Such a scenario well illustrates both of the concerns raised with respect to noncorrecting clients by SSTS No. 6 discussed above. Broadly speaking, such an attempt would certainly manifest the “bad apple” warning articulated in SSTS No. 6, paragraph 8. Simply put, “cherry-picking” would be blatantly unethical and would indicate an unlawful tax compliance culture, from which tax practitioners would do well to flee as quickly as their feet could carry them.
Secondly, tax practitioners expressly would be precluded from participating in such an attempt by the same provisions that prevent them from knowingly reflecting an erroneous position on a current return, because these provisions apply with as much force to preparing amended returns as they do to preparing current returns.9 In a sense, “cherry-picking” represents the worst of all possible worlds, in that it contemplates an attempted manipulation of the regime for correcting errors that violates both the letter and the spirit of the Rule, along with several other provisions.
What If the Client Seeks “Rough Justice” on a Currently Filed Return?
In contrast to the client’s choosing not to take corrective action on a previously filed return or seeking to “cherry-pick” on an amended return is a scenario in which the client wishes to undertake some form of self-help on a currently filed return.
Example 2: Client Z omitted income in a previously filed return. Upon discovering this error, the tax practitioner, in accordance with the Rule, informs Client Z of the understatement, discusses its consequences, and recommends amending the previously filed return. Client Z, for a variety of administrative and strategic reasons, thanks the tax practitioner for her diligence but firmly declines the advice to amend. Instead, Client Z proposes to implement a “true-up” on the current return, in which “rough justice” is achieved by overreporting an amount on the current return equal to the amount previously underreported on the previously filed return.
This scenario, which is by no means uncommon, raises a variety of questions, the first of which is whether the tax practitioner can play a role in preparing the current return under such circumstances. After all, Circular 230, Section 10.34, which has no materiality standard and applies equally to understatements and overstatements of income, explicitly prohibits a tax practitioner from knowingly preparing an erroneous return. Moreover, SSTS No. 6 specifically warns a tax practitioner whose client has refused to amend to take steps to ensure that the current return is accurate.10 Thus, even though the contemplated incorrect treatment on the current return would be beneficial to the IRS, such a “true-up” would at first glance appear to be prohibited by the plain language of both Section 10.34 of Circular 230 and SSTS No. 6.
Certainly, these authorities should give tax practitioners pause when considering the extent to which they can be associated with such attempts to achieve “rough justice” on a current return. Nevertheless, the implications of reading Section 10.34 of Circular 230 and SSTS No. 6, paragraph 5, as an absolute bar to the practitioner’s ability to assist with a self-help return are somewhat troubling. For example, if a client steadfastly refuses to amend a prior return but evidences a willingness to engage in self-help by reporting the taxable income in a subsequent year, the fisc is far worse off if the practitioner is precluded from assisting with the self-help return.
Although the client’s “true-up” strategy would transcend the annual accounting period, which is generally frowned upon in the extreme, the step is being undertaken for an innocuous, perhaps even a laudable, purpose: to square the books and to pay the proper amount of tax where the client has no obligation to self-report. Accordingly, it seems anomalous to prohibit the tax practitioner from assisting the client in this pursuit of “rough justice,” when it would achieve a substantially better result for the self-reporting system than taking no corrective action at all, which is specifically contemplated and approved by Section 10.21 of Circular 230 and SSTS No. 6.
The above discussion relating to “true-ups” accomplished via an overreporting of income on a current return is to be contrasted with a “true-up” strategy that would result in underreporting income on the current return. Such underreporting would subject both the practitioner and the taxpayer to penalties and, regardless of its transactional equity, should not be entertained as a plausible means of proceeding.
From a practical perspective, tax practitioners who feel comfortable in assisting a client in a “true-up” on a current return would be well-served to thoroughly document their threshold compliance with the Rule and the client’s unequivocal decision not to file an amended return. This documentation at a minimum should take the form of a contemporaneously prepared memorandum to the file. Likewise, the tax practitioner would do well to ensure that the documentation demonstrates the facts leading to the conclusion that the practitioner’s participation in the client-initiated effort to achieve “rough justice” on the current return was the best and most reasonable approach under the circumstances. Finally, the practitioner should consider whether specific disclosure of the “true-up” should be made on the return.
