Afraid of Being Audited? An IRS Guide May Help Ease Your Mind
The prospect of an IRS audit can cause even the most level-headed attorney to panic. Take a deep breath. The IRS’s Audit Technique Guide (ATG) covering attorneys may ease your mind, or at least provide insight into the process.
Auditor Hot Spots
Although the ATG is designed for IRS employees, knowing what auditors look for enables lawyers and law firms to provide the right information and documents and reduce the time and stress of being audited. The ATG highlights several areas of auditor interest, including:
- Unreported Income
Auditors are told how to ferret out unreported income by, for example, determining whether fees withdrawn from client trust accounts were included in income at the proper time. Special attention is given to checks from those accounts that are either cashed or deposited into accounts other than the firm’s general operating account.
- Deferred Income
Client trust accounts can also provide evidence of deferred income. After a settlement, an attorney could attempt to defer income by allowing fees to sit in the trust account until the next year. But once a settlement is received, the fee should be included in income. Auditors may analyze the source of funds remaining in the trust account at year end, especially if the account has a large ending balance.
- Noncash Payments
Auditors may examine client ledgers to uncover noncash payments. Verifying the basis of newer assets (for example, partnership interests or stock) can reveal that they were actually payments for services. Auditors could also compare an attorney’s work schedule with his or her claimed fees. If the workload has remained steady while the claimed fees from one or more clients have declined, the attorney might be working for noncash payments.
Auditors closely scrutinize entertainment expenses to determine whether there was little or no possibility of engaging in the active conduct of business due to “substantial distractions.” For example, meetings that occur at nightclubs, theatres, sporting events, cocktail parties or social gatherings are looked at carefully. Auditors also consider whether claimed expenses are simply “disguised hobbies” or other personal expenses.
Good Accounting Helps
As you might have guessed from the ATG’s areas of focus, sound accounting practices and an ethical firm culture can minimize the pain of being selected for an audit. As the ATG states, “A good accounting system for attorneys will include strong internal controls to monitor both fees billed and costs and expenses advanced for clients.”
Consider implementing policies and processes that reflect IRS expectations. For example, your firm should:
- Require pre-approval of expenses over a certain amount or of particular types (such as sporting event or nightclub bills);
- Establish clear policies about which expenses are charged to the firm and which to clients;
- Restrict the use of firm credit cards;
- Require thorough documentation of meal and entertainment expenses; and
- Maintain up-to-date cash receipts, cash disbursement and time records.
Perhaps the best way to increase your odds of smooth sailing is to regularly perform your own audits (or ask an outside professional to perform them). Self-audits often catch errors or fraudulent activities before the IRS gets a chance to find them.
Use the ATG Proactively
If you receive a letter from the IRS announcing an audit, your first call should be to your accountant. However, do not wait until you are audited. Your CPA can help you use the IRS’s guide proactively to identify (and remedy) gaps in your policies, processes and records.
How to Improve a Law Firm’s Profitability in Today’s Competitive Environment
Today more lawyers than ever before are in private practice. Almost 90% of today’s firms employ 10 or less attorneys. In this competitive environment, the challenge for every law firm is to maximize their profitability and to establish a plan for future growth. Below, we will focus on how successful law firms can improve their profitability.
Four Ways to Increase a Law Firm’s Profitability
In good times or bad, the number one priority for the management of a law firm is profitability. Although economic conditions are beyond your control, plenty of factors that drive or impede profitability are not. To boost your bottom line, here are some points to consider in order to take control of the following:
- Improve Management of Billing, Receivables and Payables
Delays in issuing and collecting invoices often lead to costly and unnecessary write-offs and write-downs. To streamline the process, consider pre-billing your clients for major expenses such as expert witnesses, depositions and travel. In addition, you should bill clients as soon as a matter is completed, regardless of the result, and in the interim, as appropriate service milestones are reached (for example, after a successful pretrial motion). When clients submit their payments, process them immediately, making daily deposits, rather than letting payments stack up. If your clients delay in paying their bills, follow strict schedules for following up with them. You might cite quarterly and year-end bank reporting as a reason to reach out on delinquent payments. Consider offering one-time discounts as incentives for clients to satisfy aged receivables, and encourage payment by credit card. It is incumbent for firm managers to review unbilled time and each attorney’s outstanding receivables. As for payables, pay your bills as close to the due dates as possible so you benefit from any early payment discounts without transferring funds unnecessarily early. If available without additional fees, take advantage of deferred payment options; regularly negotiate with vendors for discounts and lower prices. The Sidebar below offers some tips on how and where to cut your costs.
- Cross-Selling Services
It is a marketing truism that it is easier and more cost-effective to generate new work from an existing client than to attract a new client. That is where cross-selling comes in. Attorneys need to set aside time to spend with their clients to learn more about them, and to recognize if they may require additional services, now or in the future. Lawyers should be ready to introduce their client to other lawyers in the firm, or to other firms outside of their firm’s area of expertise. Note that members of your firm may need a primer on your firm’s specialties and services to help them identify cross-selling opportunities. Some might be resistant to sharing “their” clients, so you should explain the benefits of cross-selling for the firm and, ultimately, their own bottom lines. You also might want to tie cross-selling to compensation.
- Increase Specialization
Law firms that specialize in specific practice areas often see greater profits than those that take a more generalist approach. Attorneys and paralegals who specialize in an area generally work more efficiently and effectively, and produce higher quality work at a greater pace and for higher fees. Even small firms can benefit from dividing up legal work by practice area.
- Reduce the Number of Your Clients
This tip no doubt seems counterintuitive. More clients means more money, right? Not necessarily. Every firm has had its share of troublesome clients who take up time and resources without returning profits that justify such expenditures. It should be a firm policy to not take on unprofitable matters in the hopes that someday they will bring in a project that makes it all worthwhile. It is generally better to focus on having fewer but more profitable clients. When you work with a handful of large clients with continuing matters and numerous needs, you can develop a deeper understanding of your clients that leads to more lucrative cross-selling opportunities, as well as a stronger sense of teamwork both with the clients and within your firm. You will also likely reduce costs related to client acquisition. Of course, there are exceptions to this rule, but you need to be selective in the clients you choose to represent.
An Evolving Process
Improving profitability is not just a matter of instituting one or two measures and then sitting back. It is a process that requires ongoing vigilance regarding financial and economic conditions so you can spot opportunities and take advantage of them.
Sidebar: Tips for Cutting Costs
One of the easiest ways to improve profitability is to reduce your costs. This is an area where you can think creatively. For example, you might consider adopting alternative staffing arrangements. Flex-time, part-time or temporary attorney arrangements can all result in lower staffing costs. Such options can give firms access to top-notch attorneys who are not necessarily interested in the traditional partnership track, without many of the costs associated with full-time lawyers. Outsourcing might be advisable for non-attorney services such as those provided by a quality CPA firm such as identifying internal control weaknesses and tax-planning
Another idea is to take advantage of new technologies such as those found in the latest software improvements and cloud services. You will be able to find a wealth of options for increasing productivity, improving practice management and saving time on standardized tasks and forms.
And, don’t forget to look at your compensation models. Law firms are increasingly moving away from fixed salary compensation to incorporate a variable pay component based on outcomes and achievements. Changes to benefits also can cut costs. For example, employers of all kinds are increasing health insurance deductibles and employee portions of premiums.