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In many respects, operating a law firm is no different than any other business. Specifically, the law firm generates revenues through providing services to its clients and incurs various operating expenses throughout the year, including payroll and rent.

But there are some significant differences. First, the practice of law is heavily regulated by the States and professional boards. Accordingly, lawyers are bound by certain professional and other ethical obligations that are unique to other types of businesses. Second, some lawyers generate fees, if at all, on the basis of certain contingencies, such as the success of litigation in a lawsuit. In other cases, the lawyer may opt instead for a fixed-fee or retainer compensation arrangement with the client.

The IRS is keenly aware of these differences when it audits law firms and lawyers. Indeed, the IRS has its own “Attorneys Audit Technique Guide” to assist its examiners on these issues, among others that relate to the practice of law. This Insight discusses some of the federal tax issues that may arise during an IRS audit of a law firm or a lawyer.

Bank Accounts. Almost every business maintains at least one operating bank account. However, State regulations and rules require attorneys to maintain client funds in bank accounts separate from their operational bank account. The purpose of this rule is to ensure that client funds are properly accounted for and kept safe until they are remitted to the attorney or the client.

In most cases, settlement awards and award proceeds are deposited into these trust accounts (sometimes referred to as an IOLTA). The attorney generally controls the flow of funds in and out of the trust account in these situations. Because the attorney controls the trust account, the IRS has recognized that attorneys can improperly attempt to defer earned income from one tax year to a subsequent tax year. Regardless of when the funds are deposited into the trust account, however, there is ample federal tax law that requires the attorney to include in his or her income the legal fees earned in the year in which the fees are determinable and available. See Isaacson v. Comm’r, T.C. Memo. 2020-17.

Advanced Client Costs. Personal injury attorneys commonly advance litigation expenses to their clients with an expectation that they will be repaid in the event the lawsuit is successful. Because attorneys also usually utilize the cash basis of accounting, accounting distortions would occur if attorneys were permitted to immediately deduct the litigation expenses when paid. Recognizing this, federal courts have generally concluded that these costs are to be treated similarly to loans for federal tax purposes. See, e.g., Herrick v. Comm’r, 63 T.C. 562, 569 (1975). Thus, they are not deductible by the attorney as a current cost of conducting business, with some exceptions. In the event the attorney is not repaid the advanced client costs, the attorney may be able to claim a bad debt deduction in the year that such costs are determined to be uncollectible.

Employee vs. Independent Contractor. All businesses are required to withhold and remit employment taxes to the IRS if a worker is characterized as an employee. In these instances, the employee receives a Form W-2 reporting his or her wages and the amount of withheld and remitted employment taxes. Conversely, businesses are not required to withhold and remit employment taxes if the worker is characterized as an independent contractor. In these instances, the independent contractor receives a Form 1099 and may potentially pay self-employment tax on the compensation.

The IRS and federal courts look to a variety of factors in determining whether any given worker is an employee or an independent contractor. Generally, the most significant factor is whether the business has the right to direct and control the worker who performs the services. That is, if the 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, the worker will generally be characterized as an employee for federal tax purposes.

Because of the nature of their work, attorneys generally exercise a higher degree of control over their work than other types of employees. Therefore, the determination of whether any given attorney is an independent contractor or an employee may be more difficult than with respect to workers in other businesses. However, federal courts have recognized that the “right-to-control” test is generally a lower bar when applied to professional services, such as attorneys. See James v. Comm’r, 25 T.C. 1296, 1301 (1956); Azad v. U.S., 388 F.2d 74, 77 (8th Cir. 1968) (“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.”).

Attorney-Client Privilege. Generally, attorneys have an obligation to withhold documents and other information under what is known as “attorney-client privilege.” Originally, the attorney-client privilege doctrine developed as a means to protect an attorney’s honor—that is, old common law recognized that clients should be able to inform their attorneys of secrets without risk of others being told. Today, federal courts recognize the attorney-client privilege as a necessary means to encourage clients to make full disclosures to their attorneys.

When conducting an audit of a lawyer or law firm, the IRS may request fee arrangements and client identities. Some federal courts have recognized that such information is not subject to attorney-client privilege on the basis that such information is not a confidential communication between the attorney and client. See, e.g., In re Colton, 201 F. Supp. 13, 15 (S.D.N.Y. 1961), aff’d 306 F.2d 633 (2d Cir. 1962). Thus, IRS examiners are instructed that they may issue a summons for such information under Code § 7602 in the event a lawyer or law firm refuses to provide such information during the audit. Of course, the lawyer or law firm may raise attorney-client privilege and other defenses to the summons where the IRS attempts to enforce it judicially.

Conclusion. As shown above, the practice of law—like any other business—is not immune from IRS scrutiny. To the extent a lawyer or law firm is subject to an IRS examination, the lawyer or law firm should ensure they have carefully considered the common audit issues discussed in this Insight.

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DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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