August 1998 Issue

There is a penalty for encroachment.

CPAs and the Unauthorized Practice of Law

By James R. Hamill

In Brief

The Line of Demarcation Is the Federal Law.

As CPAs continue to expand their services beyond what the public may regard as the "traditional" practice of accounting, the need to understand the boundaries established for unauthorized practice of law will increase.

The U.S. Supreme Court established a rule of Federal preemption of state unauthorized practice of law statutes in a case involving a nonlawyer registered to practice before the U.S. Patent Office. While precluded from the general right to the practice of law, he was permitted to perform those activities necessary to the preparation and prosecution of patent applications. A similar preemption of state unauthorized practice of law statutes is contained in Treasury Circular 230 that governs the practice of attorneys, CPAs, and enrolled agents before the IRS.

Courts in two states were not willing to adopt broad prohibitions on the conduct of CPAs that seemed in conflict with Federal regulations and thereby outside the reach of state courts. However, there are many areas of practice in which CPAs may, if not cautious, cross the line of what is permitted by Federal statute and regulation. The author cites a few examples in tax practice where this may occur.

CPA's tax practice typically involves preparation of Federal and state income tax returns, research to determine the appropriate treatment of prospective and completed transactions, and representation of a taxpayer in administrative proceedings. Each of these may require an analysis of how statutory law, regulations, judicial decisions, and administrative decisions and pronouncements may affect a taxpayer's particular fact pattern, and this analysis will often involve what is accepted as the practice of law. States have various remedies for the unauthorized practice of law, including misdemeanor statutes that may be enforced with fines or imprisonment, injunctive relief granted by the courts, or punishment for contempt of court. The issue of when tax practice by CPAs involves the unauthorized practice of law is not a new one; but the expanding services provided by CPAs (many of which overlap with services provided by attorneys) together with an increase in the number of practicing attorneys, may increase the visibility of the issue. CPAs need to be aware of practice areas that may be in conflict with state unauthorized practice of law statutes or beyond the professional competence of the CPA.

As CPAs continue to expand their services beyond what the public may regard as the "traditional" practice of accountancy, the need to understand the boundaries established for unauthorized practice of law will increase. By clearly defining the areas of practice within the professional competence of each profession, strategic alliances between attorneys and CPAs can best serve the needs of the client and enhance the practices of both professionals, improving quality and increasing service hours.

Federal Preemption of State Statutes

Determining whether current tax practices of most CPAs involve the unauthorized practice of law requires a facts-and-circumstances analysis of the specific practices as well as a consideration of the protection offered by Federal preemption of state unauthorized practice of law statutes. It is the nature and scope of this Federal preemption that must be addressed in a case-by-case analysis. The CPA must also analyze whether his or her competencies satisfy the ethical obligation of performing services only in those areas in which he or she has the requisite expertise.

The U.S. Supreme Court established a rule of Federal preemption of state unauthorized practice of law statutes in Sperry [373 U.S. 379 (1963)]. Mr. Sperry was a nonlawyer registered to practice before the U.S. Patent Office. His practice included rendering opinions as to the patentability or the infringement of patents and preparing certain legal documents required for patent applications. Federal law granted the Commissioner of Patents the authority to prescribe regulations governing the right to practice before the Patent Office, and the regulations in force at the time of the Sperry case established one register for lawyers and another for nonlawyers. A predecessor regulation also stated that the register "shall not be construed as authorizing persons not members of the bar to practice law." The Supreme Court accepted that, under Florida law, Mr. Sperry's activities constituted the practice of law. However, it also held that "the law of the State ... must yield when incompatible with Federal legislation." Moreover, it stated that the language in the predecessor regulation was meant to clarify that no general right to the practice of law was intended, thereby restricting the practice of law by nonlawyers to those activities necessary to the preparation and prosecution of patent applications. The power of Federal agencies to admit nonlawyers to practice was found to have historical support and the court found this power "is in no way conditioned on the approval of the state."

A similar Federal preemption of state unauthorized practice of law statutes is found in 5 U.S.C. Section 500, which is interpreted by Title 31, Part 10, of the Code of Federal Regulations, more commonly known as Treasury Circular 230. Circular 230 governs the practice of attorneys, CPAs, and enrolled agents before the IRS. Section 10.2(b) defines a CPA to be any person "duly qualified to practice" as a certified public accountant in any state, possession, territory, commonwealth, or the District of Columbia. In those jurisdictions that have a two-tier professional designation, whereby a permit to practice is obtained separately from the CPA certificate, the definition appears to apply only to those persons who have a permit to practice.

