The prospect of an IRS audit can cause even the most level-headed attorney to panic. Take a deep breath. The IRS's Audit Technique Guide (ATG) covering attorneys may ease your mind, or at least provide insight into the process.

Auditor Hot Spots

Although the ATG is designed for IRS employees, knowing what auditors look for enables lawyers and law firms to provide the right information and documents and reduce the time and stress of being audited. The ATG highlights several areas of auditor interest, including:

  • Unreported Income. Auditors are told how to ferret out unreported income by, for example, determining whether fees withdrawn from client trust accounts were included in income at the proper time. Special attention is given to checks from those accounts that are either cashed or deposited into accounts other than the firm's general operating account.
  • Deferred Income. Client trust accounts can also provide evidence of deferred income. After a settlement, an attorney could attempt to defer income by allowing fees to sit in the trust account until the next year. But once a settlement is received, the fee should be included in income. Auditors may analyze the source of funds remaining in the trust account at year end, especially if the account has a large ending balance.
  • Noncash Payments. Auditors may examine client ledgers to uncover noncash payments. Verifying the basis of newer assets (for example, partnership interests or stock) can reveal that they were actually payments for services. Auditors could also compare an attorney's work schedule with his or her claimed fees. If the workload has remained steady while the claimed fees from one or more clients have declined, the attorney might be working for noncash payments.
  • Expenses. Auditors closely scrutinize entertainment expenses to determine whether there was little or no possibility of engaging in the active conduct of business due to "substantial distractions." For example, meetings that occur at nightclubs, theatres, sporting events, cocktail parties or social gatherings are looked at carefully. Auditors also consider whether claimed expenses are simply "disguised hobbies" or other personal expenses.

Good Accounting Helps

As you might have guessed from the ATG's areas of focus, sound accounting practices and an ethical firm culture can minimize the pain of being selected for an audit. As the ATG states, "A good accounting system for attorneys will include strong internal controls to monitor both fees billed and costs and expenses advanced for clients."

Consider implementing policies and processes that reflect IRS expectations. For example, your firm should:

  • Require preapproval of expenses over a certain amount or of particular types (such as sporting event or nightclub bills);
  • Establish clear policies about which expenses are charged to the firm and which to clients;
  • Restrict the use of firm credit cards;
  • Require thorough documentation of meal and entertainment expenses; and
  • Maintain up-to-date cash receipts, cash disbursement and time records.

Perhaps the best way to increase your odds of smooth sailing is to regularly perform your own audits (or ask an outside professional to perform them). Self-audits often catch errors or fraudulent activities before the IRS gets a chance to find them.

Use the ATG Proactively

If you receive a letter from the IRS announcing an audit, your first call should be to your accountant. However, do not wait until you are audited. Your CPA can help you use the IRS's guide proactively to identify (and remedy) gaps in your policies, processes and records.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.