards those who claim deductions to which they are not entitled.

Many circuit courts have rejected the Tax Court’s “erroneous deduction exception.” Unvert v. Commissioner, 656 F.2d 483 (9th Cir. 1981) (and cases cited therein); Hughes & Luce, LLP v. Commissioner, 70 F.3d 16 (5th Cir. 1995). Check your Circuit to see how it is handling the “erroneous deduction exception" and if there is no precedent, check with your local Counsel to see how to proceed.

The advanced client costs issue should be raised if the amount of deducted client costs is material. The change in treatment of advanced legal costs is a change in method of accounting under IRC § 446 that generally requires an IRC § 481 adjustment. A Service initiated method change is made using the procedures in Rev. Proc. 2002-18, 2002-1 C.B. 678. In appropriate circumstances, a change in method of accounting may be done on a cut-off basis. See § 5.04(2) of Rev. Proc. 2002-18.

An examiner making a Service initiated method change under Rev. Proc. 2002-18 will ordinarily make the change in the earliest taxable year under examination, or if later, the earliest taxable year that the method is considered to be impermissible. Under certain circumstances, the examiner may designate a later year as the year of change. See § 5.04(1) of Rev. Proc. 2002-18. For example, an exception may exist if the manner in which the attorney's records are kept makes it extremely difficult to arrive at all the required beginning and end of year balances. The examiner must exercise judgment in making this determination, and the reasons for any deviation from the general rule must be well documented. 

An examining agent changing the taxpayer’s treatment of advance legal fees will ordinarily result in an IRC § 481(a) adjustment, subject to the computation of tax under § 481(b) (if applicable). The IRC § 481(a) adjustment is necessary to prevent amounts from being duplicated or omitted that result solely from the change in method of accounting. However, the examining agent must apply the limitation on tax provision in IRC § 481(b) if the involuntary method change results in an increase in the taxpayer’s taxable income for the year of change by more than $3,000. 

The IRC § 481(a) adjustment, whether positive or negative, will be taken into account in the year of change. See § 5.04(3) of Rev. Proc. 2002-18.

The IRC § 481(a) adjustment includes total unrecovered client costs deducted in years prior to the year of change even if those years are barred by statute. The figure needed is the total amount outstanding for client costs receivable at the beginning of the year of change. 

In addition to the IRC § 481(a) adjustment, a current year adjustment under IRC § 446 must be calculated for the year of change and, if applicable, any subsequent taxable year under examination. A current year adjustment is the amount which is attributable solely to the year under audit, and as such, a separate adjustment is made in each of the audit years. Accordingly, a current year adjustment for this accounting method change is the change in the amount of accrued but unrecovered client costs that occurred during the year. The current year adjustment will generally be the difference between the receivables balances at the beginning and end of the year as calculated under the old method of accounting and reported on the tax return for the year. 

A portion of the disallowed costs could result in a bad debt deduction in subsequent years. This would occur if the costs were determined to be uncollectible in that year. The specific rules for bad debt deductions should be followed for this issue.

Computing the Adjustment

Making the adjustment is a simple mechanical procedure if balances for outstanding client costs are available. Ideally, the taxpayer will maintain the books in such a manner that the accounts receivable balances at the beginning of the year and the end of the year can be easily obtained. However, very seldom will the books contain more than cash disbursements and cash receipts. In this more typical situation, the computation of the outstanding balances may be quite cumbersome. To obtain the receivable figures, the taxpayer will have to go through the client ledger cards or client files and list the amounts owed by clients at the beginning and end of the year of change. If the audit involves multiple years, outstanding balances for each of those years must also be obtained.

Figure 3-1, below, presents an example of how to use these figures to arrive at the adjustments, assuming the year of change is 2010.

Assuming the outstanding receivables balances (client costs and advances accrued but not yet recovered) are:

  • At 1-1-2010  =  $65,000, and
  • At 12-31-2010  =  $85,000

The IRC § 481(a) adjustment is $65,000 and accounts for all client costs deducted in prior years but not recovered. The IRC § 446 adjustment is $20,000 ($85,000 end of year balance - $65,000 beginning of year balance = $20,000). This amount is attributable entirely to the 2010 year.

