May 2018

IRS Properly Reconstructs Attorney’s Income: The Importance of Trust Fund Accounting Through the Lens of Tax Litigation

By Shawn Spaulding

Attorney at Law

As attorneys, we are all familiar with the trust fund accounting requirements found in Rule 4-100 of the State Bar of California Rules of Professional Conduct. Failure to follow Rule 4-100 can result in significant disciplinary action. But, the importance of proper trust fund accounting is not limited to the Rules of Professional Conduct. As discussed below, failure to maintain accurate trust fund records can end up costing you thousands in additional taxes and penalties.

Canatella v. Commissioner, T.C. Memo. 2017-124 (2017)

In this 2017 case, the taxpayer (an attorney) was audited for tax years 2008, 2009, and 2010. During the audit, the IRS determined the taxpayer underreported gross income, which resulted in aggregated tax deficiencies of $469,187 (plus an additional $93,837 in accuracy related penalties). The IRS analyzed the taxpayer’s bank statements in determining his gross income. Upon receiving the statutory notice of deficiency, the taxpayer timely petitioned the United States Tax Court for review.

At trial, the taxpayer challenged the validity of the IRS’s method of reconstructing his income. Generally, taxpayers are required to maintain records sufficient to establish their federal income tax liabilities. In cases where the taxpayer fails to maintain adequate records, the IRS may reconstruct the income by any reasonable means. In Canatella, the IRS relied on the bank deposits analysis method in reconstructing the taxpayer’s income. The bank deposits method assumes all deposits are taxable income. However, the IRS must account for transfers between accounts and make adjustments for non-taxable deposits, to the extent of its knowledge.

One of the major issues in this case dealt with “client trust fund accounting.” Specifically, whether the taxpayer could exclude all deposits to bank accounts he used for trust fund deposits. Generally, money a taxpayer receives in trust for another person or entity is not includible in the taxpayer’s gross income. Although the court concluded some of the deposits were in trust, and therefore non-taxable, it did not accept the taxpayer’s assertion that all deposits were in trust. The court reached this conclusion because the taxpayer did not follow the CA Rules of Professional Conduct related to Trust Fund Accounting. Accordingly, the court analyzed a total of three disputed deposits based on the facts and circumstances surrounding the transactions (instead of relying on the general rule above).

Deposit 1
The first deposit analyzed by the court, for $61,467, was made to an account not labeled as a “trust account” but claimed to be used as one by the taxpayer. The taxpayer used the account to deposit fees, pay business expenses, and pay personal bills. The court found that the taxpayer failed to follow the labeling, anti-commingling, and record-keeping requirements for maintaining a client trust account. As a result, $41,467 was included in the taxpayer’s gross income ($20,000 was excluded because the taxpayer paid it to a client).

Deposit 2

Next, the court reviewed a $40,960 inter-account transfer that took place a day after receiving a $150,000 settlement check. The taxpayer claimed the transfer was made in order to hold the funds for another client. However, he failed to provide a trust ledger or other substantiating documents to prove-up the assertion. Therefore, the court included this deposit in the taxpayer’s gross income.

Deposit 3

The third deposit was another $150,000 settlement and the check was paid to “Joan Roback and Cotter & Del Carlo, her attorneys.” Three days after the deposit, the taxpayer paid $80,000 to Joan Roback. Additionally, he transferred $32,000 to his operating account, leaving $38,000 in the alleged non-IOLTA trust account. The court excluded $80,000 from the taxpayer’s gross income but included the remaining amounts because, again, the taxpayer failed to provide a ledger required under Rule 4-100.

Conclusion

Client trust fund accounting is an important function of attorneys’ ethical and professional responsibilities. Following the guidelines in Rule 4-100 and implementing a strong trust fund accounting system will protect your practice in several ways. First, it will prevent disciplinary action, which will allow you to focus on growing your practice and serving your clients. Second, in the event of a tax audit, it will allow you to avoid protracted negotiations/litigation with the IRS or other tax agency.