Additional Practical Considerations
Complex issues arise when the tax practitioner becomes aware of an error in connection with a return that is about to be examined or is being examined by the taxing authority.
As detailed at the beginning of this article, it is the taxpayer’s decision whether to remediate an error, and a practitioner rarely, if ever, can unilaterally remediate a client’s error. At the same time, the tax practitioner has both ethical duties and legal obligations in connection with representing a taxpayer undergoing an examination, and these practitioner considerations must move to the forefront when the practitioner is aware of an error on a return that the taxpayer has decided not to correct, despite the circumstance that the return has been selected for examination by the taxing authority.
Many tax examiners use the opening meeting of an examination to ask taxpayers if they are aware of any subsequent developments concerning items on the original return. If the practitioner has informed the client of an error prior to that kickoff meeting, the practitioner’s heart likely will skip a beat as he or she waits for the client to answer this question.11 As awkward as this situation can be, practitioners should also be aware that the examiner may ask the same question directly to the practitioner. A practitioner must carefully weigh the legal and ethical implications of any answer.
Once the exam is underway, the practitioner may become aware of an error. While Section 10.21 of Circular 230 and SSTS No. 6 provide some signposts here, they are not sufficiently detailed to address every issue. Additional factors must be considered. First, and perhaps most important, for many reasons, including professional responsibility, the practitioner cannot engage in misleading conduct. For example, Circular 230, Section 10.22(a)(1), provides that a practitioner must exercise due diligence in preparing, assisting in the preparation of, or approving documents, affidavits, and other papers, as well as returns, to be submitted to the IRS. Similarly, Circular 230, Section 10.22(a)(2), provides that practitioners must exercise due diligence in determining the correctness of oral or written representations they make to the Treasury Department, including the IRS.
The difficult questions here are not those involving direct deceit by the client but rather the “cherry-picking” response discussed above. For example, if the taxpayer has an investment account that has both gains and losses in taxable income due to an innocent error, what are the practitioner’s obligations if the client contemplates a partial correction of the error by disclosing to the IRS the transactions that were losses but not those that generated gains? Can any amount of carefully calibrated language transmitting the information on the loss transactions to the IRS satisfy the practitioner’s responsibility to exercise due diligence if the client asks the practitioner to review it prior to its submission to the IRS? What are the practitioner’s responsibilities if an IRS agent asks the client if he or she is comfortable with the amount reported in connection with an item and the client responds affirmatively or artfully dodges the question with an ambiguous or nonresponsive answer?12
One of the principal differences between the AICPA standard and Circular 230 is the cautionary note that the AICPA raises about continuing the client relationship if the client does not correct the mistake. Without reiterating the issues surrounding the termination of the client relationship, the preceding discussion illustrates that in many cases, tax practitioners may be wise to limit their involvement in a subsequent tax examination if the client opts not to take affirmative action to remediate an error.
As noted in part I of this article, one of the noteworthy differences between SSTS No. 6 and Circular 230, Section 10.21, is that the former has a materiality standard, although, as also noted, there is no guidance on how materiality is to be measured. Taxpayers seem to frequently employ their own concepts of materiality in evaluating whether to file an amended return or take other appropriate action to remediate an error. This section discusses some of the practical considerations that come into play when a practitioner tries to apply the materiality concept.
First, although the AICPA standard excludes errors that have “an insignificant effect on the taxpayer’s tax liability,” as noted previously, there is no further gloss on how to interpret the phrase.13 It is not clear whether, when evaluating the materiality of an error, the financial statement definition of the term is relevant. While a $100,000 timing difference would be immaterial on the financial statement of many publicly traded corporations, it is not clear it would be for purposes of SSTS No. 6.
