What happens to a firm if a lawyer doesn't file taxes?

Byline: Correy Stephenson

Lawyers who fail to file tax returns face more than the wrath of the Internal Revenue Service.

A recent case from South Carolina demonstrates that by failing to follow tax law, attorneys also violate state rules of professional responsibility.

And for law

One complicating factor is that some law firms that are structuredas LLPs or LLCs issue partners K-1 tax forms and not W-2s, meaning that a firm may not know if its partners are informing the IRS of the correct amount of their income — or filing their taxes at all.

In the South Carolina case, a lawyer pled guilty to one count of failure to file his state income tax returns and paid a fine as well as the taxes he owed.

Then, the state bar sanctioned the attorney with a 90-day suspension for violating multiple state rules.

The attorney admitted that he violated Rule 8.4(b), which states that lawyers shall not engage in conduct that is prejudicial to the administration of justice.

But the court additionally found that he violated Rule 8.4(a) — which states that lawyers shall not commit criminal acts that reflect adversely on their honesty, trustworthiness or fitness — and Rule 8.4(d) — which says that a lawyer commits professional misconduct by engaging in conduct involving dishonesty, fraud, deceitor misrepresentation.

Michael Downey, a partner at Hinshaw & Culberston in St. Louis, Mo. who focuses his practice on ethics and blogs at The Ethical Quandary , said that most states have similar rules in place.

“The notion that people who fail to file taxes are deemed tohave violated the rules of professional responsibility is fairly common,” he said.

The dangers

In addition to losing the revenue of a lawyer placed on suspension, law firms can face other problems if partners fail to pay taxes.

Craig R. Campbell, a CPA who advises law firms of all sizes as part of his tax practice at Anders Minkler & Diehl in St. Louis, Mo., said that it is not uncommon for a firm to become the target of its ownaudit if the audit of one of its partners turns up problems.

“It is very common for an auditor to look to the other partners and to go upstream and audit the partnership as well,” if there are inconsistencies with one partner’s returns, he said.

Downey noted that the IRS can prohibit a firm with a tax practice from making an appearance in tax-related litigation (before the U.S. Tax Court or a tax appeal to the Federal Circuit) if a partner fails to pay his or her taxes.

The issue has become a greater problem in recent years, Campbell explained, for two reasons.

First, more law firms have structured themselves in a way that results in lawyers receiving tax forms that give them greater leeway in reporting their income. And second, the IRS’s increasingly computerized system has made it easier for the service to catch those whofail to report accurately.

Over the last 25 years, more and more entities transitioned from acorporation to an LLC or LLP and their tax status changed, affectinghow lawyers report their income, Campbell said.

Instead of receiving W-2s stating an attorney’s income, partners in an LLP receive K-1s as a return on capital, he said.

Many years ago, as W-2s became increasingly computerized, the IRS developed a program where it could cross-check the income an employeereports with the income the employer reports.

A similar “matching program” for K-1s was launched in 2000, Campbell said, but encountered so many problems that it was discontinued. However, it was re-launched a few years later and is currently in operation.

What that means for lawyers is that the IRS can now push a button and electronically check to see that a partner is reporting the correct amount of income from a K-1, Campbell explained, making it much easier to catch inaccuracies and prosecute those who don’t file or under-report their income for tax purposes.

Minimize risk

Law firms have a few options to make sure their partners are actually filing their taxes.

“Having partners certify [that they filed their taxes] is essentially a protective device for the law practice itself,” Campbell said, adding that he has noticed a trend of more law firms doing this.

The certification can be as simple as a one-page form that a lawyer signs, or a firm can require supporting documentation, such as a copy of the receipt a taxpayer receives after electronically filing hisor her taxes.

But the safest thing a firm can do is require each partner to provide a copy of his or her tax return, Downey said.

Campbell said he has seen this requirement most often in small practices, with just three or four lawyers operating as a partnership. In such smaller operations, the partners often have to personally guarantee some of the firm’s debt — a lease, for example, he said.

While the practice isn’t common now, “firms that are on the ball — especially after the [South Carolina] opinion — may start asking for copies of tax returns,” predicted Charles Rubin, a partner at Gutter Chaves Josepher Rubin Forman Fleisher in Boca Raton, Fla. who blogs at Rubin on Tax.

This article was originally published in Lawyers USA, Minnesota Lawyer’s national sister publication.