LAW PRACTICEóA FORENSIC INVESTIGATION

By Ron J. Anfuso, CPA/ABV

The following is an excerpt from "Income Reconstruction: A Guide to Discovering Unreported Income," published by the American Institute of Certified Public Accountants. It provides insight into how a forensic accountant would trace non-disclosed income in one particular type of business.Ý

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Overview of Law Practices

It is important to understand how law practices account for income and expenses to gain insight into how an attorney can possibly underreport his or her income. Most law practices' books are maintained on the cash receipts and cash disbursements basis of accounting for income tax reporting purposes. Occasionally, a second set of internal books using the accrual method or modified cash basis method of accounting is created. This separate set of books provides reliable assessment of the firm's financial position and results of operations during any given interim period, and can provide a better evaluation of internal controls.

For cash deposits, law firms generally use one general bank account oftentimes together with one or more client trust accounts. They may also open separate payroll, savings and/or money market accounts. Total deposits into accounts held in banks or in other quasi-banking institutions, when compared to gross receipts, will pinpoint probable diversion of income away from company coffers.Ý

Size and makeup of firm play a significant role in assessing whether or not the firm reports all of its income. Additionally, the number of individuals in control can influence whether the practice reports only necessary business-related expenses or whether discretionary or personal expenses are paid through the practice. As with most other businesses and professional practices, larger organizations usually have more stringent internal controls than smaller firms and are less likely to understate income. An indicator of an attorney's degree of control over the books is the nature of his involvement with the company. Some attorneys are employees. Others are self-employed, partners or shareholders in large law firms or closely held law practices. Attorneys who are employees have less power to manipulate the books and less control to self-allocate discretionary funds for personal expenses than do owners of law firms.

One other factor that defines the method with which law firms collect and report income is the type of law they practice. The type of legal practice usually determines the arrangement for client payments. A general law firm, practicing as many types of law as their expertise will allow, oftentimes charges an agreed upon fee for a particular legal engagement, which usually involves a pre-paid retainer. Commonly, this retainer is put into a client trust account and the attorney pays him or herself from the trust account as the case progresses. This is when the income is reported. Law firms specializing in personal injury cases may base their fees on a percentage of the settlement. This is referred to as a contingent fee. Most attorneys, practicing in such areas as family law, civil law, bankruptcy, estate-planning, corporate law, taxation, criminal law, environmental law and maritime law base their fees on the number of hours worked at their respective hourly rates plus fees and costs incurred on the particular case.

Case Study Background

The basis for this book chapter is an engagement related to dissolution of marriage action. The names of the parties involved have been changed to protect the innocent (or the guilty, as the case may be). This case involved a 17-year marriage, from which there were three children. The wife, Mrs. Smith, was a homemaker. The husband, Mr. Smith, was one of three senior partners in a law firm that practices admiralty and general maritime law. In addition, the firm practices civil, real property, environmental, probate, insurance and estate law.

Our accounting firm was engaged to: 1) value Mr. Smith's interest in the law practice; and 2) to determine his gross cash flow available for spousal and child support. The proper and complete reporting of income affects both of these assignments.Ý

The Los Angeles-based law firm in which Mr. Smith is a 33 percent owner employs more than 40 attorneys and boasts such clients as large oil companies and nationally known insurance firms. The law firm grosses more than $10 million per year and, after adding back unreported income and perquisites, has a profitability factor of approximately 49 percent. This is about 6 percent lower than the average profitability by area of specialty, region, firm size and city population as reported in the 1994 Survey of Law Firm Economics (the most current survey available at the time of the engagement, which was based on 1993 data), developed by Altman Weil Pensa.ÝÝ

At the date of our valuation (which was determined by the attorney who engaged us), the practice was worth more than $3 million. Mr. Smith's interest in the firm as a 33 percent shareholder was therefore worth more than $1 million. His annual gross cash flow also was in excess of $1 million, including unreported income and perquisites (personal expenses ran through the law practice).

Many of the methods we employed for the valuation process are based on the standards and procedures used by the IRS. In response to criticism of the IRS for more aggressively conducting economic reality audits by training agents to "be more skeptical concerning the taxpayer's return as filed," the IRS adopted the practice of requiring only "reasonable indications of unreported income" before employing these techniques. This response was beyond what the AICPA suggested, which was to use the economic reality audit only if there is a documentable fact that backs up a reasonable suspicion of unreported income. Our standards of due diligence for divorce cases are closer to those used by the IRS in that we are required to perform a thorough forensic investigation in many cases where a suspicion of unreported income has been expressed by one of the litigants.

The Initial Interview

The engagement began with the formulation of a case plan. The main objective is to draw out, in an initial interview, the specific attributes of Mr. Smith's law firm. Many useful planning procedures found in the Internal Revenue Service audit training guide for attorneys, 3149-102 (Rev. 6-94), have been incorporated in our guidelines, as follows:

Attorneys tend to answer questions literally and offer little additional information. As such, prepare direct, specific questions that will elicit quantitative or qualitative responses.

