Limiting Tax Practice Liability

By Dale Bandy

In our February issue, the article "Managing a Tax Practice to Avoid Malpractice Claims, by William F. Yancey, concentrated on demonstrating how various tax malpractice judicial decisions gave rise to settlements against tax practitioners. That article also included a tax malpractice prevention checklist. The present article explains and expands on the guidance in that checklist.

Direct malpractice liability costs include insurance premiums, settlements, and legal fees. Indirect costs include lost time, damage to professional reputation, and the emotional burden of an attack on the work done. For some, the direct cost of malpractice protection is the single largest practice expense after employee compensation, running at 10% of total expenses. Although individual tax malpractice settlements are often smaller than other accounting related malpractice settlements, the number of tax related claims against practitioners is larger. Tax engagements result in almost half of all AICPA professional liability insurance plan claims. In addition, tax law contains numerous penalties that apply to practitioners who fail to meet compliance requirements.

Limiting the practice liability is something every tax practitioner or firm must do to minimize the risk of a major financial catastrophe. An effective strategy for limiting tax practice liability includes carefully designed practice procedures and controls including those that address aggressive tax positions; effective client selection, retention, and relations; adequate insurance coverage; and sensible staff utilization and development.

Aggressive Tax Return Positions

Perhaps the single most effective way to limit malpractice liability is to carefully regulate tax return aggressiveness. That is, practitioners must use care when deciding whether to take a tax position favorable to a client when the appropriateness of the position is uncertain. Return positions may be divided into issue and evidentiary aggressiveness.

Issue aggressiveness involves taking a position favorable to a client in instances where tax authority is unclear. For example, a lack of authority or the presence of conflicting authority can mean it is simply unclear whether a taxpayer is entitled to a deduction. The subjective nature of many tax issues leads to difficult determinations. For instance, determining whether a worker is an employee or independent contractor can be a difficult issue requiring careful exercise of professional judgment. (See "Tax Preparer Penalties and Client Conflicts" in the January 1996 issue of The CPA Journal for a comprehensive discussion on preparer requirements and penalties relating to tax return positions.)

Evidentiary aggressiveness involves taking a position favorable to a client in instances where it is unclear exactly what has transpired. For example, a lack of documentation can mean a practitioner is unsure how much revenue a client received during the year. In each case, it is necessary to determine how the questionable item should be handled on the client's return. These difficult issues often become the subject of IRS examinations. When the IRS determines additional taxes are owed because of the position taken, clients may blame the practitioner for their problems.

Risk Minimization

Research. There are three steps toward risk minimization associated with these situations. The first step is to carefully research the underlying issue to be sure what the identified authoritative sources state. Thorough research can demonstrate that due professional care has been taken and can protect practitioners from claims of negligence or carelessness.

Profession and Statutory Guidelines. The second step is to ensure that the level of aggressiveness is within the limits of professional and statutory guidelines. The most commonly applicable aggressiveness threshold is the "realistic possibility standard." All personnel involved in tax work should be aware of the professional and statutory guidelines and firm policy relative to aggressiveness. The AICPA Tax Division's Statements on Responsibilities in Tax Practice, the American Bar Association's Formal Opinion 85-352, IRC Sec. 6694, and Circ 230 Sec. 10.34, all establish "realistic possibility" as the standard for resolving uncertainty.

The American Bar Association in 1985 adopted Opinion 85-352, which states that a lawyer may advise a reporting position on a tax return so long, "as the lawyer has a good faith belief that... [the position is] warranted under current law, or can be supported by a good faith argument for an extension, modification, or reversal of existing law...and that there is some realistic possibility of success if the matter is litigated."

In the report of the Special Task Force on Formal Opinion 85-352, the realistic possibility standard is interpreted as being met when there is a one in three chance of success if litigated. Rather than prepare a return that does not meet the realistic possibility standard, a lawyer must, under Rule 1.16(a), withdraw from representation of the taxpayer.

