What Special Guidance Does IRS Give Agents for Audits of Attorneys?

By: Dennis Duitch, CPA, MBA
With: C. Frederick Reish & James R. McDaniel, of the law firm of Reish & Luftman, P.C.
The Journal of Taxation April 1995

Guidelines for the Service’s nationwide audit project on attorneys were issued in September 1993. This was the result of a 1988 pilot study in San Diego that found a significant number of lawyers (i.e., 10% of the sample) did not file returns, and many of those who did file provided inaccurate statements or excessive claims for deductions.

IRS officials stress that the attorney project is not an audit crackdown on attorneys, but rather a training exercise that is part of the Service’s Market Segment Specialization Program (MSSP). So far, IRS has said, 66 industries or market segments have been identified for the MSSP, covering a wide range of business activities.1 In addition to attorneys, six other business activities have been the subject of written audit guidelines (air charter companies, bed and breakfasts, gas stations, mortuaries, taxicabs, and trucking companies). These guidelines are the agents’ instruction manual for conducting an audit of the particular type of business or market segment. They are therefore a must-read document for the tax advisor called on to help the targeted business owner prepare for, and anticipate how to deal with, an IRS audit.

TARGETING THE ATTORNEY

The Service has been developing the MSSP and associated training manuals for almost two years, and the attorney audit program is one of the more advanced. Nationwide, IRS scrutiny in recent years has been very limited in terms of both the number of law firms selected for audit and the nature of issues queried. Prior to the MSSP, IRS agents generally had examined only traditional travel and entertainment issues. Typically involved were the business use of automobiles and country clubs, spousal accompaniment at educational or promotional venues, and business referral meals, concerts, sports events, etc., with clients or other attorneys.

The IRS training manual2 provides a composite profile of a typical audit-target attorney:

– Solo or small-firm practitioner.
– Graduate of a prestigious law school.
– Engaged in real estate, personal injury, immigration, or criminal law.
– Investor in various assets from condominiums to boats.
– Recently involved in a disciplinary hearing.
– Filed returns for the past five years consistently reporting minimal income.

Not all these factors need be present to rouse an agent’s interest in a particular individual. Of course, none of these traits need be present once the Service discovers that the lawyer has not filed a return.

The audit guidelines contain the Service’s position on the sensitive issue of attorney-client privilege and its impact on the documents available for review by the agent. For example, the IRS asserts that, once an audit begins, lawyers may not invoke the attorney-client privilege to protect business records or client identity. The privilege is solely the client’s prerogative. Further, unless the disclosure would implicate the client in a crime, even the client may not invoke the privilege merely to hide identity or fee arrangements.

Small firms. Just as it did when it launched its controversial small pension plan audit crackdown,3 the IRS has identified small firms or solo practitioners as the most likely targets for examination.4 The greater the ability to control the books, the more opportunity there is for manipulation. Attorneys employed by large firms have less access to financial records, the IRS reasons. Moreover, small and mid-sized law firms, very often structured as partnerships of individual attorney corporations, have allowed the individual attorneys to set their own policies and procedures in many areas with tax-reporting latitude — often with distinctly different approaches for precisely identical issues, even among partners in the same firm. In many firms, the partnership reports only “above the line” items in the Schedule K-l profit allocations, and thus questionable expenses are reported on the corporate partners’ separate returns. What such law partnerships often overlook, however, is that an adverse tax audit for one partner has a strong probability of leading the IRS agent to any or all of the other partners. As protection against flagrant abuse, and as an assurance that partners have in fact filed timely, some law firms require all partners to submit returns (individual or corporate) to the firm’s management.

Areas of practice. The four legal specializations noted above have been identified as likely to yield the most on audit. IRS agents can consult publicly available lawyer listings, including yellow-pages advertising and bar association referrals, to put together a working database of attorneys practicing in these targeted specialties.5

The Service understands that personal injury attorneys often advance client costs. Litigation expenses may include travel, costs of obtaining medical records, reports, interpreters’ fees, witness fees, and depositions.6 Some attorneys deduct these items as business expenses, even though they expect to be reimbursed from the settlement. As discussed further below, IRS agents are directed to disallow the deductions because these expenditures are advances.