In addition, although some errors and omissions affect only a single tax year, many are timing differences; i.e., the item of income or deduction has been, or will be, reported in a different tax year from the year the reporting rules would deem appropriate. It is not clear how the materiality concept applies to such timing errors. Many timing errors are simple to describe, e.g., revenue that must be reported as taxable in the year received by the taxpayer, where the taxpayer erroneously defers a portion to a later tax year in a manner consistent with its financial statement treatment.
Even within these simple facts, however, application of a materiality standard can quickly become complex within the entire landscape of the taxpayer’s financial affairs. Examples of considerations that can complicate the analysis are the alternative minimum tax; state and local taxes; changes in tax rates and effective tax rates; and the attributes of the taxpayer, such as net operating loss or capital loss carryforwards and whether the taxpayer is a passthrough entity. Thus, it is not clear that a one-year timing difference would always be an immaterial error.
Why a Client Might Not Want to Remediate
Practitioners advising clients about errors quickly appreciate that it is naïve to assume that all taxpayers will readily correct errors brought to their attention. Almost as quickly, practitioners understand that the reluctance of many taxpayers to remediate is rational and often based on proper motivations. Indeed, it is not unusual for taxpayers to hesitate to make even a correction that would benefit them.
As a counseling point, both noneconomic and economic considerations may be at play when a client hesitates upon being advised to correct an error. The noneconomic considerations may be as simple as the client’s reluctance to admit having made a mistake. At the extreme, it may be driven by an employee’s concern that conceding an error may reflect badly on job performance or even result in losing his or her position. In these cases, the practitioner should seriously consider whether the person is acting in the best interest of the taxpayer or out of conflicted personal interest in deciding whether and how to remediate an error.
Other difficult-to-quantify considerations may come into play in connection with whether to remediate the error. For example, taxpayers frequently express concerns about whether amending returns will make an examination more likely and the effect on a statute of limitation. In some cases, the statute of limitation for claiming a deduction is near closing, and taxpayers are understandably reluctant to amend a return if it would extend the statute of limitation. Such is particularly the case if the taxpayer is aware of any tax exposures within its return that might outweigh the benefits of amending.
Many of the situations where taxpayers hesitate to remediate errors involve considerations akin to those discussed above in connection with materiality. In some cases, a rational cost/benefit analysis would not support remediating small-dollar errors. Amending a tax return to correct an error can be time-consuming and costly if the taxpayer must hire a professional. In addition, an error on a federal return of a multistate taxpayer can have a ripple effect into the returns of many states, which increases the costs of remediation. Furthermore, even if the error is material on the federal return, it is not as likely to be material on all the state returns, regardless of the definition of materiality.
An even clearer example of where cost/benefit considerations may argue against correcting an error is an improper accounting method that must be remediated by filing a Form 3115, Application for Change in Accounting Method, with the IRS, for which the standard IRS user fee is $7,000.14 A client may not see the benefit of paying a $7,000 user fee to correct an erroneous accounting method that results in a deferral of $500 of tax between years. And, of course, the user fee is in addition to any professional fees the taxpayer must pay.
Similarly, taxpayers may be reluctant to correct errors that are simple timing errors. Any movement of taxable income, loss, or deduction between years can lead to an interest charge or payment to the taxpayer. Furthermore, as discussed above, other considerations, such as limitations applicable to different tax years, rate changes, or differences in state tax consequences may cause substantive differences in the tax effect of any item shifted between years. That said, the taxpayer may be reluctant to file an amended return to shift to the proper year an item that was erroneously recognized in a prior year. Moreover, most taxpayers do not quantitatively analyze the relative tax effects of the item in different years and instead tend to be guided more by the qualitative factors discussed above.
Partnerships and Other Passthrough Entities
Circular 230, Section 10.21, applies to any submission to the IRS and thus clearly applies to federal partnership returns, returns of other passthrough entities, information returns, and the like. To avoid repetition, this section focuses on partnership returns, because the discussion that follows does not depend on the entity or return to any significant extent.
As noted previously, SSTS No. 6 is limited to tax returns. Thus, it is not clear whether, from a professional standards perspective, there is any applicable AICPA guidance relating to errors on a tax form that is not a return, such as a partnership’s state information return in a state where a partnership is not subject to a partnership-level tax. However, to the extent that an error on the partnership’s return affects the accuracy of its partners’ returns, it would be prudent for a CPA to apply SSTS No. 6 by analogy to an error on the return of a passthrough entity.