In 1988, the AICPA Tax Division issued revised advisory Statement on Responsibilities in Tax Practice (SRTP)(1988 Revision) No. 1 Tax Return Positions to inform CPAs of the standard to be followed when recommending tax return positions. The standard requires CPAs to have "a good faith belief that the [tax return] position has a realistic possibility of being sustained administratively or judicially on its merits if challenged."

The AICPA standard is substantially identical to IRC Sec. 6694, which imposes a $250 penalty on tax return preparers if any part of an understatement of tax liability on a return is due to a position for which there is not a realistic possibility of being sustained on its merits. When revising IRC Sec. 6694 in 1989, Congress noted that realistic possibility was the professional standard employed by both attorneys and CPAs.

In 1990, the Tax Division of the AICPA issued SRTP Interpretation No. 1-1 providing guidance for complying with the "realistic possibility standard" through both a general interpretive discussion of the standard and specific illustrative examples. The statement specifies that the realistic possibility standard cannot be expressed in terms of percentage odds. The statement elaborates, indicating "the realistic possibility standard is less stringent than the 'substantial authority' and the 'more likely than not' standards that apply... [to] taxpayers. However, it is more strict than the 'reasonable basis' standard under regulations issued prior to the Revenue Reconciliation Act of 1989."

Client Participation. The third means of reducing malpractice exposure associated with tax return aggressiveness is client participation. When significant uncertainty exists as to the proper treatment of an item, the client should be informed of that uncertainty and warned that the issue may be raised by the IRS upon examination. Such warnings are appropriate for questions relating to both the lack of clear-cut authority and limited evidentiary support. Clients should decide themselves whether to take or forgo an aggressive position. Clients who have made an informed decision as to how an item is handled are assuming responsibility for their returns.

Practitioners may suggest how the problem currently at hand may be avoided in the future. Recommendations may include suggestions relating to record keeping and retention, and even suggestions as to how transactions may be better formulated. These recommendations normally should be in writing. When client questions are answered over the telephone or in person, documentation is important. The answer provided by telephone or in person can be summarized in a note included in the client's file.

Other Practices and Procedures

Other practices and procedures that can reduce malpractice and tax penalty risk include client questionnaires, return checklists, supervisory reviews, and file control and retention. If clients complete questionnaires prior to work beginning on their returns, there is less likelihood they will forget important information. Completing the questionnaire often reminds clients of items they otherwise would have overlooked. Practitioners have been penalized for failing to ask necessary questions. For example, one practitioner was penalized for failing to include interest income in a client's return in a situation where the practitioner was unaware of the interest. The court concluded the practitioner was careless because he failed to ask the client whether there was any additional income. The IRS has ruled that practitioners can be penalized if they fail to ask about substantiation that is required for automobile use, entertainment, and depreciation of listed property. In cases where clients are not asked or are unwilling to complete a questionnaire themselves, the practitioner may ask the questions face-to-face.

Similarly, staff checklists can remind preparers of items that need to be considered. Of course, reviews of completed work by supervisory staff can identify problems that might otherwise be overlooked. Documentation of these reviews should become part of the client file. Preparation of these documents not only reduces errors, but also serves as evidence of careful controls within a practice. Both can reduce malpractice exposure.

Client Selection and Retention

Carefully developing and applying appropriate procedures for the selection and retention of clients can help limit malpractice problems. Clients who initiate malpractice cases often exhibit similar characteristics. They include a history of risky/problem behavior, a fault finding/ argumentative personality, questionable integrity, and weak accounting controls and records.

Past problems that can signal future malpractice claims include slow payment of both professional fees and taxes, a past record of bankruptcy and business failure, engaging in high-risk financial behavior (e.g., speculative investments, heavy indebtedness), and a record of bringing lawsuits or being the target of lawsuits by others. A client with a fault-finding, argumentative personality may question fees, argue tax issues without knowledge of the law, and demand work be done in an unrealistic time period. Clients with questionable integrity may want to underreport income and even brag about how they have gotten away with unlawful acts. Clients with weak accounting controls and records include those who prefer to deal in cash, do not retain receipts, and do not document entertainment, business use of automobiles, and contributions.

