Tax Update. Presented by David Roberts FM21 5/24/2016 8:00 AM - 9:15 AM. May 22-25, 2016 Los Angeles Convention Center Los Angeles, California

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1 May 22-25, 2016 Los Angeles Convention Center Los Angeles, California Tax Update Presented by David Roberts FM21 5/24/2016 8:00 AM - 9:15 AM The handouts and presentations attached are copyright and trademark protected and provided for individual use only.

2 Tax Issues Specific to Law Firms David Roberts, CPA Partner-In-Charge, Law Firm Services Session Introduction Changing tax laws means law firm management needs to gain a better understanding of tax planning strategies to minimize the burden on the Firm and the Partners. In this session you will: Gain high-level insights of tax laws and tax planning strategies important to law firms in order to maximize tax planning opportunities and minimize risks. 1

3 Agenda for Today Entity Structure Overview Unreasonable Compensation Costs Advanced on Behalf of Clients Settlements and 1099 Reporting Unapplied Cash Capital Accounts Year End Planning and Phantom Income Entity Structures C Corporation S Corporation Partnership (LLP, LLC) Sole Proprietor 2

4 Entity Structures C Corp W-2 S Corp W-2 and K-1 Partnership K-1 Sole Prop Schedule C (Income Statement) W-2 = $ 600,000 W-2 = $ 400,000 Ordinary Inc = $ 612,000 Rev = $ 2 mil K-1 = $ 200,000 Interest = $ 6,000 Exp = $ 1.4 mil GP = $ 42,000 Net Inc = $ 600,000 Deprec = ($ 60,000) Unreasonable Comp February 2016 Brinks, Gilson & Lione, APC (T.C. Memo ) Facts of the Case Detrimental Tax Consequences Should you be concerned? Partnership C - Corporation No Maybe 3

5 Brinks, Gilson & Lione, APC Unreasonable Comp Case Chicago IP Law Firm Corporation 150 total Lawyers / 65 Shareholders The Law Firm was audited the previous year and the issue did not come up Issue: Compensation for Services vs Dividends Paid to Shareholders (Double Taxation) Results: Additional Tax $368,000 Penalties $425,000 Facts of the Case Allocation of Compensation = Ownership of Shares Annual Comp Determination = Proportionate Adjustment in Shares Shareholder Agreement stated the shareholders were entitled to dividends, when declared by the Board (But for the last 10 years, no dividends were ever declared) Capital was $8 to over $ 9 Million (approx. $130k per partner) They did not specifically ask the advice of their outside accounts 4

6 Independent Investor Test The owners (or investors) of a business, with significant capital, are entitled to a return on their investment An independent (non-owner) would probably not approve of the compensation arrangement if, year after year, all profits were paid out as compensation and nothing was paid to investors Mulcahy v Commissioner The Court said, when a thriving Firm that has nontrivial capital reports zero corporate income, it is apparent that the Firm is understating its tax liability 5

7 Detrimental Tax Consequences The issue of comp vs dividends was not litigated it was conceded to by the Law Firm The only issue in this case was the dispute over penalties (although they unsuccessfully tried to re-open the comp issue) When the Law Firm conceded the underlying issue, they should have negotiated the penalties at that time What Should You Do to Lessen the Risk 1. If you are a C corporation, link shareholder year end bonuses to specific criteria (new clients, reputation, extraordinary success, etc.), NOT TO ownership percentage (and pay all staff and associate bonuses at year end also) 2. Document that compensation is for services (not just to zero out corp) 3. Be careful of the amount of Capital in the Firm - If it becomes significant, consider paying dividends 4. If you believe there may be a possible concern, seek specific advise 6

8 Costs Advanced on Behalf of Clients What are they? How are they treated for tax purposes? Effect on Cash Flow When are they an expense? Is your firm accounting for it correctly? What can you do if your firm is doing it incorrectly? o Determine potential exposure o Evaluate options o Communicate to appropriate people o Take corrective action (Possibly file a Form 3115) Settlements and 1099 Reporting Taxable vs. Non-Taxable Settlement Usually Defendant s Responsibility to file Form 1099 (not the Law Firm) Who should receive a Form 1099 What does the Law Firm do when they receive a Form 1099 for a large (or numerous) settlements 7

9 Unapplied Cash What is it? What s the proper accounting treatment? Capital Accounts Firm Capital vs. Individual Partner Capital Accounts Accounting for Individual Partner Capital Accounts Buy-In What s the difference between Real Capital vs. Fake Capital? Pay out upon withdrawal (taxability) What happens to negative capital accounts upon withdrawal? 8

10 Capital Accounts Beg Capital Contributions Income Withdrawals Ending Capital Partner A $200, $600,000 $625,000 $175,000 Partner B $200, $600,000 $575,000 $225,000 Partner C $100,000 $20,000 $300,000 $300,000 $120,000 Partner D $100, $300,000 $280,000 $120,000 Partner E ---- $20,000 $250,000 $250,000 $20,000 Partner F ($30,000) ---- $270,000 $280,000 ($40,000) Total $570,000 $40,000 $2,320,000 $2,310,000 $620,000 Phantom Income 9

11 Year End Planning and Phantom Income What is Phantom Income? Why is there a difference between Book Income and Taxable Income? What are the two different types of Phantom Income? o Timing Differences o Permanent Differences Year End Planning Revenue Expenses Book Net Income INCOME CASH $10,000,000 $10,000,000 (6,500,000) ($6,500,000) $3,500,000 $3,500,000 Cash Adjustments (Timing Differences) o Increase in Client Costs ($300,000 to $450,000) (150,000) o Increase in Deposits ($ 50,000 to $100,000) (50,000) o Purchase of Fixed Assets ($500,000) (500,000) o Depreciation ($350,000) 350,000 Book Income vs Available Cash $3,500,000 $3,150,000 Tax Adjustments (Permanent Differences) o Meals & Entertainment ($200,000 x 50%) 100,000 o Club Dues ($ 50,000 x 100%) 50,000 o Life Insurance ($ 40,000 x 100%) 40,000 o Gifts ($ 10,000 - $25 limit) 7,500 Taxable Income vs Available Cash $3,697,500 $3,150,

12 Summary Entity Structure Overview Unreasonable Compensation Costs Advanced on Behalf of Clients Settlements and 1099 Reporting Unapplied Cash Capital Accounts Year End Planning and Phantom Income Thank You! Questions? Contact Us: David Roberts, CPA Partner In-Charge, Law Firm Services p

13 Your Opinion Matters! Please take a moment now to evaluate this session. 12