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Monday, March 27, 2017

Costly Surprises: Hidden Tax Liabilities for Law Firms


By David Roberts, Practice Leader, and Derek Barto, Principal, Law Firm Services group

Imagine this scenario: You’re one of four partners in your 25-lawyer firm. One partner decides to retire. You and the other two remaining partners buy him out, and he heads off to spend his time fishing. Shortly afterward, an IRS audit of your firm uncovers a $300,000 tax liability created by improper treatment of client costs. The remaining partners (that includes you) are now on this tax hook for the liability, plus any penalties and interest.

No one wants to be in a situation like this. Yet for small and mid-sized law firms, these kinds of unpleasant—and costly—tax surprises happen all too often. Many managing partners, executive directors, and even controllers and chief financial officers are unaware that their firm faces substantial risk because of incorrect or overlooked tax and accounting positions.

Four surprises you don’t want to get
If you’re like most managing partners or executive directors, you don’t have an extensive background in law firm tax and accounting rules. Theoretically, you shouldn’t need to understand the nuances of complex tax and accounting regulations to manage your business. However, what you don’t know can definitely hurt you when it comes to specific tax rules for the legal industry.

Here are some often overlooked or incorrectly handled issues that can result in substantial tax liabilities, penalties and interest for law firms: 

  1. Client costs
  2. Are these deductible business expenses or non-deductible loans to clients?  The IRS considers these costs paid on behalf of clients to be loans to clients, not operating expenses of the business. Therefore, these costs are not deductible by the law firm (unless they are not reimbursed by the client, and then they can be written off as bad debts).  Many firms still incorrectly take these client costs as deductions on their tax returns―a mistake that could leave the firm, or its partners, facing a large and unexpected tax bill.

  3. Negative partner capital accounts
  4. As a partner in a law firm, is having a negative capital account a good thing or a bad thing?  And how do you get a negative capital account balance? The short answer is that you received more draws or distributions than you were allocated income.  So I guess you could say that’s a good thing. Who wouldn’t want more cash―especially when you don’t have to pay tax on it, since you are taxed on income allocated to you and not the cash you take (corporations are different).  The bad thing comes about when your negative capital account becomes positive (now you have more taxable income than cash), or when a partner withdraws from a firm and their capital account is negative (you either have to pay it back or it becomes taxable).

    Many law firms don’t pay much attention to these capital account issues until there is a problem, like a partner withdrawal.  Then there could be analysis and reconciliations going back years, just trying to explain what happened, with a significant cost for hiring experts and a potential tax liability.

  5. Payments to withdrawing or retiring partners/shareholders
  6. When a partner or shareholder leaves a firm, it is not unusual for that individual to receive some type of payment.  The issue here is how to properly structure the payments to be as tax efficient as possible. What is best for the withdrawing partner/shareholder may prove to be a significant burden on the firm and the remaining partners/shareholders.  Buying a partner’s interest or a shareholder’s stock upon withdrawal could cost as much as 60% more in aggregate taxes paid if the payment is structured poorly.

  7. Multi-state economic nexus
  8. Does your firm provide a significant amount of legal services for out-of-state clients? If so, a recent requirement in some states could mean that you have to file tax returns and pay taxes there.

    Before a taxing jurisdiction (state) can require an out-of-state firm to file an income tax return and pay tax, that firm must have a sufficient connection with the state, known as “nexus.”  Historically this required a physical presence, such as property or payroll in the state. But recently, many states (including California and New York) have adopted something called “economic nexus,” under which a physical presence is not required as long as the firm has an economic connection to the state. For example, a single-office, California-based law firm providing $1,100,000 in legal services to a New York client would likely be required to file a New York franchise tax return, even if all of the services were performed in California.

Is your firm at risk?
Although you know the law business, you have to trust your professional advisors to know the business of law, including the specialized tax issues.  The tax and accounting rules for law firms are technical and unique to this industry. You need to understand your tax liability risks to prevent nasty financial and tax surprises. A law firm tax and accounting expert can identify the many issues that are specific to the legal industry and provide your firm with sound solutions.

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