By Michael Luchies and Carin Weiss Krolikowski of Kahuna Accounting.
The word “audit” makes every entrepreneur cringe. According to tax lawyer Robert Wood, solo practice and small firm lawyers are prime targets for auditors. The IRS has long found lawyers to be a fruitful source of revenue and information and even launched ‘Project Esquire’ in the late 1980s to target attorneys. While reasons for the processes behind audits are tightly held IRS secrets, there are several red flags and indicators that make lawyers likely audit targets.
Here are the top five reasons why lawyers are more likely to be audited:
1. Level of income
At an average rate of $250/billable hour, a lawyer who works just 16 hours a week would make $208,000 a year. While this is above the average salary of most attorneys, it’s feasible, and it’s also a red flag for auditors. Individuals making over $200,000 are nearly twice as likely to be audited than individuals making $25,000 to $200,000 per annum.
2. The complexities of trust accounting
When a trust liability account doesn’t match what’s stated in an attorney’s books, this is a sign of shoddy bookkeeping, illegal activity, or both. This is a big red flag for the IRS. Auditors are going to look at the balance sheet, trust bank account, and client liability account to make sure they balance. If they don’t, you’re at a very high risk of being audited and potentially disbarred. Learn how Clio’s new Trust Request feature can help you avoid common trust accounting mistakes.
3. Excessive deductions
Business owners are allowed to write off expenses in categories outside of what impacts their bottom line. A business-related dinner, a trip to meet with a client, or taking your team on a short retreat are legitimate write-offs. However, if you don’t carefully track and record these receipts and are unaware of what is and what isn’t eligible for a write-off, you’re at risk of being audited.
“The IRS has a program that compares your itemized deductions (especially charitable donations) with others in your tax bracket to see if it is reasonable,” said Andy Phillips, a director of the Tax Institute at H&R Block. “That doesn’t mean you don’t want to claim them, just make sure you can back them up.”
4. Mixing personal expenses with business expenses
- Used his law firm bank and payroll accounts to issue checks for personal expenditures
- Created and maintained ledgers concealing his personal expenditures
- Established bank accounts for nominee trusts and used them to disguise assets
- Titled personal residences in the names of nominee trusts to disguise their ownership
5. Entity/filing structure
How you file also has an impact on your audit risk according to Wood. “Having a business pay the owner’s personal expenses is hardly unique to the practice of law. It occurs across a wide spectrum of small business and is probably a big reason why individual tax returns with a Schedule C—on which sole proprietors report their business income and losses are the most likely returns to be audited.”
Lowering your risks
Every entrepreneur is responsible for the taxes they submit. This responsibility shouldn’t be taken lightly, but it doesn’t have to be done alone either. The best way to immediately lower your risks of being audited is by working with a trained professional accountant that specializes in working with attorneys and law firms.
If that isn’t an option, educating yourself on how to properly track and record trust accounting related transactions and documents are key. It’s also important to dedicate yourself to capturing and recording transactions daily. You always want to have a paper trail that can show third-parties how and why you made specific entries.
Interested in learning more about how to streamline your accounting processes? Watch our webinar on Legal Accounting and learn how to balance your books and avoid a messy audit.
Kahuna Accounting provides virtual accounting and bookkeeping to solo and small firm attorneys all over the United States. Specializing in integrating Clio with accounting, Kahuna helps firms unload the headache of bookkeeping to they can focus on their practice.