In the Sperry case, the Supreme Court took caution to note that the right of a nonlawyer to practice patent law was limited to those activities constituting practice before the Patent Office. The court stated that "the state maintains control over the practice of law within its borders except to the extent necessary for the accomplishment of the Federal objectives." Section 10.32 of Circular 230 states that nothing in the regulations "shall be construed as authorizing persons not members of the bar to practice law." This language is similar to the predecessor regulations cited by the Florida Bar Association in Sperry, which the Supreme Court found to mean that no general right to the practice of law was intended, restricting the practices of nonlawyers to those permitted by the Federal agency. Similarly, the Federal preemption against unauthorized practice of law provided to CPAs by Circular 230 is limited to those activities constituting practice before the IRS. Section 10.2(e) of Circular 230 defines practice before the IRS to include:

All matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a client's rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service. Such presentations include preparing and filing necessary documents, corresponding and communicating with the Internal Revenue Service, and representing a client at conferences, hearings, and meetings.

The scope of the Federal preemption depends on how narrowly or broadly "practice before the Internal Revenue Service" is interpreted. In Sperry, the Florida Bar argued that the right to practice before the Patent Office meant, quite literally, that the person must be physically present before the Patent Office in the District of Columbia, a view rejected by the court as inconsistent with long-established practice. Because Circular 230 defines practice as including representation before any officers or employees of the IRS, the need for a physical presence in D.C. clearly cannot be argued. However, a similarly literal reading of what constitutes practice before the IRS raises questions as to much of what CPAs do in tax practice.

What Activities Are Within the Federal Preemption?

A task force of the AICPA Tax Division has defined tax practice activities to include tax consultation, tax return preparation, and tax representation. Tax consultation involves "developing a range of options for the tax treatment of both prospective and completed transactions, specifying the relevant authority in support of or in opposition to each option, assessing the relevant weight of authority for each option, and recommending a course of action to the client." Tax return preparation involves taking tax positions and completing a return based on information supplied by the client. Tax representation includes representing the client's interests before the IRS or some other administrative proceeding as well as assisting in judicial proceedings.

Tax consultation often requires significant interpretation of authoritative sources of the tax law and may raise unauthorized practice of law issues. Some CPAs have been admitted to practice before the tax court by passing an examination on rules of procedure administered by the court. More recently, CPA tax practitioners have expanded their services to include personal financial planning, business valuations, and a variety of special consulting engagements.

Some question whether tax consulting activities involve the application of legal principles to such an extent that they border on the practice of law. In addition, many CPAs routinely prepare memoranda describing how the tax laws apply to a particular client fact pattern. It could be argued that preparation of such memoranda is not within the scope of the Circular 230 protection, unless it is related to a ruling request or a tax audit. However, such a view would be both inconsistent with long-established practice and also with the CPA's duty to provide effective representation of a client before the IRS. The overlap of legal and accounting principles in all areas of tax practice renders it impossible to represent a client's interests before the IRS without interpreting how the tax laws apply to a particular fact pattern. This is so whether the CPA's activities are related to tax consulting, tax return preparation, or tax representation, each of which requires preparing for a potential or actual tax controversy.

The public recognizes the expertise of CPAs in preparing tax returns, but it may do so without an appreciation of the interrelationship of legal principles with the accounting aspects of return preparation. Almost 50 years ago, the New York Appellate Division stated that an income tax return "may be prepared by one having no legal knowledge, from instructions prepared for lay consumption, or by one having only incidental legal knowledge." Whether or not this was true at the time, the complexity of current tax law means that few returns can be prepared without the need to research how the law applies to a particular fact pattern. Much of current tax practice by CPAs involves advising clients how to structure prospective transactions to obtain the most desirable tax result or consulting as to the most advantageous reporting of a completed transaction. This research is often not contemporaneous with the filing of a tax return or a ruling request and it may be conducted for a client who will not also engage the CPA conducting the research to prepare the tax return. It is difficult to imagine how a CPA could represent a client's interests before the IRS without conducting tax research that includes the interpretation of statutory law and administrative and judicial interpretations of those laws. CPAs face often unique fact patterns that raise subtle questions of how authoritative sources of tax law will apply. The great baseball player Satchel Paige once said, "I never threw an illegal pitch. The trouble is, once in a while I toss one that ain't never been seen by this generation." The CPA who is prohibited from interpreting the tax laws to judge the legality of a particular treatment of each client's unique and perhaps never before seen fact pattern may be unable to complete a tax filing or later represent that client in an administrative proceeding.