Criminal law and immigration attorneys tend to demand full cash payment up front and generally have more access to cash than most other attorneys. Real estate attorneys have the opportunity to receive in-kind payments such as ownership interests or second trust deeds for services rendered. These factors are viewed as opportunities to underreport taxable income

Income data sources. Using their working list of small firms or solo practitioners in the four specialty areas, IRS agents can gain computer access to individual returns with Schedule C entries showing high audit potential. Attorneys who have not filed at all are referred for audit or possibly fraud investigation.

An agent’s decision to turn the investigation into a full-scale inquiry might depend on whether the attorneys on the list own substantial assets. Large holdings suggest the nonfiler may be receiving substantial unreported income. Also, the assets represent a potential means of recovery for the government.

Sources of asset information abound, and a resourceful IRS investigator need not contact the targeted attorney to uncover at least some possessions and holdings. A department of motor vehicles registry, county records, and the local tax collector’s office all keep data on ownership of various assets. Individuals and businesses are required to register fictitious business names as well as property records in the county or city. Real estate transactions in a county are available on microfiche, including the value of the property when purchased. Local courthouse files also provide good starting points for the investigator, particularly with regard to divorce and bankruptcy. Generally, these records are open for public inspection. The FAA and the Coast Guard keep records of aircraft and large boat owners, respectively.

Identifying a possible offender sets in motion the standard IRS audit procedures: a thorough pre-contact analysis, an in-depth inspection of the taxpayer’s income records, and independent verification or refutation of taxpayer’s statements. Several other independent sources of asset and income information include:

1. Currency and banking retrieval system. Banks and businesses must report certain cash transactions. For example, banks file Form 4789 (Currency Transaction Report) for transactions over $10,000. Cash payments exceeding $10,000 received in a trade or business must be reported on Form 8300.

2. Bankruptcy court’s chapter 13 trustee. The trustee makes disbursements of legal fees directly to attorneys and keeps a record.

3. Return preparer listings. Detailed lists of all returns prepared by a particular preparer may be obtained by agents through the Return Preparer Coordinator. IRS notes that these can be “useful where the attorney performs tax services for clients, pointing out potential new cases as well as trends in preparations.”7

4. IRS transcripts. These detail the Forms 1099 reported to the IRS, showing payments to the attorney-taxpayer, including interest and dividends (possibly leading to other bank accounts or investments).

THE AUDIT

The attorney should expect an extensive face-to-face audit session with the IRS agent. The agent will delve into office procedures that relate to charging fees, receiving payments, depositing funds, recording expenses, and disbursing payments.

The attorney examination project educates agents about the business peculiarities of law practice, including what financial records are available in a law firm, the basic types of fee arrangements, how office expenses are allocated per client, and the basics of trust accounts. Agents are told to focus on records of “time spent” on transactions.

The IRS training guide makes trust and bank accounts the first points of scrutiny, because many lawyers disburse their own fees and expenses out of the trust account and compute gross income based on such withdrawals. A personal injury attorney, for example, would deposit settlement funds in a trust account, pay out any expenses and the contingent fee, and remit the balance to the client. An attorney may deposit fees into other personal or business accounts, however, or the income may bypass bank accounts altogether. The auditor is therefore cautioned to examine deposits into all bank accounts, as well as track personal living expenses and case expenditures. Loans and other nontaxable sources of income should be identified during the initial interview.8

Initial interview. The training manual places particular emphasis on the revenue agent’s initial interview of the attorney. Direct testimony from the attorney-taxpayer is needed to establish the taxpayer’s responsibility for financial transactions, the IRS says, and a representative generally will not have adequate knowledge of the attorney’s practice. All possible income sources need to be pinned down initially, so that they cannot be introduced as explanations later. The Service believes that, when dealing with attorneys, particularly relevant questions include:

– How much cash was on hand at the beginning and end of the year?
– Were any loan proceeds received?
– Were referral fees received from other attorneys?
– Was compensation received other than cash?
– Are there any foreign accounts or offshore interests?
– Are there any interests in other entities?