Exhibit 3-2 is used to compute the current year adjustment. This work paper should be used only if the audit involves the first year that the attorney was in practice. This schedule makes no calculation for picking up the prior year adjustment. It also makes no allowance for any portion of the IRC § 481(a) adjustment which is included in income in the current year.

 

Figure 3-1 UNRECOVERED ADVANCED CLIENT COSTS WORKSHEET
Client   Balances at 1-1-2010 Costs Incurred in 2010 Costs Recovered in 2010 Balance at  12-31-2010
Client A

8,000

2,000

10,000

0

Client B

15,000

10,000

0

25,000

Client C

10,000

5,000

0

15,000

Client D

0

5,000

0

5,000

Client E

20,000

5,000

0

25,000

Client F

12,000

3,000

0

15,000

Total

65,000

30,000

10,000

85,000

The Current Year Adjustment (IRC § 446) is computed as follows:
For the year 2010, the tax return shows a deduction for $30,000.
From which you subtract the total costs recovered and included in income during 2010 in the amount of $10,000.
To arrive at the Current Year IRC § 446 adjustment of $20,000.

Another way to compute the Current Year IRC § 446 adjustment is simply to calculate the difference between the ending balance and the beginning balance (85,000 less 65,000)

The Prior Year Adjustment (IRC § 481(a)) is 65,000 (the balance as of the beginning of the year)

At January 1, 2011, the taxpayer's books will show an asset account in the amount of $85,000 for client costs receivable. Any future expenses incurred are debited to this account, and recoveries are credited. There will be no future entries to income or expense accounts for client costs. One exception exists for unrecoverable costs which are written off following the rules for bad debt expenses.

Employee Versus Independent Contractor Issue

Note to Examiner: If you have a potential employment tax issue or a worker reclassification issue, refer the issue to the Employment Tax Specialty Group to work. The discussion below is included to help you identify this issue in your case.

The following is a brief outline of the law regarding employment status and employment tax relief. It is important to note that either worker classification-independent contractor or employee -- can be valid.

The first step in any case involving worker classification is to consider Section 530 of the Revenue Act of 1978. An examiner must provide the taxpayer with a written notice of the provisions of Section 530 (Publication 1976) when examining employment status issues. If the requirements of Section 530 are met, a business may be entitled to relief from federal employment tax obligations. Section 530 terminates the business's, but not the worker's, employment tax liability, including any interest or penalties attributable to the liability for employment taxes.

In determining a worker's status, the primary inquiry is whether the worker is an independent contractor or an employee under the common law standard. Under the common law, the treatment of a worker as an independent contractor or an employee originates from the legal definitions developed in the law of agency -- whether one party, the principal, is legally responsible for the acts or omissions of another party, the agent -- and depends on the principal’s right to direct and control the agent.

Guidelines for determining a worker's employment status are found in three substantially similar sections of the Employment Tax Regulations:  Sections 31.3121(d) -1, 31.3306(i) -1, and 34.3401(c) -1, relating to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and federal income tax withholding. The regulations provide that an employer-employee relationship exists when the business for which the services are performed has the right to direct and control the worker who performs the services. This control refers not only to the result to be accomplished by the worker, but also to the means and details by which that result is accomplished. In other words, a worker is subject to the will and control of the business not only as to what work shall be done, but also how it shall be done. It is not necessary that the employer actually direct or control the manner in which the services are performed if the employer has the right to do so. To determine whether the control test is satisfied in a particular case, the facts and circumstances must be examined.

The Service looks at facts in the following categories when determining worker classification:  behavioral control, financial control, and relationship of the parties. The 20 common-law factors described in Revenue Ruling 87-41, 1987-1 C.B. 296, summarized in Exhibit 3-3, fall within these three categories.

