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Tax Tips for Lawyers pg2

Next let's look at entertainment expenses as a tax deduction. To deduct entertaining expenses, entertainment expenses under Internal Revenue Code Section 274, there is a substantiation requirement and this applies not only to entertainment expenses but it applies to travel expenses and to gifts. What the substantiation requirement provides is that unless the taxpayer substantiates by adequate records or by sufficient evidence corroborating the taxpayer's own statement, there are four tests that must be satisfied. One is you must substantiate the amount of the expense. You must substantiate the time and place of the travel or the entertainment and the date or description of the gift. Third, you must have documentation of the business purpose of the expense and finally, number four, the business relationship of the taxpayer to the persons entertained must be documented. So basically, you need to maintain a record for each expense which is for entertainment. You need to document these substantiation items on a contemporary basis. These can be written on the receipt. You can document on the receipt or on a form attached to the receipt to make sure that you cover these four substantiation requirements.

Also there is under Internal Revenue Code Section 274, there's the directly related or associated test that also must be met in addition to the substantiation test. The directly related test means that it must be directly related to the conduct of the trade or business. The associated test, it provides that directly before or after a substantial and bonafide business discussion associated with the conduct of that trade or business, that the entertainment must be either directly before or after a substantial and bonafide business discussion.

So for example, if you were to have an entertainment in a night club, theater or sporting event where there is little or no possibility of engaging in the active conduct in trade or business, then those would not meet the directly related substantiation requirement. So if it is, for example, a theater or a sporting event, then you would need to have a substantial and bonafide business discussion either directly before or directly after the event.

Also under Section 274, there are some excluded activities that are not considered to be entertainment expense and these are things like meal reimbursement that's provided by an employer to their employees working overtime. That's not considered to be an entertainment expense. Also a hotel room that's provided by the employer for the lodging of the employees while on business travel, that's not considered to be an entertainment expense. An example of a disallowance of an entertainment expense was the Israelson v. United States case. There the taxpayer sought to deduct as an ordinary and necessary business expense half of the cost of a party at a country club that was attended by 150 persons, mostly husbands and their wives. But the court held that the evidence failed to meet the test established under Section 274 because there was no business discussed at the meeting and also there was no before or after substantial business discussion. So it's important to make sure that you meet those directly related or associated with tests.

Next we'll talk a little bit about travel expenses. Those generally must be documented in the same manner as the entertainment expenses under Section 274. I've actually sat through audits with clients where the IRS wanted to see every single trip, the substantiation for that trip. So it's really important to keep those records.

Next on expenses for business, periodicals and software, generally the costs of books and subscription services with the useful life of more than one year, these items are generally depreciated over a five-year period. Software is not depreciable property and it's typically to be amortized over a three year straight line period. But books and subscription services and software purchased on an annual basis having a useful life of one year or less are currently deductible.

As you may know, bonus depreciation and the Section 179 depreciation rules have been changed significantly recently because after December 31, 2011, the bonus depreciation amount for qualifying business assets has returned to its former level of 50%. The main thing for bonus depreciation qualifying property is that the bonus depreciation allowance is only available for new property, which means that the original use must begin with the taxpayer and furthermore, the new property must be depreciable under the maker's depreciation methods and have a recovery period of 20 years or less. Also with the end of 2011, also we've had a change in Section 179 depreciation deductions. There's now a $125,000 limit on property expense under Section 179 and there's a $50,000 investment limit on tax and that's for tax years beginning in 2012. So these are substantially less than the limits were in 2011.

Next let's look at some other tax and accounting issues. This can have a substantial impact on how much tax you pay in a given year. First look at your choice of accounting method and basically the two methods that you would choose from is the cash method or the accrual method. The cash method, if you use this method of accounting, then generally you record income only when you receive cash from your clients. You would record an expense only when you write a check to the supplier or vendor. Most individuals prefer to use the cash method for their personal finances because it's a simpler and less time-consuming. However, the caveat is that this method, the cash method, can distort your income and expenses, especially where you extend credit to your clients.