Questions on how the practice started and areas of specialization will give insights into probable systems of accounting. Just the same, specifically ask for the system of accounting in place, the size and scope of the taxpayer's practice, and what sorts of income and operating costs to expect.

An effective income probe is crucial since unreported income is often an issue. All possible sources of income need to be identified and explained so that they cannot be introduced as explanations later. Questions to ask which are particularly relevant when dealing with attorneys are:

• How much cash was on hand at beginning and end of year?
• Were any loan proceeds received?
• Were referral fees received from other attorneys?
• Was compensation received other than cash?
• Are there any foreign accounts or offshore interests?
• Are there any interests in other entities?

A thorough understanding of the taxpayer's bookkeeping system and internal controls is necessary. Have the attorney or the bookkeeper step through the recordation process from the point in which the attorney is retained by a client up to the settlement of the account. Is there another set of books apart from the one used for income tax purposes?

Ask for the bank records for all accounts including any investment accounts. Question the taxpayer about the use of each account. Depending on the size of the practice and the level of sophistication of the books, a number of different accounts may be used to pay expenses and deposit receipts. It is easier to ask up front and verify the information given than to try to decipher the numerous accounts later.

At the conclusion of the initial interview, you should have an understanding of the taxpayer's system of accounting, his or her level of involvement in that system, and who to go to with questions during the audit. In addition, the taxpayer's level of credibility can be established through comparison of the pre-audit analysis and information supplied during the interview.

By modifying the above IRS suggested planning procedures, and utilizing our own pre-determined planning procedures and interview questions, we determined which procedures and questions to ask Mr. Smith at the initial interview. In addition, it is our policy to perform financial statement analysis of the company(ies) in question. One of the pre-engagement planning tools is the preparation of historical comparative financial statement spreadsheets. Typically, five or more years of balance sheet and income statement data, if available, are input into a spreadsheet with percentages as to total assets and gross receipts. This information is one of the factors to consider when valuing a company pursuant to IRS Revenue Ruling 59-60.

This is only the beginning of what the financial statement "spreads" as we call them can tell us. The percentage of net income to gross receipts can be compared to industry standards by year as a preliminary tool to determine if the practice is possibly understating income. Not reporting cash receipts by depositing them into a personal or other hidden account or just cashing the check is the first of the two most common methods of not reporting income. Drastic changes in expense accounts may indicate personal expenses or perquisites exist. Perquisites are the second of the two most common ways income is not reported. By concealing personal expenses as business expenses, an individual actually has evaded income taxes and disguised his or her income as legitimate business expenses.

The questions we asked of Mr. Smith to determine if he was properly reporting his income and if he had perquisites were as follows:

1. What is your standard of living (monthly recurring living expenses after taxes, including such expenses as mortgage payments, car payments, laundry bills, grocery costs, clothing purchases, furniture expenses, children's expenses, house maintenance {including domestic help} and entertainment costs)?

2. Is your reported income sufficient to support your standard of living (i.e., is the reported income after taxes greater than the monthly expenses)?

3. What is your accumulated net worth?

4. When and how was this net worth accumulated?

5. Has your reported income been sufficient to fund this accumulation? (We consider net worth to be accumulation of wealth from all sources, not just taxable income. These include loan repayments, sales of investments at a loss, refinancings of assets, gifts and inheritances, and gambling winnings.)

6. What is your method of accounting?

7. Are any of your cases handled on a contingency basis?

8. When and how are contingency cases billed? What is their approximate value in billing?

9. How long do you estimate it takes for contingency cases to get to trial?

10. What personal expenses of yours are paid for by the law practice?

11. What personal expenses for the other shareholders are paid for by the law practice?

At this interview, Mr. Smith informed us that the practice had discreet general ledger accounts. Each of the shareholders had individual general ledger accounts for expenses such as life insurance, entertainment, business promotion, travel and auto expenses. We received copies of the relevant documents and concluded our interview.

Calculation of Unreported Income

Many attorneys calculate their gross fees based on the money transferred from the client trust account(s) into the general account(s). At times, we have encountered attorneys who deposit fees into personal accounts, thereby bypassing the general accounts all together. In this particular case, we examined client ledger cards and discovered that cash receipts posted to the ledger cards were not accounted for in the cash receipts journal or the general ledger. Upon analyzing the bank reconciliations, we determined that these receipts were not deposited into the firm's bank accounts and therefore not included in the gross fees reported by the law practice. Apparently, Mr. Smith and his partners were cashing client checks and, in some instances, depositing them into personal bank accounts. These checks represented approximately 13 percent of the gross income of the corporation, or $1.3 million.

Additionally, after inspection, we found checks from the trust account representing expense reimbursements that were endorsed directly to the attorneys. These reimbursements, for the most part, were for personal expenses. We determine which expenses are business versus personal on an expense by expense basis. For example, some expenses, such as psychiatric fees, are inherently personal. Others we need to inquire about with the client.