Behavioral Control:  Facts that substantiate the right to direct or control the details and means by which the worker performs the required services are considered under behavioral control. This includes factors such as training and instructions provided by the business. However, virtually every business will impose on workers, whether independent contractors or employees, some form of instruction (for example, requiring that the job be performed within specified time frames). This fact alone is not sufficient evidence to determine the worker's status. The weight of “instructions” in any case depends on the degree to which instructions apply to how the job gets done rather than to the end result.

The degree of instruction depends on the scope of instructions, the extent to which the business retains the right to control the worker's compliance with the instructions, and the effect on the worker in the event of noncompliance. The more detailed the instructions that the worker is required to follow, the more control the business exercises over the worker, and the more likely the business retains the right to control the methods by which the worker performs the work. The absence of detail in instructions reflects less control.

Financial Control:  Economic aspects of a relationship between the parties illustrate who has financial control of those activities. The items that usually need to be explored include:

  • Whether the worker has a significant investment,
  • Whether the worker has unreimbursed expenses,
  • Whether the worker's services are available to the relevant market,
  • Whether the worker is paid by the hour as opposed to a flat fee for the services performed, and
  • Whether the worker has the opportunity for profit or loss.

The first four items are not only important in their own right but also affect whether there is an opportunity for the realization of profit or loss. All of these can be thought of as bearing on the issue of whether the recipient has the right to direct and control the means and details of the business aspects of how the worker performs the services.

The ability to realize a profit or incur a loss is probably the strongest evidence that a worker controls the business aspects of the services rendered. If the worker is making decisions which affect his or her bottom line, the worker likely has the ability to realize a profit or loss.

Relationship of the Parties: The relationship of the parties is important because it reflects the parties’ intent concerning control. Courts often look to the intent of the parties, which is most often embodied in contractual relationships. A written agreement describing the worker as an independent contractor is viewed as evidence of the parties’ intent that a worker is an independent contractor. However, a contractual designation, in and of itself, is not sufficient evidence to determine worker status. The facts and circumstances under which a worker performs services are determinative of a worker's status. The designation or description of the parties is immaterial. The substance of the relationship governs the worker's status, not the label.

For an in-depth discussion, refer to Internal Revenue Manual 4.23.5, Technical Guidelines for Employment Tax Issues, which includes the Section 530 determination, and related exhibits, and Rev. Proc. 85-18, 1985-1 C.B. 518. Publication 15A, Employer's Supplemental Tax Guide, is an additional resource.

An employment tax issue may exist where attorneys treat their receptionists, secretaries, paralegals, or law clerks as independent contractors. Paralegals and law clerks are frequently hired to perform research for attorneys and may be used to help prepare any necessary legal paperwork. This can be done on either a temporary or permanent basis as well as on a full or part-time basis (for example, law students hired as summer law clerks or for part-time work). Paralegals and clerks under an attorney's close supervision and control should generally be classified as employees.

For example, in Casety v. Commissioner, T.C. Memo. 1993-410, a paralegal was treated as an independent contractor by the lawyer for whom the services were provided. The Tax Court found, based on the facts presented, that the lawyer retained the right to control the manner in which the paralegal's services were performed. This led to the conclusion that the paralegal was an employee and not an independent contractor.

The determination is more difficult when other attorneys provide the services since the right to control is not as clear. In Weber v Commissioner, 60 F.3d 1104, 1110 (4th Cir. 1995) in deciding whether a United Methodist minister was an employee or independent contractor, the court stated:

The “right-to-control” test is the crucial test to determine the nature of the working relationship. The degree of control is one of great importance, though not exclusive. Accordingly, we must examine not only the control exercised by an alleged employer, but also the degree to which an the alleged (sic) employer may intervene to imposed control. In order for an employer to retain the requisite control over the details of an employee’s work, the employer need not stand over the employee and direct every move made by that employee. Also, the degree of control necessary to find employee status varies according to the nature of the services provided.