To obtain a thorough understanding of the taxpayer’s bookkeeping system and internal controls, the agent is to get the attorney or the bookkeeper to explain every step from the attorney’s being retained by a client to the settlement of the account. The taxpayer’s level of involvement in bookkeeping, check writing, and trust account activity should be determined in case the attorney later tries to pass responsibility for problems and discrepancies to the office staff. This is important, according to IRS, if fraud becomes an issue. Agents are told that attorneys generally handle trust accounts personally, but other duties may be delegated and the agent should interview any other personnel involved with the bookkeeping.9

Although the Service assumes that a taxpayer-attorney will provide data directly to the field agent, any taxpayer has the right to designate a representative through power of attorney. While most taxpayer representatives take the position that their attorney-clients should never meet directly with examining agents, proactive advisors are now rethinking this traditional advice for MSSP targeted audits. Their concern is that refusal to let the IRS agent meet directly with the attorney being audited puts the agent in the difficult political position of being unable to accomplish the “direct testimony” emphasized in the training manual, with the attendant risk of a less reasonable negotiation. One compromise approach involves shifting the audit venue to the representative’s offices (rather than the taxpayer’s), and making the taxpayer-attorney available for face-to-face discussion later on in the audit (after most issues and exposure have been identified). Under Reg. 301.7605-l(e)(3), however, IRS has sole discretion to transfer the place of examination to the representative’s office, and the Service’s position on MSSP location transfers remains to be seen.

Attorney-client privilege. The IRS warns its agents that attorneys are likely to invoke attorney-client privilege to prevent the agent from delving any deeper into client files and accounts. Nevertheless, the IRS believes there is strong precedent on its side.10

The attorney-client privilege, originally meant to protect an attorney’s integrity, later developed into a way of protecting the client’s confidences and enabling the attorney to properly service the client.11 As noted above, the privilege is the client’s — not the attorney’s — to raise, and then in only narrow circumstances. A client may claim it only for a communication made by the client to an individual member of the bar acting as a lawyer. The communication must have been made without strangers present and in order to secure legal advice or services, not for the purpose of committing a crime or tort.

Where a party demonstrates a legitimate need for a court to require disclosure, fee arrangements and the identity of the client fall outside the scope of the privilege.12 The IRS maintains that even a client trust account is not protected by the attorney-client privilege.13  A client’s identity and fee arrangements may be privileged, however, if the client can show that disclosure would implicate the client in criminal activity for which legal advice was sought.14   If IRS issues a summons against an attorney who refuses to submit documents because the client invokes the privilege, the attorney bears the burden of showing the information is protected.

Cash reporting. A related battleground involves the cash-reporting requirements. Recent decisions in this area do not bode well (by analogy) for claiming in a tax audit that the attorney’s business records come within the attorney-client privilege.

Section 6050I requires anyone who receives more than $10,000 in cash in a business transaction to file an information return (Form 8300) within 15 days after the transaction. The return identifies the individual from whom the cash was received, including name, address, Social Security number, and amount received. Attorneys have argued that, by supplying the information demanded on Form 8300, they are violating their ethical obligation to keep their client’s dealings with them confidential. In most cases involving noncompliance, the attorney failed to file Form 8300 or filed it without disclosing the required information, asserting the attorney-client privilege, and then refused to comply with an IRS summons.