The Sperry decision recognized that, although the Federal regulations were silent on this point, a practitioner could not prepare patent applications without rendering opinions as to the patentability of a client's inventions. That is, it is not possible to practice before the Patent Office by merely engaging in a mechanical completion of lines and boxes on a form. The Supreme Court agreed that the activities of Mr. Sperry did constitute the practice of law, but it approved of such practice as consistent with the objectives of Federal regulation. Similarly, in rejecting the petition of the Florida Bar Association to approve a proposed opinion defining permitted areas of practice by nonlawyers with respect to pension plans, the Supreme Court of Florida stated, "We cannot prohibit professionals from preparing and presenting the necessary documents to Federal agencies before which they are admitted to practice." The Florida Bar had proposed to define as unauthorized practice of law, giving advice that a "particular pension plan qualifies for tax benefits under the code, revenue rulings, and court decisions," and giving an opinion or advice "regarding the consequences or effects of the tax laws or other laws on pension plans." Although these activities involve more than simple preparation of documents, they form a significant part of the pension consulting done by many CPAs. The refusal of the Florida Supreme Court to restrict the pension consulting activities of CPAs seems to reject the limitation of practice before the IRS to the mechanical preparation of documents.

Circular 230 grants a status-based exemption to CPAs to practice before the IRS; that is, no special test or additional education is further required from a licensed CPA. In rejecting the Bar Association petition to establish rules governing unauthorized practice of law, the Supreme Court of South Carolina noted its "respect for the rigorous professional training, certification and licensing procedures, continuing education requirements, and ethical code required of ... CPAs" in support of the decision that "allowing CPAs to practice in their area of expertise, subject to their own professional regulation, will best serve to both protect and promote the public interest." It is the respect the CPA profession has built over many years that justifies the public trust that allows for a special status-based exemption from certain aspects of unauthorized practice of law statutes. It is important, however, that CPAs restrict their activities to those reasonably associated with the effective representation of the taxpayer before the IRS and within the professional expertise of the CPA.

The potential for conflicts with the Federal preemption, and thus the potential for unauthorized practice of law challenges, may be expected to rise as the CPA profession expands the scope of services offered to the public. The potential for such challenges should not be taken lightly, even given victories in Sperry and the states of Florida and South Carolina. Both states implied that they would be willing to find CPAs to be engaged in unauthorized practice of law based upon the facts and circumstances of a particular case. The courts were merely not willing to adopt broad prohibitions on the conduct of CPAs that seemed in compliance with Federal regulations and outside the reach of state courts. However, there are many areas of practice in which CPAs may, if not cautious, cross the line of what is permitted by Federal statute and regulation. The South Carolina court emphasized allowing CPAs to practice in their areas of expertise, subject to professional oversight. The New Jersey Supreme Court noted that unauthorized practice of law statutes should be enforced based upon the public's realistic need for protection and regulation, a need that would be mitigated where the provider of a service is both competent to offer that service and is subject to professional regulation. It may be expected, then, that the future risk of court-imposed sanctions for unauthorized practice of law may be minimized by restricting activities to those which are within the professional competence of the individual CPA and subject to regulatory oversight by the CPA profession. Effective self-regulation by the profession should reduce the need for intervention by the courts for the purpose of protecting the public.

Current Activities of CPAs and Challenges of the Future

CPAs may generally conduct a tax practice within the protections offered by Circular 230 if they recognize the need to consult an attorney when resolution of a tax question requires an interpretation of legal principles that extend beyond Federal tax law. To illustrate how the principles of the Federal preemption of state unauthorized practice of law statutes may apply to a CPA's tax practice, four general areas of tax practice--partnership taxation, real estate taxation, entity choice and classification, and estate and gift taxation--will be examined.

Partnership Taxation. One advantage of the partnership or LLC form over an S corporation is the ability to make special allocations of items of income, gain, deduction, loss, and credit. Such allocations will fail to be respected, however, if they lack substantial economic effect. A special allocation must satisfy a two-part test that requires the allocation first have economic effect and the economic effect must then be substantial. One of the tests for economic effect requires that a partner have an obligation to restore a deficit capital account balance upon liquidation of his or her interest. A CPA may review a partnership agreement to determine if the substantial economic effect test is satisfied; and, the CPA's skills in maintaining required capital account balances are well-suited to maintaining the validity of special allocations from year to year. However, the determination of whether or to what extent a deficit restoration obligation exists, as well as the meaning of the term "partnership agreement" for purposes of the IRC section 704(b) regulations, may require an analysis of obligations imposed by state law and the validity of side agreements made between the partners. When such questions arise, the CPA should defer to an attorney if the issues require interpretations of state law.