The threshold level of control necessary to find employee status is generally lower when applied to professional services than when applied to nonprofessional services. In James v. Commissioner, [25 T.C. 1296, 1301 (1956)] this Court stated that “despite this absence of direct control over the manner in which professional men (and women) shall conduct their professional activities, it cannot be doubted that many professional men (and women) are employees.” Also, in Azad v. United States, [388 F.2d 74, 77 (8th Cir, 1968)] the Court of Appeals for the Eight Circuit said that “From the very nature of the services rendered by *** professionals, it would be wholly unrealistic to suggest that an employer should undertake the task of controlling the manner in which the professional conducts his activities.” Generally a lower level of control applies to professionals. (internal citations omitted)

The absence of the need to control the manner in which an attorney or other professional conducts his or her duties should not be confused with the absence of the right to control. The right to control contemplated by the common law as an incident of employment requires only such supervision as the nature of the work requires. McGuire v. United States, 349 F.2d 644, 646 (9th Circuit 1965).

Close scrutiny should be given in cases where both Forms W-2 and 1099 are issued to the same party.

Corporate Officer is an Employee

There is an employment tax issue if an officer of a corporation is being paid as an independent contractor. Under IRC §§ 3121(d) and 3401(c), an officer of a corporation is an employee. Consequently, the corporation is liable for employment taxes.

1099 Issues:

Another potential audit issue exists where Forms 1099 are not issued to independent contractors for payments made to the contractors out of an attorney's trust account.  The argument that the funds belonged to the contractor will not relieve the attorney from this reporting responsibility. IRC § 6041(a) states that all persons engaged in a trade or business who make payments to another person of $600 or more in the course of such trade or business are required to file information reports. 

It is possible for a taxpayer to present copies of Forms 1099 to an agent without ever filing them with the Internal Revenue Service or providing copies to the payees. To determine if the IRS has received the forms, a PMFOL can be requested. It will show the number and dollar amount of Forms 1099 filed by a taxpayer.

1099s are also required to be filed for payments to recipients of lawsuit settlements or awards unless specifically exempt from taxation under IRC § 104. More information on types of settlements and awards can be found in the Lawsuits, Awards, and Settlements Audit Techniques Guide (PDF).

Form 8300 Issue

IRC § 6050I (26 United States Code (U.S.C.) 6050I) and 31 U.S.C. § 5331 require that certain information be reported to the IRS and the Financial Crimes Enforcement Network (FinCEN). This information must be reported on IRS/FinCEN Form 8300.

Each person engaged in a trade or business who, in the course of that trade or business, receives more than $10,000 in cash in one transaction or in two or more related transactions, must file Form 8300. Any transactions conducted between a payer (or its agent) and the recipient in a 24-hour period are related transactions. Transactions are considered related even if they occur over a period of more than 24 hours if the recipient knows, or has reason to know, that each transaction is one of a series of connected transactions.

If you have an issue regarding Form 8300, contact your local SBSE Bank Secrecy Act (BSA) Manager for advice and direction.

Related Entities/Taxpayers

Corporate Taxpayers

Many times the agent will find that the income of a personal service corporation comes from a partnership. This arrangement is usually set up to lessen personal liability and to establish a pension plan. The Form 1120 will show expenses such as dues, travel, auto, and pension plan deductions. A review of the partnership agreement and return will show if the taxpayer is deducting items that have already been deducted by the partnership or items that are properly expenses of the partnership.

Sometimes, shareholders deduct personal travel and entertainment expenses as corporate expenses. Oftentimes, these expenses are paid for by the corporation through corporate credit cards. 

Some corporations that pay their employees an auto allowance fail to properly include it on the Form W-2. This can occur either when an employer has a reimbursement or other expense allowance arrangement that does not meet the requirements of IRC § 62(c) or Treas. Reg. section 1.62-2(c), or where the arrangement does meet these requirements but the employee does not substantiate the expenses. In these cases, the advance would be properly treated as wages on Form W-2.

The agent should be alert to "disappearing corporations." Occasionally, a corporation will cease operations and not take into account liquidating distributions to the shareholder(s). These corporations may simply stop filing tax returns.