To date, courts have rejected attorney-client privilege as a basis for not filing or filing an incomplete Form 8300. In Goldberger & DubinP.C., 935 F.2d 501 (CA-2, 1991), the court concluded that identification of clients on Form 8300 did not disclose privileged information. In Leventhal, 961 F.2d 936 (CA-I1, 1992), the court asserted that merely seeking an attorney’s legal assistance should not create an expectation of confidentiality on the part of the client, and also rejected application of the “last-link doctrine,” which extends attorney-client protection to nonprivileged information that would reveal privileged information.15

The clear import of the Form 8300 decisions is that the attorney-client privilege will be construed very narrowly where the disclosure of requested information appears to bear only a remote or tenuous status as part of an intended confidential communication. Consequently, an IRS summons of an attorney’s financial records as part of an MSSP tax audit of the attorney is not likely to be blocked by attorney-client privilege. The attorney’s client-file records still should be protected, however. As to the financial records, other objections (e.g., the summons is (1) unduly broad or burdensome and oppressive in scope, (2) searching for improper purpose, or (3) not relevant if the type of requested records are unlikely to bear on the audit issues) should be considered as legitimate and possible supportable grounds for refusing to comply with a summons.

AUDIT ISSUES

The agent is likely to concentrate on specific areas such as unreported income, improper expenses, and employment tax issues.

Unreported Income

The IRS suspects that some attorneys, particularly personal injury practitioners, do not properly account for settlement checks. Others may try to defer income or fail to report noncash receipts.

Bank and trust accounts. The agent will insist on examining all bank accounts — business and personal — giving particular scrutiny to the trust accounts. The training manual notes that most attorneys have one or more trust accounts under their control and instructs auditors that adjustments to taxable income most frequently arise when an attorney diverts funds from a trust to a personal account or defers income by allowing fees to remain in a trust account. Even if the firm uses a cash-method accounting system, an attorney who has the unconditional power to receive or delay actual receipt of trust account funds may be in constructive receipt of income. According to the Service, special attention should be given to all checks that are either cashed or deposited into accounts other than the general operating account. In addition, funds may be withdrawn directly through the use of an ATM card.16

The manual instructs agents to determine whether any funds in a trust account represent fees that have been earned on settled cases. In the practical context of most audits, this would be accomplished by matching the timing of client and cost disbursements with disbursements of the attorney’s fees. When a settlement (or the collective trust account disbursements related to a settlement) is deferred to the next year, the constructive receipt issue most likely would not surface.

Another possible area of adjustment involves deferred billing. One audit revealed that a public defender had billed the county for only the first half of the year even though he could have submitted bills monthly. The other half of the fees were billed the following year. IRS maintained that the attorney was in constructive receipt of the fees he could have billed and received earlier. While this may have been an egregious situation, if the Service’s position were carried to an extreme, a great majority of cash method law firms might find their year-end unbilled work-in-progress classified as taxable income.

Noncash income. The IRS is aware that many opportunities exist for attorneys to obtain noncash compensation for services rendered. A noncash transaction is not usually reflected in bank records, and real property or stock could be camouflaged via dummy trusts or owners.

The training manual states that an attorney’s sources of noncash income may depend on the practitioner’s specialty or the particular work done for clients. An attorney who does real estate work may accept as a fee a second or third trust deed on a client’s property. A client may quitclaim a partial or entire interest in a property, or pay the attorney through a sale or purchase escrow. An attorney whose services include setting up partnerships or corporations may accept an interest in the entity in exchange. Agents are instructed to examine client ledger cards or request verification of basis for partnership interests shown on the attorney’s return. In general, client ledgers and the attorney’s appointment books are recommended as sources for finding some indication of noncash payments. Revisiting the financial and ownership information gathered prior to the initial contact may alert the agent to discrepancies between fees charged and income reported, and the extent of assets held.17

While client charge-offs are not discussed in the training manual’s emphasis on essential features of a law firm’s recordkeeping system, it is reasonable to expect that agents also might look for documentation of unbilled services rendered, evaluating the possibility that payments may have been received in noncash assets or bartered services.