Another advantage of the partnership or LLC form over an S corporation is the ability to include a partner's share of third-party liabilities in the determination of the basis of the partner's interest in the partnership. How a partner's share of liabilities is determined depends, in part, on whether the liability is classified as recourse or nonrecourse, a determination that requires an analysis of obligations created by the partnership agreement, agreements with creditors, and any side agreements among the parties. Such determinations may require an analysis of legal principles that extends beyond the practice of Federal tax law. For example, whether a guarantee of a liability will affect the guarantor's share of that liability may depend, in part, on subrogation rights created by state law. Generally, a CPA will be able to determine the partners' shares of entity liabilities without the assistance of an attorney. But there are certain cases where state law principles will be relevant, and the CPA should again defer to an attorney to resolve strictly legal issues that may affect the resolution of this tax issue.

Real Estate Taxation. A common issue for taxpayers with real estate operations is whether the taxpayer is a dealer or an investor. IRC sections 1221 and 1231 exclude from the definition of a capital or IRC section 1231 asset, respectively, property held primarily for sale to customers in the ordinary course of a trade or business. There has been a significant amount of litigation addressing the meaning of this exclusionary language, and an analysis of the dealer-investor classification problem will require a reading and analysis of many court decisions. Nonetheless, the dealer-investor issue is an excellent example of the type of tax law that CPAs may practice under the Federal preemption of Circular 230 because resolution of this issue does not require the application of legal principles other than Federal tax law. The Fifth Circuit has recognized that the dealer-investor question, and other questions that rely on a taxpayer's intent, is a factual one. The factual determination of a taxpayer's intent for holding property does not require a resolution of legal issues.

A second issue that may arise in a real estate tax practice is whether property is real or personal under local law. For example, a taxpayer seeking to complete a deferred like-kind exchange may identify and receive replacement property constructed on land acquired by the taxpayer. However, any such property actually received must be substantially the same as the property identified. For this purpose, if real property to be produced is identified, and the construction of that property is not completed by the end of the IRC section 1031(a)(3) replacement period, the progress work may be replacement property if it would have been substantially the same as the identified property had it been completed and if the progress work is real property under local law. A CPA may advise on virtually all aspects of a deferred IRC section 1031 exchange, including an interpretation of how relevant tax authorities apply to the client's situation. However, the isolated issue of whether construction in progress constitutes real property under local law would require the input of an attorney.

Entity Choice and Classification. Choice of entity issues are prevalent in any tax practice, and such issues present a mix of legal, tax, and accounting questions that often require the input of an attorney beyond the mere drafting of legal documents. For example, LLCs and LLPs have become increasingly popular as a means of providing protection from liabilities to all members of the entity while retaining the flexible tax treatment of a partnership. The specific protections offered by relevant state law should be addressed by an attorney, and the CPA should generally not simply suggest to a client that the LLC or LLP form offers some unspecified legal protection. Similarly, many practitioners now advise the use of a qualified subchapter S subsidiary (QSSS or QSub) to isolate a risky business in an entity separate from an S corporation while continuing to enjoy single entity tax treatment. If a client proposes to acquire the assets of another business, and there is concern about exposing the assets of the acquiring entity to liabilities of the target entity, a forward triangular merger may be recommended. It would be appropriate for a CPA to describe the tax advantages of an LLC or LLP, how a QSSS is taxed and how the IRC section 1361(b)(3)(B) election should be made, and the tax consequences of a taxable or nontaxable forward triangular merger. However, the specific legal protections offered by each of these arrangements rely on local law and require the input of an attorney. The CPA should, consistent with the 1981 Statement of the National Conference of Lawyers and Certified Public Accountants, recommend that the client consult an attorney for these nontax legal issues. Another significant issue when a CPA recommends use of an unincorporated entity, such as an LLC, is whether that entity will be taxed as an association pursuant to IRC section 7701(a)(3). Generally, a CPA should feel free to interpret the final IRC section 7701 classification regulations ("check-the-box") in determining the default or elective classification of an eligible entity. However, an eligible foreign entity's default classification cannot be determined without a determination of whether all members have limited liability under local law and perhaps under organizational documents. Because the CPA cannot determine whether local law provides for limited liability, an attorney should be consulted before the default status of the foreign eligible entity is determined.

