BY ROBERT W. WOOD
ROBERT W. WOOD is a tax lawyer with a nationwide practice
( www.WoodLLP.com). The author of more than 30 books including Taxation
of Damage Awards & Settlement Payments (4th ed. 2009, www.taxinstitute.com),
he can be reached at Wood@WoodLLP.com.
This discussion is not intended as legal advice, and cannot be relied upon for
any purpose without the services of a qualified professional.
lthough no one likes an
IRS audit, lawyers may
dread dealing with the IRS
more than most people, especially if it
means the IRS may commence poking into
the financial affairs of their practice. By its
very nature, law practice is con-
fidential, and keeping a client’s
confidence is of supreme
importance. It should therefore
be no surprise that the thought
of the IRS looking at a lawyer’s
books could provoke concern
for clients as well as the lawyer.
No lawyer wants to keep
clients in the dark about the
risk that their identities have
been disclosed to the IRS. Yet
no lawyer wants to risk having
clients bolt by telling them the
IRS has their names either. Any
interaction with the IRS will be
an inconvenience, but it could
be expensive or even carry
grave consequences. Some
believe the IRS unfairly targets
lawyers, recalling the IRS’s
“Project Esquire” of several
decades past. More recently, the IRS has
released a new audit guide directing its
agents how to audit lawyers.
It contains interesting points even for
lawyers who have no fear of dealing with the
IRS and who would not expect an audit of
their practice to give rise to any problems.
In some cases, lawyers should beef up their
internal controls and their documentation.
Lawyers should be careful to segregate
records the lawyer considers protected by
attorney–client privilege from those that
clearly are not.
One of the primary messages of the IRS
audit guide for law practices is that the IRS
expects lawyers to have good internal
accounting and a good system of recording
costs and expenses. Many lawyers, especially
in small offices, feel they have little need for
such systems. That may be a mistake.
have too much in their trust account and are
slow to withdraw amounts from the trust
account to which they are entitled.
Yet it is clear that if a lawyer is entitled to
fees in his trust account they represent income
to the lawyer for tax purposes. It does not
matter if the lawyer waits to
actually withdraw the fees from
his trust account until the following tax year. Many lawyers
incorrectly assume that when a
case settles and funds are wired
to the lawyer’s trust account in
December, it is not income until
it is disbursed to the lawyer in
The IRS devotes significant
attention to attorney–client
privilege in its audit guide.
There is good reason for this,
because claims of privilege are
common in audits of lawyers.
Lawyers are a cautious lot and
do not want to risk violating
privilege by giving the IRS too
The IRS correctly instructs
its agents that the privilege
belongs to the clients, not to the lawyers.
Even so, of course, lawyers commonly assert
the privilege on behalf of their clients, knowing that the client is the only person who can
waive it. Yet precisely what kind of information is privileged?
The IRS audit manual states firmly that
the identity of clients and their fee arrangements are almost never considered privileged.
There is some case law on this point and
lawyers may not even want names or financial
arrangements disclosed. However, the IRS is
correct that lawyers generally cannot fail to
turn over the names of clients, the amounts
The IRS expects billing software, of
course, and will want to examine it and its
results. The IRS is particularly interested in
seeing the adjustment log that reconciles
the output of the time and billing system to
the appropriate accounts in the general
ledger. The IRS will want the accounting
and general ledger to tie together. If it does
not, the IRS may want to go through bank
records in excruciating detail.
Lawyer trust accounts are also vital
sources of information. Here, most lawyers
are careful, although precisely what the IRS
looks for may surprise some. Many lawyers