Expenses, Employment Taxes

IRS agents are told to challenge certain types of expenses attorneys may claim by focusing on the four principal elements of Section 162 (i.e., (1) ordinary and necessary expense (2) paid or incurred during the tax year (3) in carrying on (4) any trade or business). Of course, travel and entertainment expenses, which IRS sees as a major problem area, also must meet the substantiation requirements of Section 274(d) (i.e., adequate records or other sufficient evidence establish the amount, time, place, and business purpose of the item, and the business relationship between the taxpayer and any person entertained).

Entertainment and promotion. As with other types of business attorneys may not deduct expenses for an entertainment event that affords little or no opportunity to engage in the active conduct of trade or business, i.e., where distractions are substantial. If no business is discussed, no deduction is allowed. For example, attorneys may not deduct expenses for purely social events meant to generate publicity and goodwill.18

The IRS believes that attorneys have abused claims for deductions based on entertainment, promotion, and advertising expense. According to the Service, one personal injury attorney deducted more than $60,000 over three years for rock-and roll concert tickets, dinners, and limousine service to entertain doctors, fellow attorneys, and potential clients. The attorney contended that he was making his name well known in the music business so that people in the industry would come to him when they needed an attorney. IRS found the reasonableness of this assertion questionable.19

Notwithstanding the IRS position, for that musically inclined attorney the expenses may have been properly deductible (if the Section 274(d) record keeping requirements were met). Section 162 does not deal with the reasonableness of a taxpayers belief that an activity will generate a profit.20 Instead, it requires the taxpayer carry on the activity with a good-faith purpose of making a profit or a belief that a profit can be made.21 If the attorney could show these expenses had produced new clients or business income, arguably they would be deductible under Section 162 notwithstanding the element of personal pleasure or social diversion involved in the activity.

Travel and hobbies. IRS agents will look for travel deductions that may disguise vacations. Some attorneys are licensed to practice in more than one state and thus may have related business travel, but they still must provide proper substantiation.22

Agents are also instructed to search for efforts by attorneys to deduct the costs of their hobbies. Questioning the attorney about hobbies during the initial interview, IRS says, may provide information valuable in the audit of expenses. According to the Service, many self-employed attorneys have enough income to afford the luxury of very expensive hobbies, which often turn up on tax returns as some sort of business expense.23

Obviously, where an attorney has improperly claimed personal travel or hobby expenses as business related, the deduction will be disallowed. Nonetheless, combining travel with an educational or professional activity may make part or all of the expense deductible. Attending a seminar or traveling to develop a new client prospect, for example, can make travel, meals, and lodging expenses all deductible under Section 162.24

The attorney should keep the necessary substantiation records to support the business purpose of the expense. The costs of sightseeing, social visiting, and similar activities that are incurred in connection with the business-related activity should not be deducted.25 This also shows the good-faith effort of the attorney to properly segregate business and nonbusiness expenses. Most tax advisors strongly recommend using a different credit card to charge personal and business transactions. As self-serving as the argument may be, the representation that an expense was business related because it was transacted on the business card (versus a separate personal card) has occasionally satisfied an agent’s inquiry. The IRS, however, wants agents to go beyond such evidence and look for abuses in this area (as discussed further below).

Corporate expenses. An agent will inquire about the attorney’s lifestyle and personal living costs, to see how they match reported income. The training manual notes that attorneys who are corporate shareholders often use a company credit card for travel and entertainment. Frequently, personal expenses are charged on those cards and paid by the corporation. Thus, agents auditing incorporated attorneys will consider constructive dividends for personal expenses paid by the corporation.26

As mentioned in the preceding discussion, the careful attorney always should adequately document the business purpose of an expenditure. Furthermore, combining business and pleasure does not make the business expense portion nondeductible — the taxpayer merely has to maintain adequate records to show the business purpose.

Depreciable books and periodicals. Generally, the cost of law books and services and similar materials may be depreciated over five years.27 The cost of books and other publications that have a useful life of one year or less may be expensed in the year purchased. IRS is concerned that attorneys are immediately deducting the full cost of publications that have a five-year life.

