Law Firms: Consider These High-Risk Areas to Avoid an IRS Audit!

The IRS is feeling the effects of government budget cuts, leaving the agency short-handed for the upcoming tax season. But if you think this means you won’t have to worry about the possibility of an audit, think again.

The IRS chooses returns to audit using a variety of methods. In addition to  randomly selected returns, the IRS frequently chooses large corporations and individuals with potential participation in abusive tax avoidance transactions. Companies and individuals preparing  their own tax returns may be more likely to be audited. Law firms, especially those handling large sums of money like criminal defense, real estate and immigration lawyers, are especially susceptible.

To help reduce the risk of your law firm being audited – or to help your firm emerge from an audit, unscathed, consider these high-risk areas.

1. Documenting expense reimbursements

Does your firm have a policy for handling expense reimbursements? Does that policy address the way expenses will be reported? Characterizing personal expenses as business expenses and vice versa is a common mistake – but one that could land your firm in hot water with the IRS. Be sure to adequately document your expense reimbursements and your policy.

2. S Corp. stockholder compensation

Officers’ compensation is top-of-mind for the IRS when it is reviewing a return. Is the compensation paid to your firm’s stockholders justified? Is it reasonable? If a stockholder earns a salary below the market average, or doesn’t earn a salary at all, the IRS could consider this a red flag and take action.

3. Reporting trust account balances

Does your firm have trust accounts for escrow funds? The way this money is reported will likely be reviewed closely by the IRS and the state bar association. Properly recording and reconciling trust account transactions, as well as adequately recognizing income, can help your firm if the IRS comes knocking.

4. Handling of client costs

How precise are the records your firm keeps about client expenses? Are those expenses allocated correctly? Law firms need to keep accurate and updated records about client-incurred expenses. Mishandling client costs is a red flag for the IRS to take a closer look at your return.

5. Reporting tax deductions

Can you prove that the money you spent on dinner, entertainment or travel served a business purpose? Big meal, travel and entertainment deductions are a red flag for the IRS, and a clue that your firm may be selected for an audit. In order to qualify for these deductions, you need detailed records documenting the amount, place, attendees, business purpose and even the nature of the discussion for each expense you claim. If you retain this information, you should be able to claim those tax deductions even if the IRS audits your tax return.

You may not be able to avoid an IRS audit.  But being prepared in case one occurs means being thorough with your policies and procedures and the support for what is being reported on your return. Frivolous claims, missing receipts and misallocated expenses won’t cut it under the IRS microscope. Identify issues and obtain the proper documentation you need now, so you can avoid a mess later.