Costly Surprises: 4 Hidden Tax Liabilities for Law Firms
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 the hook for this liability, plus any penalties and interest.
No one wants to be in a situation like this. Yet for small and midsize 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 firms face 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
Are these deductible business expenses or nondeductible 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, at which point 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.
2. NEGATIVE PARTNER CAPITAL ACCOUNTS
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? (You’re taxed on income allocated to you and not the cash you take; corporations, however, are different.)