Advances of client costs. Attorneys who take cases on a contingency basis generally pay litigation expenses on behalf of their clients. These expenses are deducted when paid and the recovered costs are included in income when received. Concluding that an item is deductible, however, does not necessarily identify the tax year in which the deduction may be claimed. For most taxpayers, it is advantageous to accelerate deductions to the earliest tax year permitted. Courts, however, have characterized advances of client costs as loans rather than deductible business expenses. If the advances become uncollectible, the attorney may deduct them as business bad debts.28

The agent will inquire whether costs are being advanced and, if so, the length of time over which the costs are recovered. The longer the time between the advance and the recovery, the more distorted the income picture gets, according to the IRS. The agent will review the attorney’s client ledger cards showing expenses paid for each client. Recoveries included in a cash receipts journal usually are listed separately from the fee income from the case.

In auditing attorneys’ returns, agents scrutinize deductions claimed under “other expenses” or “client costs,” the typical categories that generally reflect advances. The Service has informed its auditors that some attorneys offset these costs against gross receipts and reflect only the net amount in the return.

Beyond taxpayer arguments that such costs should be allowed based on year-to-year consistency in reporting, this issue has become far more difficult to defend. In recognition of this fact, one Colorado law firm instructed its accountant to file for a change in accounting method for client advances to reflect the item as a loan, having determined that it was not worth the time and cost to defend this issue in anticipated future audits.

Employment tax issues. The IRS is concerned that attorneys, like many other employers, are treating employees as independent contractors to avoid employment taxes. According to the training manual, there is an employment tax issue where an attorney treats a receptionist or secretary as an independent contractor. Attorneys often hire paralegals to do research and write briefs, and law clerks may be used to complete much of the necessary legal paperwork. In most cases, the paralegals and clerks are under the close supervision and control of the attorney, and IRS would classify them as employees. This determination is more difficult however, where such services are provided by other attorneys. The training manual states that consideration must be given to the method of compensation (e.g., by the hour or by the case). Control also is an important factor. Generally, other attorneys are independent contractors and should be issued a Form 1099. This is particularly true where their services are offered to the general public.29

The IRS has found that some attorneys who pay independent contractors (e.g., expert witnesses) out of trust accounts do not issue Form 1099 as required under Section 6041. These attorneys assert that the form was not their responsibility because the trust fund source of the payments belonged not to them, but to their clients. Nevertheless, the Service maintains that Section 6041(c) requires that the lawyer file the forms. The auditor examining copies of Forms 1099 will verify that they were filed.

OTHER MATTERS

Consequences for the audited attorney’s clients and the Service’s treatment of nonfiling attorneys are two areas in which an attorney audit can have significant fallout.

Client abuses. The IRS has alerted agents to be aware of abuses by attorneys’ clients. Often these abuses could not have been accomplished without the attorney’s cooperation. Auditors will look for any unusual transactions between the attorney and others that can lead to related examinations.

In one instance, a client paid $100,000 in purported legal fees, which the attorney deposited in his professional trust account. After the close of the client’s fiscal year, the attorney returned the funds. The client claimed a $100,000 deduction and the attorney did not declare taxable income. In another scheme, a doctor paid alleged legal fees to an attorney who deposited the funds into a trust account. Later, those funds were gradually funneled into an S corporation, which used the money to construct a vacation home for the doctor.

Voluntary compliance by nonfilers. According to IRS estimates, over $7 billion in tax collections are lost due to nonfiling.30 As noted above, in the San Diego pilot study the Service found that over 10% of attorneys did not file returns.

In December 1992, the Service reconfirmed its practice of not recommending criminal prosecution of nonfilers who voluntarily file late.31 Criminal prosecution may be avoided where the non-filer:

– Informs the IRS that returns have not been filed for one or more tax periods.
– Has only income from legal sources.
– Makes the disclosure before being contacted by the IRS (for this purpose, “contact” means that the IRS notified the nonfiler or a representative via telephone, letter, or personal visit that the taxpayer was under criminal investigation).
– Files true and correct returns and cooperates with the IRS in ascertaining the correct tax liability.
– Pays the amount due in full, or makes bona fide arrangements to do so.