There may be IRC § 482 issues in these audits. If there are other businesses under the control of the attorney, consideration should be given to the reasonableness of allocations for income and expenses between these related parties. If income or expenses are not properly allocated, it may be necessary to determine a more equitable allocation of these items.

Corporate and Individuals

Inspection of disbursements to other attorneys from the client trust accounts can lead to the examination of the payees. The backs of checks show into which accounts these payments are deposited. Occasionally, checks are not deposited into the general business account of the payee attorney but rather are cashed or deposited into accounts that appear personal in nature.

Close scrutiny should be given to all funds entering and leaving the trust accounts. Questionable transactions by clients have been uncovered during audits which resulted in adjustments to the clients' tax returns. Such questionable transactions may include prepayments deducted by clients which are not included in the attorney's income and are returned to the client in a subsequent taxable year, or deductible prepayments which are used for the client's personal benefit rather than for legal services. The agent should be alert for any unusual transactions between the attorney and others as these can lead to related examinations. Third party contacts are valuable tools that should be used to develop these issues.

For example, a client paid $100,000 to an attorney and claimed a deduction for legal fees. The attorney deposited the "fees" into his trust account. The "fees" were then returned by the attorney to the client after the end of the client's fiscal year. This transaction resulted in a $100,000 deduction for the client and no declared taxable income to the attorney.

In another case, a taxpayer paid "fees" to an attorney and took a deduction for them on his tax return. The funds were deposited into the attorney's trust account. From the trust account, these funds were then funneled into an S-Corporation. The S-Corporation then used these funds to construct the taxpayer’s vacation home.

Personal Service Corporation Accounting Periods and Tax Computations

The tax year of a personal service corporation (PSC) must be a calendar year unless the corporation makes an election under IRC § 444(a) or can satisfy the Commissioner that there is a business purpose for having a different tax year. IRC § 441(i)(1).

In defining a personal service corporation, Treas. Reg. section 1.441-3(f)(1) states that personal services are substantially performed during the testing period (2009 is the testing year for the 2010 tax year) by employee-owners of the corporation if more than 20 percent of the corporation's compensation cost (for personal service activities) for such period is attributable to personal services performed by employee-owners.

An entity may elect a fiscal tax year by filing a Form 8716 with the IRS Service Center by the earlier of:

  1. The 15th day of the fifth month following the month that includes the first day of the taxable year for which the election will first be effective, or
  2. The due date (without regard to extensions) of the income tax return resulting from the IRC § 444 election. Treas. Reg. section 1.444-3T(b)(1).

Attorneys generally file tax returns using the cash basis, although some of the accounts for income earned, work in progress, and costs advanced will be kept on the accrual basis. Any income the attorney receives over which he or she has control, such as retainers, will be considered income in the year of receipt (see "Gross Income").

A qualified personal service corporation (QPSC) is taxed at a flat 35 percent rate on its taxable income. For this purpose, a qualified personal service corporation is defined in IRC § 448(d)(2) which states:

(2) Qualified personal service corporation. -- The term “qualified personal service corporation” means any corporation--

(A) Substantially all of the activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting, and

(B) Substantially all of the stock of which (by value) is held directly (or indirectly through 1 or more partnerships, S corporations, or qualified personal service corporations not described in paragraph (2) or (3) of subsection (a)) by--

(i) Employees performing services for such corporation in connection with the activities involving a field referred to in subparagraph (A),

(ii) Retired employees who had performed such services for such corporation,

(iii) The estate of any individual described in clause (i) or (ii), or

(iv) Any other person who acquired such stock by reason of the death of an individual described in clause (i) or (ii) (but only for the 2-year period beginning on the date of the death of such individual).

To the extent provided in regulations which shall be prescribed by the Secretary, indirect holdings through a trust shall be taken into account under subparagraph (B).

