Evaluating Law Practices

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.

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.

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 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:

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.

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.

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. 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.