For life insurance, for example, we ask about the beneficiary. If the beneficiary is the firm (which is sometimes the case when the policyholder is a key member of the firm), then it is a legitimate business expense. If the beneficiary is the spouse or children, however, it becomes a personal expense. For automobile expenses claimed, we ask such questions as what the distance is between home and business because those commuting miles are not considered business miles according to the IRS. We also inquire about business use of the automobiles. Our goal is to determine the actual business mileage incurred and deduct that from the total miles claimed to determine the personal automobile mileage and therefore personal expenses.

We inspect credit card receipts used for travel and ask about purpose of travel. If the client doesn't provide us with information, we make estimates regarding how much of the expenses are personal based on our professional experience. For example, 50 percent of meal and entertainment expenses are not deductible per IRS code and are commonly considered personal expenses. Depending on the financial information used (i.e., tax returns versus financial statements), we estimate the amount of personal expenses deducted for net income purposes.

Following are the personal expenses for Mr. Smith that we culled out of the business expense ledger, with our determination supported by actual analysis and estimates based on personal experience:

Mr. and Mrs. Smith's automobiles:	$Ý 87,045
Mrs. Smith's psychiatric bills:	$Ý 38,700
Ski trips for the family:	$Ý 12,525
Mrs. Smith's cellular phone:Ý	$ 17,826
Uninsured medical expenses:	$119,529
Life insurance:	$Ý 12,060
Entertainment and business promotion:	$Ý 41,709
Disability insurance:	$ÝÝÝ 8,577
TOTAL	$337,971

These personal expenses totaled $ 337,971. Based upon our conversations with Mr. Smith, the other two shareholders enjoyed similar personal benefits paid for by the corporation.

Finding Other Unreported Income

Identifying personal expenses is one of the steps in our forensic investigation. Another step is examining the client's and/or spouse's bank accounts for money not accounted for in the tax returns. In cases in which there are business or personally guaranteed loans, personal financial statements of the parties may be on file with the bank. Banks normally maintain customers' records for at least two years and often for as long as seven years. Attorneys can subpoena deposit slips, cancelled checks, signature cards, bank statements and other relevant information that can assist in the forensic investigation.

We look for patterns in checks deposited or issued. Red flags are large deposits made to the personal account that do not constitute either regular salary checks or expense reimbursement checks.Ý For example, we found four large checks totaling more than $425,000 deposited into Mr. Smith's personal bank account during a two-month period. We verified that these checks were not regular salary checks or expense reimbursements. A closer examination of the accounts receivable aging report for the same period revealed that there was approximately $1.3 million of accounts receivable written off with no explanation. This amount represents just over three times the amount deposited into Mr. Smith's personal account. We requested that the attorney subpoena the records from the various clients and when the documentation was produced we had clear and convincing evidence that the three shareholders had colluded with one another to not report this income. Is this evasion of income taxes? You bet.

We get further clues as to the nature of unreported income by taking photocopies of the front and back of other checks produced pursuant to subpoena from the law firm's clients and examining both who endorsed them and where they were cashed. This information may establish a money trail leading to the attorney or other parties and entities directly related to the lawyer. If the link is established, it is possible to determine other amounts of income which has been diverted from the books and records of the practice.

Debit and credit memos can be another source of information. In our experience, we have discovered other bank accounts by examining these documents, which can point to international or domestic wire transfers, payments or repayments of loans, transfers between accounts (thereby leading to discovery of accounts previously unreported), and purchases of cashiers' checks.

Conclusion

Mr. Smith reported his income to be $400,000. After employing the above methods, we discovered $762,971 of unreported income. His adjusted income for purposes of our engagement, therefore, was $1,162,971. This is illustrated as follows:

Reported Income	Ý	$ 400,000
Unreported Income	$ 425,000	Ý
Perquisites	$ 337,971	Ý
Total Unreported Income	Ý	$ 762,971
Total Cash Flow	Ý	$1,162,971

The results of these procedures in effect increased the value of Mr. Smith's interest in the law firm by approximately $575,000 and increased his gross cash flow available for support from $400,000 to $1,162,971.Ý More than 50% of his income was not reported or taxed.

Mr. Smith's case settled at the mandatory settlement conference without having to go to trial. Did our analysis of unreported income help to facilitate the settlement? I think so.Ý Are these typical numbers that one would find outside of Los Angeles? Probably not.Ý Los Angeles is a city with many wealthy individuals (and a high cost of living) and as such, the numbers may seem inflated to those evaluating businesses in other parts of the country. However, the procedures outlined above are just as effective whether the client is worth $10,000 or $1 million. Only the number of zeros changes.

Keep in mind, however, that the above procedures are only guidelines. Every case has its own unique facts and circumstances and must be evaluated accordingly. The procedures outlined in this chapter were successful tools for this forensic investigation. Modifications will be necessary for a proper evaluation of other law practices in order to determine the amounts, if any, of unreported income.