Estate and Gift Taxation. In this area of practice, it is particularly appropriate for the CPA to consult with an attorney. The need to engage an attorney early in the estate planning process is noted in a 1981 statement by the National Conference of Lawyers and Certified Public Accountants entitled Statement on Estate Planning. There are numerous examples of when the tax treatment of an item cannot be determined without reference to local law. For example, IRC section 1014(b)(6) allows a surviving spouse a basis adjustment for both the decedent's one-half share of community property included in the gross estate as well as the one-half share held by the survivor. This rule, which provides an income tax advantage to community property relative to separate property, is well within the expertise of the CPA to interpret and explain. However, clients often want to know what items of property are held as community. The determination of community property is a strictly legal issue, albeit one with tax consequences, and must be resolved by an attorney. Although many CPAs in community property states gain some familiarity with local law, they should not attempt to answer questions about the classification of community property. The issue may be deceptively complex, as many residents of community states have moved from separate property states during their marriage.

Another estate and gift issue that blends legal and tax issues is the timing of a qualified disclaimer of property held as joint tenants with rights of survivorship (JTWROS). IRC section 2518 states that a qualified disclaimer must be made within nine months of the date on which the transfer creating the interest is made. In proposed regulations filed on August 21, 1996, the IRS accepted the views of prior court decisions that, where the joint tenancy may be unilaterally severed by either party under local law, the survivorship interest may be disclaimed within nine months of the death of the first joint tenant to die. However, the proposed regulations stated that if the joint tenancy is not unilaterally severable under local law, the survivorship interest must be disclaimed within nine months of creation of the joint tenancy. For disclaimers made after December 30, 1997, final regulations permit a post-death disclaimer regardless of severability. A CPA may advise that a qualified disclaimer of JTWROS property may help to repair an estate plan in which property held as JTWROS passes, by operation of law, to the surviving spouse. Such a plan would overfund the marital deduction and waste the unified credit in the estate of the first spouse to die. However, the CPA's advice to disclaim the survivorship interest should be accompanied by a recommendation to consult an attorney familiar with local law to determine whether a post-death disclaimer will be effective and to counsel how to effectuate such a disclaimer under local law.

Other Practice Areas. Two growing areas of practice for many CPAs are personal financial planning (PFP) and business valuation. Many PFP practitioners have significant experience in taxation and tax planning is often a significant part of a PFP practice. A comprehensive financial plan may involve creation of a living trust and strategies designed to protect the client's assets. Because such recommendations do not involve any particular Federal tax law issues, it is important to consult an attorney who may advise of the legal pros and cons of using a living trust and the effectiveness and advisability of using various asset protection techniques.

A growing area in valuation practices is the use of a family limited partnership (FLP) or a family limited liability company (FLLC) to obtain valuation discounts. It is the nature of the rights established, under local law, by use of an FLP or FLLC that supports a valuation different than the net asset value of assets represented by an interest in the entity. This change in valuation is based on rights created under state law and the partnership or LLC operating agreement, and is subject to interpretations of the application of the "Chapter 14" valuation rules found in IRC sections 2701 through 2704.

The protection from state unauthorized practice of law statutes available to the CPA who accepts an engagement to value an interest in an FLP or FLLC for transfer tax purposes is limited to an interpretation of how the "Chapter 14" rules apply. Supporting a particular valuation may require interpretations of state law with respect to issues such as the right of withdrawal of a limited partner or a member of an LLC; these interpretations must be made by an attorney.

Stay Within Competency

As CPAs continue to expand the nature of the services they offer, it is important that they not venture into areas in which they lack professional expertise. The CPA profession is held in high regard because its members have extensive education, training, and self-regulation. To best meet the needs of clients, CPAs in tax practice must comply with the principles of the 1981 AICPA-ABA Joint Statement that calls for use of an attorney when legal principles are involved, although the protection offered by Circular 230 means that CPAs should feel comfortable to provide advice on matters involving the application of Federal tax law principles. However, many CPAs have long recognized the practice development advantages of developing strong relationships with attorneys. An understanding of unauthorized practice of law statutes and a clear assessment of the scope of activities within the professional competencies of the CPA may enhance the development of strategic alliances with attorneys that benefit both professionals. *

James R. Hamill, PhD, CPA, is the Rogoff, Erickson, Diamond & Walker LLP Tax Research Fellow at the Anderson Schools of Management, University of New Mexico, Albuquerque, N.M.

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