On the other hand, nonfiling attorneys who are identified through the MSSP (or other IRS audit procedure) face potential criminal fraud prosecution. In Southern California, the IRS criminal investigation division has been engaged in “Project Esquire,” targeting attorneys who have failed to file returns.

One consequence of a successful felony tax fraud prosecution is loss of the license to practice law. Moreover, nonfiling attorneys usually are suspended or disbarred from practice before the IRS, and the Service has threatened to suspend entire law firms that refuse to expel a nonfiling attorney.32 This sanction would not apply to an attorney who voluntarily disclosed and acted to correct nonfiler status. These draconian penalties should compel the nonfiling attorney to adopt the voluntary procedures (especially given the new MSSP targeting attorneys).

CONCLUSION

The Service has denied any deliberate, premeditated nationwide dragnet on attorneys. It continues to use the computerized scoring system for selecting returns (the “audit lottery”), which red-flags returns that do not satisfy the normal relationship range between income reported and expenses claimed. The increased risk resulting from the training manual is not that more attorneys will be audited but that those tagged for audit will very likely face a well-prepared IRS agent.

Starting in October 1995, the IRS will shift from its current audit system to an industry segment approach, with attorneys categorized as a service industry. The central theme of the new approach is to better target certain profiles — e.g., attorneys — within taxpayer categories. The methods suggested in the training manual appear effective, assuming the availability of adequate IRS personnel and resources.

Attorneys who have evaded taxes in the past would need to discuss specific issues with their tax advisors, particularly the possibility of voluntarily approaching the IRS to file late or amended returns. Obtaining expert advice will be essential in maximizing any opportunities to limit tax liabilities and negotiate payment terms.

For the attorney who seeks only to minimize taxes within reasonable boundaries of tax propriety, the MSSP program should have little impact. Travel and entertainment substantiation rules remain the same, and expenses are defensible as long as the principal purpose is business and there is a clear correlation between the attorney’s calendar and those expenses. Non-work activities pursued for the potential of profit can escape the “hobby” stigma and provide legitimate deductions. Tax advisors who have dealt with these issues before can provide optimal approaches to minimizing tax exposure as well as dollars.

Nonetheless, for some attorneys the MSSP program may be a catastrophe waiting to happen. Proactive tax advisors have been strongly encouraging attorneys and law-firm clients to take action now so that, in the event of MSSP audit selection, adverse consequences may be avoided. One nationwide association of independent CPA firms has even developed a ten-page checklist to guide law-firm clients toward this objective.33Any attorney who will make the time and effort to plan ahead has the opportunity to achieve a satisfactory MSSP audit result.


1 For a complete listing, see “Market Segment Guidelines Being Developed for 66 Industries,” IRS Practice and Policy Bulletin (Tax Management, 11/12/93), pages 27-28.

2 Market Segment Specialization Program (MSSP): Attorneys, Department of the Treasury, Internal Revenue Service, Training 3149-103 (April 1993), TPDS 83183A (hereafter, MSSP: Attorneys).

3 See generally Reish and Ashton, “Most Small Plans Face Disallowances Under New Actuarial Audit Program.” 75 JTAX 4 (July 1991). IRS has not been successful in this venture. See “IRS Finally Wins Partial, Pyrrhic Victory in Actuarial Assumption Dispute,” 82 JTAX 130 (March 1995).

4 MSSP: Attorneys, supra note 2, page 4.

5 In the 1988 pilot study, IRS identified nonfilers by matching its computer databases with names in publicly available professional directones such as Martindale-Hubbell. Other sources included the yellow pages, newspaper articles, and TV and radio advertisements. Some newspapers were included in database search systems such as NEXUS or Data Times, which could be queried under either a specific name or a more generic topic. One informative source was the California Lawyer, a periodical that publishes disciplinary notices from the California State Bar Association. The notices frequently had tax implications and, since they were published after court proceedings had occurred, the information was in the public domain. MSSP: Attorneys, supra note 2, at page 6.