Second, there is no specific guidance as to who is the appropriate taxpayer in either Section 10.21 of Circular 230 or SSTS No. 6 with respect to an error on a partnership return. In most instances, it is appropriate for the practitioner to work with the person who is responsible for the return, the tax matters partner (TMP), in addressing errors. The practitioner should tread carefully, however, if, when deciding whether to remediate the error, a reasonable person might question whether the TMP is acting in the best interests of the rank-and-file partners.
In many cases, though, TMPs’ fiduciary duties cause them to act very conservatively. As discussed above, a sole proprietor may wish to engage in economic calculus to decide whether to remediate the error and may ultimately decide not to correct the error, despite exposure to penalties, extended statutes of limitation, and the like. By contrast, the TMP may have to consider whether the state-law fiduciary duties owed to its partners preclude alternatives that may expose it to penalties. The TMP will likely be well-advised to consult legal counsel where fiduciary duties come into play.
Third, the concept of materiality is particularly difficult to employ in the context of a partnership. First, it is not clear whether materiality is measured at the partnership or the partner level. For example, even assuming for the sake of argument that a $100,000 error is material, it is not clear that a partnership that omitted $100,000 from its return must act under the assumption it is material if it is a publicly traded partnership that has 1 million widely held units. Also unanswered is whether the profile of partners may be relevant in assessing materiality. For example, again assuming that a $100,000 omitted item of income would be viewed as material if it were fully subject to tax, would it still be viewed as such if it is a partnership item where all or the majority of partners are not subject to tax as tax-exempt or governmental entities, pension funds, or foreign persons?
Additional considerations may be relevant. For example, a timing error in a corporation simply affects the year in which the item is reported. In contrast, for a partnership, a difference in tax years may determine which taxpayers are affected by an item. If a partnership wishes to correct an omission of an item of income by “rough justice” reporting on the current-year return, the tax effects of the item may be shifted to partners that entered into the partnership after the year in which the error occurred, which presents a variety of other issues.
Fourth, the costs of remediating an error may be much higher for a partnership than for a corporation. If a corporation amends a federal return, it generally affects one federal return and the related state returns. By contrast, if a partnership amends its federal return to correct an error, that change may require each partner to amend its federal return and one or more state returns. Consequently, TMPs are particularly likely to be forceful in advocating “rough justice” by correcting errors, if at all, on the most current year’s tax return only, regardless of the technical support for doing so.
What If the Error on the Previously Filed Return Is
Attributable to the Tax Practitioner’s Own Advice?
How to Proceed
Occasionally, tax practitioners identify an error in a previously filed return that they prepared. Moreover, they may discover to their great dismay that the error was arguably attributable to their own tax advice. How does the Rule apply in this unhappy circumstance?
Although the tax practitioner may face a variety of complications as a result of the error, one thing that is relatively clear is how the Rule applies. By its very terms, the Rule proceeds implacably, without any regard to the source of the error or the circumstances under which it was made. Indeed, SSTS No. 6 is explicit that no distinctions are to be made in this context: “This statement applies whether or not the member prepared or signed the return that contains the error.”15
Accordingly, the Rule contemplates no variance in its application even if the error is attributable to the advice of the tax practitioner. The tax practitioner is obligated to disclose the error, to discuss its consequences, and to advise that the client correct it. While such a conversation may be awkward and unpleasant, it should directly mirror in form and content the discussion that would have taken place if the error had occurred on the watch of a different tax practitioner. Any other approach would violate the explicit terms of the Rule and would make an already bad situation worse. As a result, tax practitioners in this unenviable position should adhere scrupulously to the letter of the Rule and document that adherence.