The following tax issues arise regarding personal service corporations and/or qualified personal service corporations:

  • 35 percent corporate rate. Unlike other C corporations, which are subject to graduated income tax rates beginning at 15 percent, a QPSC, within the meaning of IRC § 448(d)(2), is taxed at a flat tax rate of 35 percent. See IRC §§ 11(b)(1) and (2).
  • Calendar year is required unless permission is granted. Unlike other C corporations, which can adopt a fiscal tax year, a PSC is required to adopt a calendar year unless it can show a valid business purpose. See IRC §§ 441(i)(1) and (2).
  • Passive Activity Losses are limited. Unlike many C corporations, which can deduct passive losses against their active income, a PSC cannot offset passive losses against its active income. See IRC § 469(e).
  • Accumulated Earnings Tax. A PSC may be subject to accumulated earnings tax if the accumulated earnings and profits exceed $150,000. See IRC §§ 532 and 535(c)(2)(B). The accumulated earnings tax is equal to 15% of the accumulated taxable income, effective for tax years beginning after December 31, 2002.
  • Reallocation of income. The IRS can reallocate income and tax attributes to the employee-owners if it determines that the principal purpose for forming the personal service corporation was the avoidance or evasion of taxes. See IRC § 269A(a). This provision applies to a PSC only when substantially all of the services of the corporation are performed for (or on behalf of) one other corporation, partnership, or other entity. See IRC § 269A(a)(1).

Note: IRC § 269A applies when a physician who is an employee of a single hospital, for example, forms a PSC through which to provide services only to that hospital. The statute does not apply to the most common kind of PSC, which is formed in order to provide services to a large number of patients or clients.

Exhibit 3-1 Client Costs and Advances

Mertens Law of Federal Income Taxation (§25:24) states, "Lawyers who advance court costs on behalf of their clients cannot deduct the costs as business expenses where the client is ultimately responsible for payment; such advances are treated as loans, not expenses.”

The following court cases support this position:

  • Henry F. Cochrane v. Commissioner, 23 B.T.A. 202 (1931)
  • Thomas Hart Fisher, 5 T.C.M. (CCH) 374 (1946)
  • Reginald G. Hearn v. Commissioner, 36 T.C. 672 (1961) aff'd, 309 F.2d 431 (9th Cir. 1962)
  • Warren Burnett v. Commissioner, 42 T.C. 9 (1964), aff’d on this issue, 356 F.2d 755 (5th Cir. 1966)
  • John J. Watts v. Commissioner, T.C. Memo. 1968-183, 27 T.C.M. (CCH) 886 (1968)
  • Adolph B. Canelo, III v. Commissioner, 53 T.C. 217 (1969) aff'd, 447 F.2d 484 (9th Cir. 1971)
  • John W. Herrick v. Commissioner, 63 T.C. 562 (1975)
  • Ronald R. Silverton v. Commissioner, T.C. Memo. 1977-198, 36 T.C.M. (CCH) 817(1977), aff'd, 647 F.2d 172 (9th Cir. 1981) (Table)
  • James F. Boccardo v. United States, 12 Cl. Ct. 184 (1987), 87-1 U.S.T.C. 9288 (1987)
    Note: In this case, the Boccardo Law Firm used the net fee contingency agreement method and the Claims Court concluded the client costs are non-deductible loans. The law firm subsequently changed to the gross fee method and continued to deduct their advanced client costs.
    In subsequent litigation, the Tax Court determined that the contingent nature of reimbursements meant these costs were nondeductible, similar to a net fee arrangement. Boccardo, T.C. Memo. 1993-224. On appeal, the Ninth Circuit reversed the Tax Court, holding that the gross fee contract did not involve advances with the implication of a loan, where, as a matter of law, there was no obligation on the client’s part to repay the money expended. Boccardo, 56 F.3d 1016 (9th Cir. 1995). The Service took the position that it will continue to challenge these expenses, except in the Ninth Circuit. See Field Service Advisory, 1997 WL 33313738 (IRS FSA) 6-2-97.
  • Milan, Miller, Berger, Brody and Miller, P.C. v. United States, 679 F. Supp 692 (E.D. Mich. 1988), 88-1 U.S.T.C. 9209 (1988)

Exhibit 3-2

Exhibit 3-2 is used to compute the current year adjustment. This work paper should be used only if the audit involves the first year that the attorney was in practice. This schedule makes no calculation for picking up the prior year adjustment. It also makes no allowance for any portion of the IRC § 481(a) adjustment which is included in income in the current year.