6 See Canelo, 53 TC 217 (1969), aff’d 447 F.2d 484 (CA-9, 1971).

7 MSSP: Attorneys, supra note 2, at page 24.

8 Id. at page 12.

9 Id. at pages 26-27.

10 Id. at page 17.

11 Colton,306 F.2d 633 (CA-2,1962).

12 In re Osterhoudt, 722 F.2d 591 (CA-9, 1983).

13 Union First Nat’l Bank of Washington, DC D.C.,4/22/80.

14 Hodge & Zweig, 548 F.2d 1347 (CA-9, 1977).

15 In Garland. DC Ga., 4/9/92, the IRS summons was enforced because it was found to have a legitimate interest in investigating noncompliance with reporting requirements. Under the summons enforcement rules, only a single legitimate purpose need be shown. See, e.g., Tiffany Fine Arts, Inc., 469 U.S. 310 (1985), and Doe, DC Tenn., 5/23/91.

16 MSSP: Attorneys supra note 2, at page 32. The IRS notes that an effective audit step may be to analyze funds in trust accounts at year-end by source, especially where there is a large balance. Agents should seek to determine whether any of the funds represent fees that have been earned on settled cases. Id at page 33.

17 Id. The Service noted one instance where an attorney borrowed a large sum of money from a corporate client. The loan was reduced and finally paid off in exchange for the performance of legal services. The attorney’s books reflected the loan but not the subsequent income. When no loan repayments were noted, the agent contacted the lender, who confirmed the loan and supplied information concerning the credits against the outstanding balance earned by services rendered.

18 Walliser, 72 TC 433 (1979); Flaig, TCM 1984-150; St. Petersburg Bank & Trust, 362 F. Supp. 674 (DC Fla., 1973), aff’d without pub. opn. 503 F.2d 1402 (CA-5, 1974); Gardner, TCM 1983-171.

19 MSSP: Attorneys, supra note 2, at page 35.

20 Hillcone Steamship Co., TCM 1963-220.

21 Doggett v. Burnet, 65 F.2d 191 (CA-D.C., 1933).

22 MSSP: Attorneys, supra note 2, at page 37. The training manual also notes that some attorneys have used motor homes on trips and claimed 100% business deductions, while others have deducted the costs of a honeymoon. Documents that include the names of the attorney’s spouse and children may create suspicion.

23 Id. IRS stated that, in one case, an attor ney said his hobby was fine wines. He and two associates had a wine cellar stocked with wines from all over the world. The agent found deductions claimed under office supply expenses for wine purchases. In other instances, deductions were claimed for hobby activities such as a charter fishing boat, polo ponies, and antique cars.

24 See Reg. 1.162-5(e)(1); Ford, 56 TC 1300 (1971), aff’d 487 F.2d 1025 (CA-9. 1973).

25 Reg. 1.162-5(e)(1).

26 MSSP: Attorneys, supra note 2, at page 38.

27 Rev. Proc. 87-57, 1987-2 CB 687.

28 See, e.g., Canelo, supra note 6; Herrick, 63 TC 562 (1975). See also TAM 9432002 (deduction of certain unbilled costs).

29 MSSP: Attorneys, supra note 2, at page 43. Rev. Rul. 87-41, 1987-1 CB 296, lists the 20 factors IRS applies to distinguish employees from independent contractors. Under this test, most law-firm support staff will be employees.

30 IR-92-94, 9/30/92.

31 IR-92-114, 12/17/92.

32 Circular 230, sections 10.24 and 10.51.

33 Continental Ass’n of CPA Firms, Inc., Englewood, Colorado. (Now Accountants Global Network International [AGN])