The accrual method, on the other hand, you would record income only when the sale or the income is provided, when the service is provided or when the sale occurs. This means that you're recording it when the services are rendered and that's regardless of when you get paid. Furthermore under the accrual method, you record and expense when you receive goods or services even though you may not pay for them until later. This accrual method actually gives you a more accurate picture of your financial situation than the cash method. This is because you record income on the books when it is earned and you record expenses when they are incurred. This results in a better matching of income and expenses in any given year. So it gives you a better picture of your net profits for each year.

The pros and cons of the cash versus the accrual method, the cash method is easier to maintain because you don't record income until you receive the cash and you don't record an expense until it is paid out. With the accrual method, you would typically record more transactions. For example, if you make a sale on account or on credit, you would record the transaction at the time of the sale with an entry to a receivables account and then when your customer or client pays the bill, then you would record the receipt on account as yet another transaction. But with the cash method, the only transaction that's recorded is when the bill is actually paid by the customer.

Another issue that often comes up is what if you want to use a different accounting method for your book purpose versus for tax purposes and this is perfectly fine to do. The IRS does allow you to use a different method for tax purposes than is used for book purposes.

Then some more specialized issues on the accounting method, what happens when you have advance payment of services, when are you’re required to include this advance payment in an income? Under the cash method of accounting, generally you include in your gross income all items of income when you actually or constructively receive during your tax year. So if you receive property or services, they are to be included in income at the fair market value and if you actually receive cash, then that needs to be recorded as income in the year that it's received. Alternatively, the accrual method of accounting, generally you report income in the year that it is earned. So under the accrual method, you would generally include an amount in your gross income for the year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. So this is a test that you would have to apply to each item that's for an advance payment is do you have the right to receive the income and can you determine the amount of the income with a reasonable accuracy.

Then some more specialized issues on the accounting method, what happens when you have advance payment of services, when are you’re required to include this advance payment in an income? Under the cash method of accounting, generally you include in your gross income all items of income when you actually or constructively receive during your tax year. So if you receive property or services, they are to be included in income at the fair market value and if you actually receive cash, then that needs to be recorded as income in the year that it's received. Alternatively, the accrual method of accounting, generally you report income in the year that it is earned. So under the accrual method, you would generally include an amount in your gross income for the year in which all events that fix your right to receive the income have occurred and you can determine the amount with reasonable accuracy. So this is a test that you would have to apply to each item that's for an advance payment is do you have the right to receive the income and can you determine the amount of the income with a reasonable accuracy.

Another issue that often comes up is that of retainers, where you receive an advance payment from a client. There are two kinds of retainers, what's called a specific retainer and an annual retainer. With a specific retainer, under the cash method of accounting, generally it is taxable when it's received and this is when you agree to perform services in a particular case or a matter. If it's an annual retainer, under the cash method of accounting is also generally taxable when it's received and this is for a fee-covering service or for a specified period of time.

There also can be an issue with respect to constructive receipt of income. Under the cash basis method of accounting, income constructively received is subject to demand and no substantial limitations. So it is subject to demand and, no, there are no substantial limitations or conditions on your receipt of that income that it is constructively received at that point. An example is in the case of an attorney who has funds in his trust account, once the case is settled, then some effort can be made to allow those fees to remain in the trust account and to thereby defer reporting that income. But the IRS has ruled that once the fee is received and it's available to the attorney, then it is considered to be income so there wouldn't be a constructive receipt there.

Next let's look at some record keeping issues. Basically, in any business including a law practice, you want to have strong internal controls. You want to make sure that fees, build, and costs and expenses advance, that these are adequately monitored. Some types of the records that you want to keep to make sure that you're doing this is to maintain, of course, your appointment book, a cash receipts journal, a cash disbursements journal, individual client accounts, accounts receivable journal, case time records, a register of cases and process, a time summary reports and these are just a few of the records you'd want to maintain. This can be greatly strengthened by using computer software such as QuickBooks or there are many time and billing software packages available that allow you to keep careful records of all the client receipts and disbursements.

 

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