Addressing a Potential Conflict of Interest
One reason compliance with the explicit terms of the Rule and careful documentation is crucial when a previous error is attributable to the advice of a tax practitioner is that such compliance can demonstrate that the practitioner’s representation of the client in this context does not constitute a conflict of interest. Anytime a tax practitioner provides allegedly erroneous advice and continues to represent the client with respect to that advice, such as in filing amended returns or undertaking other remedial measures, the tax practitioner must recognize that this representation can become a conflict of interest that might not be resolvable via a conflict waiver. Circular 230, Section 10.29, states that a conflict of interest exists when there is a “significant risk” that the representation will be “materially limited” by “a personal interest of the practitioner.”16
Nevertheless, in the context of an error on a previously filed return, the Rule provides explicit guidance on the steps to be followed by the tax practitioner. Insofar as the tax practitioner carefully follows the guidelines of Section 10.21 of Circular 230 and SSTS No. 6 and stays within the four corners of the Rule, there is no significant risk that the representation of the client will be materially limited by any personal interests of the tax practitioner. Hence, scrupulous compliance with the Rule will prevent a conflict of interest.
That said, if the application of the Rule is not clear-cut, the tax practitioner would do well to obtain a conflict waiver as contemplated in Circular 230, Section 10.29(b). Although compliance with the Rule can be a shield, even arguable noncompliance can be a sword with which even the most well-meaning tax practitioner can be skewered if appropriate protective measures are not taken.
How to proceed where a tax practitioner becomes aware of an error in a previously filed return of a client is straightforward and easily articulated. In general, the tax practitioner should inform the client regarding the existence of the error, advise the client of the consequences, and recommend corrective measures. Nevertheless, the scope of the Rule’s coverage and its specific application to unusual circumstances such as those considered in this article leave significant room for doubt and interpretation. When confronted with such complexities, however, the tax practitioner can look to the policy goals animating the Rule to chart a course of action that is ethical and practical for the tax practitioner and the client alike.
Author’s note: The author wishes to acknowledge and thank Edward Swails of Ernst & Young LLP, from whose thoughts, input, and wide-ranging contributions this article benefited immensely.
1 Note that for simplicity’s sake, this article adopts the nomenclature of “an error in a previously filed return.” This terminology, however, is intended to encompass the various situations contemplated by the Rule, including errors on a return that is the subject of an administrative proceeding, nonfiling of a required return, and erroneous use of an improper return (e.g., a corporation using Form 1120S, U.S. Income Tax Return for an S Corporation, when it did not qualify as an S corporation).
2 AICPA Statement on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, ¶8.
3 SSTS No. 6, ¶4.
4 SSTS No. 6, ¶¶5, 6, and 8.
5 Circular 230, §10.34(a)(1).
6 The tax practitioner cannot file the return without the client’s cooperation but also could not be associated with any tax return that would be rendered inaccurate by the client’s refusal to file a State A tax return.
7 SSTS No. 6, ¶5.
8 SSTS No. 6, ¶8. For more on how to withdraw, see Weston, “Firing Clients Can Be Good for Business,” 44 The Tax Adviser 184 (March 2013).
9 See Circular 230, §10.34(a)(1), and Sec. 6694 discussed above.
10 SSTS No. 6, ¶5.
11 This article does not focus on the potential criminal and civil consequences to the taxpayer or the taxpayer’s employee of a representation to an IRS examiner that there are no errors on a return while knowing that the statement is not accurate. As a matter of black-letter law, suffice it to say that this approach would not be well-chosen.
12 For example, assume that an IRS agent asks whether the client believes that an item is correct. What are the practitioner’s obligations if the client responds that the amount is correct, if the practitioner knows there is an error? What if, instead of responding that the amounts are correct, the client responds that he or she is happy with the computation?
13 SSTS No. 6, ¶1.
14 Rev. Proc. 2012-1, 2012-1 I.R.B. 1, Appendix A. The revenue procedure prescribes user fees for specified fact patterns and sets forth procedures for taxpayers to request waivers of the fee.
15 SSTS No. 6, ¶2.
16 Circular 230, §10.29(a)(2).
Michael Baillif is an adjunct professor of tax lawyering and professional responsibility at the Georgetown University Law Center in Washington, D.C. For more information on this article, please contact Prof. Baillif at email@example.com.