General Practice, Solo & Small Firm DivisionTechnology & Practice GuideAmerican Bar Association
General Practice, Solo, and Small Firm Division
The Compleat Lawyer, Summer 1996, Vol. 13, No. 3
Tax Traps for Lawyers
BY KEITH BOOTH
Keith Booth is a partner at Coopers & Lybrand L.L.P. in Houston, Texas.
In 1993, the IRS issued a market segment specialization program aimed at lawyers. This program provides a road map for IRS agents to use in selecting lawyers' tax returns for examination and making adjustments to their tax liability. Because the IRS is targeting legal practices, lawyers need to be aware of the tax traps that await them.
Almost every legal practice uses the cash receipts and disbursements method of accounting. Although the Treasury has long accepted the cash receipts method for most types of service businesses, several issues are specific to the practice of law. Many lawyers request and receive retainers from clients in advance of performing legal services. Generally a retainer will be taxable upon receipt.
Client Trust Accounts
One area of particular interest to lawyers is the income tax implication of client trust accounts. Most state bar associations require client funds that are received or held by a lawyer for the benefit of clients to be held in a client trust fund, although the lawyer exercises control over the fund. In many cases, a separate trust fund may be established for a client. The interest earned on the separate trust fund belongs to the client and he will be taxed on the interest. More often, a client's funds are deposited into the lawyer's client trust fund and commingled with the funds held for the lawyer's other clients. In this situation, the interest earned on the commingled funds is generally payable to the state bar association and therefore not taxable to either the client or the lawyer.
The funds held in a client trust account may include the attorney fees for services as well as funds held for the benefit of the client. When a matter is settled, the lawyer will make payment of funds to the client and also write a check to her own operating account for her fee and any expenses incurred on behalf of the client. The attorney fees are taxable income when the funds are transferred from the client trust account to the lawyer's operating account.
Obviously, the use of a client trust account presents some opportunity for deferral of income. The IRS, however, takes a dim view of such tactics. If a lawyer has unreasonably delayed the payment of funds from the client trust account, the IRS may attempt to assert the doctrine of "constructive receipt" and immediately tax the income to the lawyer. An example of a situation in which the constructive receipt doctrine might be applied is where the case has been settled and payment has been made to the client, but the attorney fees have been retained in the client trust account for the sole purpose of deferring taxable income.
Client Advances for Expenses
Another important issue is the treatment of client advances for expenses. This subject affects virtually all lawyers regardless of the type of law they practice. For example, it is common for personal injury lawyers to advance client expenses while working on a case. Advances commonly include travel expenses, costs of medical records, costs of reports, witness fees, deposition costs, filing fees, investigation costs, costs of photographs, laboratory test fees, and sheriff's fees for service ( Canelo v. Comr., 53 TC 217 (1969)). Corporate lawyers may incur expenses for setting up a corporation or recording fees with respect to filing documents.
While these expenses could logically be viewed as currently deductible items, it is well established that client advances are treated as loans to a client. Although this is a clear departure from the cash receipts and disbursements method of accounting, it is supported by a number of cases. It is important to separate the fees billed for services and reimbursements of client expenses because the repayment of client advances will not constitute taxable income when received. This is treated as the repayment of a loan. Any client advances that are not repaid by the client may be written off as a bad debt in the year in which they become uncollectible.
Business Meals and Client Entertainment
The proper treatment of expenses for business meals and client entertainment is an area of particular concern in a legal practice. Generally, no deduction can be taken for the cost of meals or other forms of entertainment or recreation unless the cost is either directly related to the active conduct of a trade or business or if the expense is for entertainment directly before or after a substantial and bona fide business discussion. Entertainment includes sporting events, plays, dinners, and concerts. Given the importance of client entertainment to most legal practices, make sure that there is a business purpose and substantial business discussions during the entertainment, and document the business purpose at the time of the event.
Beginning in tax year 1994, only 50 percent of the meal or entertainment expense is deductible, with several exceptions. For example, if meal expenses are incurred on behalf of a client and reimbursable by the client pursuant to the fee arrangement, the 50 percent deduction will apply to the client reimbursing the expenses. The amount of meal and entertainment expense included in client reimbursable expenses should be indicated on the invoice so that the client can properly account for these items. Alternatively, where meal and entertainment expenses are not reimbursable by a client, the impact of the reduction will be borne by the lawyer.
The elimination of the deduction for club dues for taxable years beginning after 1993 has caused considerable consternation among professionals. Dues paid to business, social, athletic, luncheon, sporting, airline, and hotel clubs are not allowed as deductible expenses. However, dues paid to professional organizations, such as state and local bar associations and civic clubs, remain fully deductible provided the primary purpose of such organizations is for business. It should be noted however, that the portion of the dues that is attributable to meal or entertainment expenses is subject to the 50 percent limitation discussed above.
The deductibility of legal publications and periodicals presents another issue. Generally, books and other publications with a useful life in excess of one year should be capitalized and depreciated over the designated cost recovery period, currently five years. However, many legal publications that are purchased each year are printed in a loose-leaf format and updated on a regular basis. These publications currently may be expensed. This is also true for continuously updated electronic databases and publications on CD-ROM.
An often overlooked area involves the deductibility of insurance expenses. Except for most life insurance premiums, the cost of insurance remains fully deductible as a business expense. This includes premiums paid for health insurance, workers' compensation, and disability insurance. When the practice has decided to self-insure, however, a deduction is generally allowable only when the claim is actually paid. This is important because of the variety of partially self-insured programs involving retroactive premium payments. Where claims are effectively paid out of future premiums, it is likely that this will be treated for tax purposes as a self-insured arrangement resulting in the deferral of deductions.
Although disability insurance premiums remain deductible when paid by an employer, it may be more advantageous to have the individual attorney pay for his or her own disability. Where disability premiums are paid by the employer, any proceeds paid during disability are taxable to the employee. However, where an individual pays his own disability premium, the proceeds that may later be received are nontaxable. This is a complex area that may require input from both an accountant and an insurance advisor.
Because most attorneys have a number of nonlawyer employees, employee withholding and employment tax issues are constant concerns. In particular, the IRS is concerned about arrangements with independent contractors. An independent contractor is an individual who is not a common law employee; therefore, the employer is not required to withhold employment taxes from payments made. These withholdings include social security taxes, Medicare tax, and state and federal unemployment payments. It is common today to find attorneys, paralegals, and support personnel working on a contract basis. While this may be a very beneficial arrangement for the law firm, the IRS may attempt to recharacterize the arrangement as an employee/employer relationship. Whether an individual is characterized as an independent contractor or as an employee is primarily determined using the 20-part test found in Rev. Rul. 87-41, 1987-1 C.B.29. Although existing law creates a presumption that a lawyer working for a fixed salary will be classified as an employer, an exception is when independent counsel is employed for a special project.
Copyright (c) 1996 American Bar Association. All rights reserved. This information or any portion thereof may not be copied or disseminated in any form or by any means or downloaded or stored in an electronic database or retrieval system without the express written consent of the American Bar Association.