Both prospective and current clients should be screened with an eye toward reducing liability risk. One method is to assign points to characteristics such as those described above. Other factors that may be appropriate to consider when evaluating clients include the practitioner's familiarity with the industry, current and potential future profitability of the client, and whether the client represents a source of referrals. Clients who fall below some threshold score may be reviewed for possible discontinuation. Turning down some clients may not only reduce malpractice exposure, but also reduce uncollectible accounts as clients with unfavorable characteristics are often less likely to pay fees. Fees may be raised for some marginal clients to move them above the normal discontinuation thresholds while other clients may be asked to pay in advance or to make progress payments.

Client Relations

An important aspect of managing tax practice liability bears on how relationships with clients are handled.

Errors in Returns. When trying to collect from slow paying clients, it is important to determine why the client is delaying payment. In some cases, clients are dissatisfied with the service received. If practitioner errors have resulted in penalties or other problems for a client, efforts to collect fees will further anger the client. That could, in turn, cause the client to contact an attorney. When errors have occurred, the emphasis should be on both protection and error repair. Whether it is appropriate to first contact an insurance carrier or an attorney is discussed below. If the practitioner caused the error, the return should be amended without charge, and the practitioner should work with the IRS to have penalties waived. Although the IRS may waive taxpayer penalties in some instances when the practitioner, not the taxpayer, caused the error, it does not always do so. In fact, the IRS fought one taxpayer all the way to the Supreme Court and won in a case where it sought to impose a late filing penalty when an attorney's error caused an estate tax return to be filed late.

If the taxpayer relies on professional advice in a situation where the tax law is unclear, the IRS may waive any penalty; but in situations where the practitioner simply was wrong, the IRS is less likely to waive the resulting penalty. Recently released Reg. Sec. 1.6664-4(b) indicates that accuracy-related penalties will not apply when a taxpayer reasonably relies in good faith on the advice of a professional tax advisor. This exception requires that the advice be based on all pertinent facts and circumstances. Further, that advice must not be based on unreasonable factual or legal assumptions such as a representation the taxpayer knows, or should know, is unlikely to be true. Responsibility for an unambiguous precisely defined duty cannot be delegated.

Failure to Make Timely Elections. One specific problem worth discussing is failure to make timely elections. When regulations establish the time for making an election, the IRS has discretion to waive its own deadline. Rev. Proc. 79-63 explains the process for requesting relief. Practitioner error may be reason for granting relief. When the time is established by statute, the IRS cannot waive the deadline unless the statute grants that authority. Thus, if a practitioner misses a deadline for making an S election, the IRS cannot waive the deadline. On the other hand, the deadline for electing the optional adjustment to basis for partnership property under IRC Sec. 754 can be waived when good cause for the failure can be shown.

Seeking Independent Counsel. One difficult problem is the question of whether a practitioner should advise a client to seek independent counsel when the practitioner made an error. In the case of attorneys, there is a professional and legal responsibility to advise clients to seek independent counsel when the attorney's error caused a client to suffer a financial loss. One attorney's license was suspended for six months when he focused on obtaining a financial release rather than advising the client to seek independent counsel. When a practitioner focuses on repairing the damages caused by the error rather than avoiding responsibility for the injury, this is unlikely to be an issue.

Multiple Professional Licenses. Recently, the U.S. Supreme Court held that practitioners can communicate to clients that they hold multiple professional licenses/designations. Yet to be resolved is how such disclosures affect professional responsibility and liability. For example, if a practitioner is both an attorney and CPA, how are different ethical standards handled? As rules in some states regarding how fees may be determined and whether the practitioners may gain relief from errors differ for attorneys and CPAs, this will become an issue. Presumably, when clients are aware the practitioner is a member of two professions, the "higher" standard must be met. Thus, for example, an attorney/CPA who discovers an error he or she caused, the attorney/CPA cannot request the client to sign a release without advising the client to seek independent counsel.

