Editor: Thomas J. Purcell III
Tax return preparers generally review prior-year tax returns in preparing the current-year tax return for new and existing clients. Statement on Standards for Tax Services (SSTS) No. 3, Certain Procedural Aspects of Preparing Returns, recommends that CPAs “refer to the taxpayer’s returns for one or more prior years whenever feasible” in preparing or signing a return for a later period.
In reviewing prior-period returns, a tax return preparer may discover an error or omission. A preparer may also discover an error on a return in reviewing a position recommended by another adviser concerning a transaction engaged in by the taxpayer. When errors are discovered, Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), and SSTS No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, impose standards of conduct on CPAs who discover an error or omission in a prior-year tax return.
AICPA members are required to comply with the Statements on Standards for Tax Services in their practice. The Statements apply to all tax practice matters, not just federal income tax engagements, while Circular 230 applies only to matters under IRS jurisdiction. Additionally, some state boards of accountancy require CPAs licensed in their state to comply with AICPA standards.
What to Do When an Error Is Discovered
SSTS No. 6 states that a CPA “should inform [the client] promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return.” SSTS No. 6 also recommends that the CPA advise the client about the potential consequences of the error and recommend corrective measures. The CPA may give the recommendation either orally or in writing.
Section 10.21 of Circular 230 imposes similar obligations on tax practitioners who discover an error or omission on a tax return. Both Circular 230, Section 10.21, and SSTS No. 6 require that the practitioner make the client aware of the error or omission and its potential consequences. The practitioner has this obligation whether the error resulted in an underpayment or overpayment of tax. Additionally, the obligation exists whether the error relates to work done by the practitioner or another tax professional.
While both Circular 230 and SSTS No. 6 require the practitioner to advise the taxpayer of the potential consequences of the error or omission, SSTS No. 6 goes even further by advising CPAs to recommend to their client measures to correct the error or omission. Circular 230 does not impose this affirmative duty on tax practitioners. If the error or omission may subject the client to allegations of fraud or other criminal misconduct, paragraph 11 of SSTS No. 6 recommends that the CPA advise the client to consult with an attorney before taking any action. Given the lack of privilege covering those communications, tax practitioners who are not attorneys must be cautious in their communications with a client regarding an error or omission that may have criminal implications or that may affect a client in a legal proceeding. There are numerous types of errors that may bring into play Circular 230, Section 10.21, and SSTS No. 6. This exhibit provides two examples of the application of those provisions.
If a CPA is engaged to prepare the current-year return and the client has not taken appropriate action to correct an error in a prior-year return, SSTS No. 6 advises the CPA to consider whether to withdraw from preparing the return and whether to retain the taxpayer as a client. The client’s refusal to amend the prior-year return to correct an error or omission should cause the preparer to question the integrity of the client and whether the failure to correct the error or omission indicates potential future behavior that may require ending the relationship. If the practitioner does prepare the client’s current-year tax return, SSTS No. 6 advises the CPA to take reasonable steps to ensure that the error is not repeated. If the current and subsequent years’ tax returns cannot be prepared without perpetuating the error, the CPA should again consider withdrawing from the engagement.
CPAs may also review the client’s tax returns and become aware of an error or omission during the course of nontax engagements. For example, during the course of the annual audit of a client’s financial statements, the audit firm may learn of a tax return position that appears to be erroneous or about income omitted from the tax return. This is more likely in the post-FIN 48 era in which auditors must evaluate the tax return positions and reserves for uncertain tax positions with greater scrutiny. A CPA may also learn during the course of due diligence for a loan or other transaction of an error or omission on the client’s tax return. In these situations, SSTS No. 6 applies even though the CPA’s engagement did not involve tax return preparation. In a nontax engagement, if the CPA learns of an error or omission on a prior-year return, the CPA must advise the client of the existence of the error and recommend that the client discuss the issue with the tax return preparer.
Communicating With Clients
Once a CPA discovers an error or omission in a client’s tax return, the CPA must decide how to proceed in informing the client of the error, explaining the potential consequences of the error, and recommending a course of action to correct the error. While Circular 230 is silent regarding the form of the communication that the tax practitioner must employ to advise the client of the error, SSTS No. 6 specifically permits the CPA to give the notification, advice, and recommendation orally. In deciding how to communicate with the client regarding the error or omission, the CPA must be aware that communications between him or her and the client are subject to discovery in tax or other litigation.
As a general rule, both oral and written communications relating to tax return preparation, including prior years’ erroneous returns, are not privileged (see Lawless, 709 F.2d 485 (7th Cir. 1983), and Davis, 636 F.2d 1028 (5th Cir. 1981)). While written communications may be beneficial to the CPA in the event of future litigation between the CPA and the client, or in disciplinary proceedings under Circular 230, under the AICPA professional standards, or under state licensure laws, tax authorities may also use them against the client. CPAs should consult their own attorney regarding the manner in which to handle these communications, including whether to use oral or written communications. The CPA should consider documenting any communication to the client by preparing a written file memo indicating in general terms that a communication occurred regarding the error, its consequences, and a recommended course of action. Practitioners should consider consulting with their attorney concerning the level of detailed discussion contained both in files and in written communications with the client regarding the error or omission.
Neither Circular 230 nor SSTS No. 6 requires a practitioner to volunteer information to the IRS regarding an error or omission on a client’s tax return. In fact, SSTS No. 6 explicitly prohibits the CPA from informing the taxing authority of the error or omission without the taxpayer’s permission, unless required by law. However, if a CPA is representing a client in an administrative proceeding with respect to a return that contains an error, SSTS No. 6 provides that the CPA should request the client’s agreement to disclose the error to the taxing authority. If the client does not consent to the disclosure, SSTS No. 6 advises the CPA to consider withdrawing from representing the client in the administrative proceeding and terminating any professional relationship with the client.
In-house CPAs responsible for financial statement reporting must also be concerned with the professional obligations associated with errors or omissions on a prior-year tax return. Failure to amend an erroneous prior-year return may require a client to record a reserve for unpaid taxes, interest, and penalties, if the amounts are material. An in-house CPA with knowledge of an error or omission on a tax return that is material to the financial statements may have committed an act discreditable to the profession in violation of AICPA Code of Professional Conduct ET Section 501.05 if he or she permits the preparation of the financial statements without reflecting the potential tax liability associated with an error or omission on a prior year’s tax return.
One of the significant differences between Circular 230 and SSTS No. 6 relates to the materiality of the error or omission. SSTS No. 6 provides that “an error does not include an item that has an insignificant effect on the taxpayer’s liability.” In determining whether an error has a significant effect on the taxpayer’s liability, SSTS No. 6 requires the CPA to exercise professional judgment based on all of the facts and circumstances known to the member. If the error relates to an erroneous method of accounting used by the client, the CPA must consider the method’s cumulative effect, as well as its effect on the tax return at issue, in determining whether the error has more than an insignificant effect. While SSTS No. 6 includes a materiality exception, Circular 230 does not provide an explicit exception for immaterial or insignificant errors or omissions.
The reputation of the CPA profession depends on its members acting with honesty and integrity in their dealings with clients, the general public, and tax authorities. The consequences of a CPA’s failing to comply with the requirements of Circular 230, the Statements, and other applicable professional standards can have both economic and reputational consequences for the CPA. Such failures also damage the reputation of the CPA profession as a whole.
Thomas Purcell III is a professor of accounting and professor of law at Creighton University in Omaha, Neb. Blaise Sonnier is a professor at the University of Colorado–Colorado Springs in Colorado Springs, Colo. For more information about this article, contact Prof. Sonnier at firstname.lastname@example.org.