Five Things You Should Know About Tax Law
by Jason B. Freeman
“Tax law”—the phrase is as likely to conjure images of pocket protectors and wire-rimmed glasses as to prompt a sudden burst of uncontrolled heart palpitations. Nonetheless, tax laws affect every lawyer’s practice. Here are a few tips for the less-tax-savvy counsel to help identify and diagnose some frequently faced tax issues:
1. Contingent Fees. When a lawyer works on a contingency-fee basis and the client recovers an award, the client generally must recognize and report the entire amount of the recovery as gross income, regardless of whether the lawyer’s contingency fee is paid directly by the client. For instance, if a jury awards a plaintiff $1 million and the lawyer keeps a 30-percent contingency fee, generally the plaintiff has $1 million of income, not $700,000—again, even if the client never touches the lawyer’s share. “So what?” you say, “can’t the client just deduct the fee?” Well, that depends.
2. Deducting Legal Fees. When it comes to deducting legal fees, not all fees are created equal. On one end of the spectrum, “ordinary and necessary” legal fees incurred in carrying on a trade or business are generally deductible. If a business is in the start-up phase, expenditures on legal fees may not be immediately deductible because the taxpayer is not yet carrying on a trade or business. They may have to be “capitalized” instead.
On the other end of the spectrum, legal fees incurred for purely personal purposes—for example, divorce—are generally non-deductible. The line between business and personal expenditures, however, is not always clear. Courts generally invoke the “origin of the claim” doctrine to determine their nature in the context of legal fees. Under that doctrine, even legal fees that may seem personal—for example, those incurred in defending a criminal bribery charge against an individual—may be deductible if the genesis of the claim is found in the taxpayer’s “trade or business.”
Of course, the Internal Revenue Code also recognizes other categories of expenditures, some of which are accorded special treatment. For instance, legal fees for tax advice are deductible—even fees for non-business, personal purposes are deductible to the extent they relate to tax advice. Thus, a lawyer can often minimize her after-tax cost to a client by distinguishing her fees between those that are deductible and those that are not, since some representations will inevitably involve different categories of legal fees—e.g., a divorce involving tax advice.
3. Statute of Limitations. The Internal Revenue Code establishes an intricate and, for the most part, self-contained statute-of-limitations framework for the assessment and collection of taxes. Generally, the IRS has only three years to assess additional tax liability after a tax return is filed or deemed filed. However, under the so-called “substantial omission” exception—the most common, though not only, exception—the general three-year period is extended to six years if the tax return reflects a substantial omission from gross income (defined as an amount exceeding 25 percent of the gross income stated on the return). Exceptions related to failures to report foreign accounts and income are also becoming increasing important. Finally, if the tax return is determined to be fraudulent, the IRS can assess additional tax at any time in the future—in other words, there is no statute of limitations.
4. IOLTAs. Lawyers are often curious about how IOLTA trust accounts are treated for federal tax purposes. Interest earned on IOLTA trust accounts and paid to the Texas Access to Justice Foundation is not includible in the income of either the client or the lawyer. Moreover, the lawyer is not required to report the interest paid to the Foundation; thus, there is no need to issue a 1099-INT.
5. The Collection of Taxes. Finally, let us address a few important facts about the collection of taxes. To put it mildly, the IRS is not your average creditor. When the IRS demands payment and a tax is not paid, a lien automatically arises by statute. The lien is expansive, attaching to “all property and rights to property” belonging to the taxpayer—and it is effective regardless of whether the IRS has actually filed a Notice of Federal Tax Lien or not. Thus, it is often referred to as a “silent lien.”
Attorneys should pay particular care (especially where a tax lien has been filed) when representing an executor, trustee, or other person functioning in a representative capacity. Under the federal priority statute, such a person can be held personally liable for distributions or disbursements from an estate or trust made while federal taxes are owed. How is that for a trap for the unwary?
And finally, one last pointer that is a common source of confusion: State homestead protection laws do not prevent the federal government from foreclosing on a taxpayer’s home when it has a tax lien on the home. While state law creates legal interests in property, federal law governs what is and is not exempt from levy and foreclosure in this context. Even if property is exempt from foreclosure under state law, the supremacy clause allows the federal government to sweep aside state-created exemptions and foreclose.
Jason B. Freeman, J.D., C.P.A. is an associate at Meadows Collier. He can be reached at email@example.com.