Disagreement on Causation. Practitioners and clients sometimes disagree as to who caused an error. Clients feel they provided all necessary information, while practitioners believe errors were caused by incomplete or inaccurate information. Perhaps the best safeguard against such disputes is the client questionnaire recommended above.

Who Pays. Ordinarily, additional taxes are a client's responsibility regardless of who was responsible for the error. For example, if a practitioner mistakenly claims an improper deduction, error correction results in additional taxes. Those taxes, however, would have been owed had the original return been correctly prepared. In some instances, practitioner errors do increase the taxes owed. To the extent a practitioner's error results in taxes that would not otherwise be owed, a practitioner may be responsible. Thus, a practitioner who fails to properly execute an S election may be responsible for additional taxes owed because of the error. In determining responsibility, consideration should be given to the net impact of the error. Thus, any savings in individuals' taxes should be factored in. Most additions to tax also result in interest. Is the practitioner responsible for the interest when the practitioner's error caused the mistake? Certainly the taxpayer did have use of the funds. There is limited authority on the issue, but in at least one case, the court allowed recovery of interest on an underpayment without discussion.

Engagement letters are not routine for many tax practitioners. This does not mean they are inappropriate for some tax clients. Where multiple returns or particularly complex returns are involved, a letter to the client stating what work is to be performed should be considered. The letter can specify when the work will be done and outline how the professional fee will be determined. Particularly when there have been previous problems with fee collection, the engagement letter should specify when and how fees are to be paid. This can help avoid subsequent disputes over fees. Engagement letters can be important tools to establish what the practitioner believes client expectations are. They will frequently smoke out misapprehensions of the client or the practitioner at an early stage of the engagement.

An engagement letter can list what information the client is expected to provide and when. When appropriate, the letter should point out that the practitioners will rely on the information provided by the client, and affirmatively state that no audit or other review will be conducted. The later point can communicate to the client that the preparation of the tax return is not an audit. An engagement letter has been used by CPAs to avoid liability for failing to detect embezzlement by a store's cashier. The letter indicated the engagement could not be relied on to detect fraud, defalcation, or other irregularities. Such statements should be considered for most business clients.

Insurance Protection

Malpractice liability insurance reduces the financial exposure faced by practitioners. Practitioners are not, however, always aware of the limitations of such coverage. Liability insurance covers the services ordinarily associated with a particular profession. Although the scope of a particular insurance policy is governed by the policy itself, accounting malpractice liability coverage has been held to exclude providing investment advice, but has been held to cover an accountant who advised a client on the tax consequences of a transaction. Accordingly, accountants involved in financial planning should obtain separate coverage. Although policies do not cover fraudulent acts by practitioners, insurance companies have been required to defend accountants until it was proven their acts were fraudulent.

CPAs who learn they have made errors when preparing returns are required by professional ethical standards to inform the clients of the errors and advise them of the appropriate handling of the matters. Although such communications are appropriate and necessary, that may not be the first step a practitioner takes after learning of an error. Failure to provide prompt notice of a potential claim to an insurance carrier may violate the terms of the policy and void coverage. As a result, it may often be appropriate to contact the carrier before contacting the client.

Staff Development and Assignment

As staff members do much of the work for many clients, staff development is most important. Clearly, any precaution described above is useless if staff members are untrained or, worse yet, unaware of the safeguard. Assignments should be consistent with the backgrounds of individual staff members and not be outside an individual staff member's expertise. This could mean that more difficult work is assigned to more experienced professionals, the firm consults with attorneys or others who may have necessary technical expertise, or a firm simply chooses not to perform some work because it is outside the firm's fields of specialization. Staff members should be familiar with firm procedures and professional ethical guidelines. That is, they should know what the firm expects of them in a specific situation.

Professionals feel responsible for their own work. For that reason, many professionals want to fix their own mistakes. In fact, many professionals find it difficult to admit even to themselves that they may have made a mistake. Firm policy should specify how errors are to be handled and all staff members should be aware of that policy. Staff members should be instructed to inform supervisors of errors. The judgment of the individual who made an error may be clouded and the solution of the problem should be left to a supervisor. *