Hardly Anybody Trusts Attorneys, and Certainly Not the IRS

A December 2023 Gallup poll revealed that only 16% of Americans rate lawyers’ honesty and ethical standards as “high.” Perhaps the IRS was among those polled, as the IRS has announced an examination campaign against law firms.

In recently issued Fact Sheet 2024-32, the IRS announced an examination campaign to address an alleged tax deferral transaction in which plaintiff’s attorneys or law firms fail to report contingency-based legal fees in a timely manner. As described by the IRS:

• Plaintiff's attorneys or law firms representing clients in lawsuits on a contingency fee basis may receive as much as 40% of the settlement amount that they then defer by entering an arrangement with a third party unrelated to the litigation, who then may distribute to the taxpayer in the future; generally, 20 years or more from the date of the settlement.
• The taxpayer law firms fail to report the deferred contingency fees as income at the time the case is settled or when the funds are transferred to the third party. Instead, the law firms defer recognition of the income until the third party distributes the fees under the arrangement.

According to the IRS, the goal of this newly launched campaign is to “ensure taxpayer compliance and consistent treatment of similarly situated taxpayers which requires the contingency fees be included in taxable income in the year the funds are transferred to the third party.”

The IRS’ interest in law firms has been growing over the years. In 2022, the IRS revised its Audit Technique Guide for Attorneys, highlighting issues surrounding (i) client trust account accounting, taking issue with attorney practices of not recognizing as income funds that remain in trust following a final settlement of a client case, (ii) the treatment of advanced client costs, which the IRS believes should not be immediately deducted but instead treated as loans, and (iii) employee (mis)classification issues surrounding part-time attorneys as well as receptionists, secretaries, paralegals and law clerks. In my personal experience, the IRS has commonly raised all of these issues in attorney audits for the past two decades.

The IRS’ campaign against attorneys was not the only subject of the IRS Fact Sheet. In a hodge-podge fashion, the IRS also attacked my BFF (see prior Blog post linked HERE), stating that the IRS is on the look-out for filings of Form 8275 that lack a reasonable basis. The IRS advised that “Taxpayers should be aware that Form 8275 disclosures that lack a reasonable basis do not provide penalty protection…and should consult a tax professional or advisor to determine how to come into compliance.” Finally, something that the IRS and I agree on.

If you or your clients have any questions about this Blog post or other tax-related topics, feel free to contact me at (214) 749-2464 or adaddino@meadowscollier.com