Tax issues for solo practitioners and small law firms are pretty much the same as those for other businesses. In order to reduce your chances for an Internal Revenue Service or state taxing authority audit, report all income, and do not over-deduct your expenses.
The IRS pays close attention to Form 1099 reporters, so make sure all of that income gets reported on your Form 1065 partnership return, Form 1120S income tax return, or your Schedule C if your firm is not a partnership or S-corporation.
From the expense perspective, your firm is allowed to deduct reasonable, ordinary and necessary business expenses. For general law-firm operation, that means rent, office supplies, telephone costs, legal research charges, bar association dues and other expenses that help you help your clients.
The IRS gets very picky about a few things, though, and a front-line revenue agent conducting an exam will go by the book and disallow certain expenses if you do not properly substantiate them. In particular, mileage expenses, food expenses and promotional expenses are particularly troublesome to those experiencing an IRS audit.
For each of these expenses, a short rule of thumb is to keep all receipts and a log recording the “who, what, when, where and why” of the expense. You should note on the back of the receipt what the expenses are for on the same day that the money is spent. Do not let receipts pile up. Unless you are really good about annotating receipts, you will forget what it is for.
Internal Revenue Code Section 274(d), for example, requires taxpayers who deduct mileage to keep a log detailing the mileage, the starting point and destination, and the business purpose of the trip, or the entire deduction is subject to disallowance. Even the normally more-reasonable Appeals Officers will sustain a disallowance if a taxpayer cannot substantiate a mileage expense.
For meals, a taxpayer is permitted to deduct only 50 percent of the expense, and must keep a contemporaneous recording of who attended the meal, the business purpose of the meal and what was discussed. Legibly writing these details on the receipt is permitted.
Because of huge abuses in the past, revenue agents closely scrutinize promotion expenses for all three of the basic requirements: are the promotion expenses ordinary, necessary and reasonable? Generally, the test is one of production — i.e., do the (usually high) promotion expenses actually result in increased clients and revenues?
A golf outing, for example, may or may not qualify as a legitimate business expense, depending on the extent to which business is discussed and transacted. Also, the number of golf outings claimed as deductions can determine whether an IRS agent will examine the expenses more closely. If a practitioner claims one golf trip, the IRS will probably not focus on it. If 15 golf outings are claimed, the IRS agent may think this is worth greater scrutiny.
Additionally, employment taxes are an important part of running a business. The IRS closely monitors employment tax payments. If they are not paid, the IRS (and the state taxing agency) is quick to enforce collection of the taxes due. Sometimes collection action will occur within two quarters of nonpayment. This can cause some undercapitalized businesses to “pyramid” in the nonpayment of taxes, which only makes an IRS revenue officer more determined to get the business into compliance through lien filings, bank levies and other direct collection action, or to shut it down.
The IRS considers the nonpayment of payroll taxes equivalent to making the United States an unwilling business partner or lender. Unlike debts to a business partner or lender, though, Trust Fund Recovery Penalties assessed against “responsible persons” who “willfully fail” to collect and pay payroll taxes are not dischargeable in bankruptcy.
Solo practitioners and small law firms, like other businesses, should consult with a Certified Public Accountant or qualified tax lawyer for tax assistance. With the proper guidance and tax planning, your practice can grow while minimizing your tax burden and the likelihood of an audit.
Anthony G. Sandonato, CPA/ABV, CVA, Esq., is a partner with Mengel, Metzger, Barr and Co. in Rochester. He can be reached at (585) 423-1860 or by email at firstname.lastname@example.org.