TAXPAYER'S NAME:
AGENT:
FORM, YEAR:
DATE:


 

CLIENT COSTS/ADVANCES 2010
Date 2010 Client 2010 Costs Year Case Closed Costs Recovered Cost Outstanding
1-15 Alpine, L.

1,000

2010

1,000

0

1-30 Boulder, S.

500

2010

500

0

2-13 Crockett, A.

3,000

2010

3,000

0

4-19 Douglas, P.

1,500

2011

0

1,500

5-11 Evans, J.

400

2010

400

0

5-24 Fisher, S.

4,500

2011

0

4,500

6-20 Grant, C.

2,000

2010

0

0

8-5 Hill, T.

1,200

1991

0

1,200

9-12 Jenkins, K

600

1991

0

600

10-15 Kane, C.

800

1991

0

800

11-22 Lawrence, O.

1,100

Open

0

1,100

12-14 Mitchell, D.

300

Open

0

300

TOTAL  

16,900

 

4,900

10,000

C. Grant Case was lost and $2,000 costs absorbed by attorney.

Calculate the adjustment based on the formula:

Current year costs 16,900
Less Current year costs recovered (4.900)
Less Current year costs unrecoverable (2,000)
Equals Adjustment 10,000

Verify that the costs recovered of $4,900 have been included in income.

Note: The $10,000 of disallowed costs should be set up as an asset account on the books. As the costs are recovered (or written off) the receipts will be credited to this account.

Exhibit 3-3 20 Common-Law Factors/Rev Rul 87-41

  1. INSTRUCTIONS re when, where, and how a worker is to complete their tasks
  2. TRAINING provided to the worker
  3. INTEGRATION of worker's services into business operations
  4. SERVICES RENDERED PERSONALLY by the worker
  5. HIRING, SUPERVISING & PAYING ASSISTANTS if the persons for whom services are performed hire and pay assistants, that is indicative of an employer/employee relationship. If the worker hires, pays and supervises assistance, that is indicative of an independent contractor relationship.
  6. CONTINUING RELATIONSHIP between worker and the persons for whom services are rendered. There may be a continuing relationship where work is performed at frequently occurring but irregular intervals.
  7. SET HOURS OF WORK the persons for whom services are rendered establishes set hours for the worker
  8. FULL TIME REQUIRED the worker must substantially devote their full time to the persons for whom services are rendered (impliedly limiting the worker’s ability to work for others)
  9. WORKING ON EMPLOYER'S PREMISES-especially if the work could be done elsewhere
  10. ORDER OR SEQUENCE SET BY EMPLOYER the employer sets or dictates the sequence of work tasks performed. This can be shown if the employer retains the right to set the order or sequence of work tasks performed.
  11. ORAL OR WRITTEN REPORTS required by employer
  12. PAYMENT BY THE HOUR, WEEK OR MONTH
  13. PAYMENT OF BUSINESS AND/OR TRAVEL EXPENSE by employer
  14. FURNISHING OF TOOLS AND MATERIALS (employer furnishes significant tools & materials)
  15. SIGNIFICANT INVESTMENT in facilities by worker that are not normally maintained by employees is indicative of an independent contractor.  The lack of investment by the worker is indicative of an employer-employee relationship.
  16. REALIZATION OF PROFIT OR LOSS a worker who can realize a gain or loss as a result of their services is generally an independent contractor, but a worker who cannot is generally an employee
  17. WORKING FOR MORE THAN ONE FIRM AT A TIME
  18. MAKING SERVICES AVAILABLE TO GENERAL PUBLIC
    (on a regular and consistent basis)
  19. RIGHT TO DISCHARGE by employer
  20. RIGHT TO TERMINATE by worker without liability
Page Last Reviewed or Updated: 21-Mar-2014