AICPA Alert on IRS RAL Program

To: Tax Practitioner Members of the AICPA

From: David A. Lifson, Chair, AICPA Tax Executive Committee

Subject: IRS Program to Provide Debt Indicators With Respect to Refund Anticipation Loans

Some tax practitioners (CPAs and others) who prepare returns for low-income taxpayers offer those taxpayers a "refund anticipation loan" under which they will receive the cash equivalent of their refund immediately (less any fees deducted) and repay the loan when the actual IRS refund arrives. The IRS has reinstituted—after having ceased the program a few years back because of perceived abuse—offering such practitioners a "debt indicator" agreement under which the practitioner will receive an indicator from the Service that the refund will actually be paid to the taxpayer and not offset by other taxpayer obligations collectible by the government. However, the Service is requiring such practitioners to enter into an agreement with them under which there is a quid pro quo for the debt indicator: certain enhanced reporting requirements to the IRS with respect to returns that are either "fraudulent" or "potentially abusive" (as defined in the agreement).

Because the agreement creates, in our view, a few potential issues for AICPA members signing such agreements, we feel it important to lay out those issues for those members who offer (through their own practices or an affiliate) refund anticipation loans (RALs) to taxpayers. If RALs are a feature of your practice, I hope you will read the following memorandum carefully. It provides a discussion of the issues and several recommendations to help you avoid future problems.

AICPA Views on IRS Electronic Filing Debt Indicator Program

The AICPA would like you to be aware of certain issues connected with the IRS e-file debt indicator pilot program currently being offered to practitioners (including CPAs) who qualify as electronic return originators, transmitters, or on-line service providers (e-file preparers). While the debt indicator program is voluntary, practitioners participating in it must sign an agreement requiring, among other things, reporting to the IRS with regard to taxpayers whose circumstances would result in the filing of what the IRS/e-file preparer contract defines as a "fraudulent" or "potentially abusive" return.

The contractual definition (see discussion below) does not track any of the standard definitions in the Code or regulations (Sec. 6694, Sec. 6662, Circular 230), and it is therefore important that CPAs understand the obligations they are undertaking in entering into the debt indicator pilot program. Further, there are issues of confidentiality under our AICPA Code of Conduct that may make it advisable for CPAs to take some additional steps with respect to their clients that are not specifically mandated in the agreement with the IRS.

The Debt Indicator Program

For some taxpayers, especially lower-income taxpayers who may be entitled to refunds because of refundable credits such as the earned income tax credit (EITC), the importance of quickly obtaining the cash associated with their tax refunds has led to the development of a Refund Anticipation Loan (RAL) business by tax practitioners, including CPAs (in their practices or through an affiliate). However, since the lender expects to be repaid from the IRS refund due to the taxpayer, it is critical that the lender know the Service will not offset that refund by some other obligation collectible by the government from the taxpayer (such as taxes from an earlier year or child support payments). Accordingly, IRS has agreed to provide these lenders with a "debt indicator" which indicates to the lender that the expected refund will be paid to the taxpayer and not be reduced or eliminated by other liabilities collected by the government.

The great majority of returns against which RALs will be made involve an EITC. Because IRS has determined, through experience, that this is an area of significant abuse and fraud, and because the government is not required by law to issue debt indicators, the Service is tying practitioner desire for debt indicators to more extensive reporting requirements for RAL returns than would otherwise be the case. E-file preparers who sign a debt indicator agreement with the Service must agree to screen and code returns he or she prepares or starts to prepare; and to notify the IRS on a weekly basis of any such returns the e-file preparer regards as "fraudulent" or "potentially abusive." The screening is required only for RAL returns, though similar screening and reporting is permitted (even encouraged) by IRS for other returns as well.

The AICPA supports IRS efforts to improve EITC compliance. Further, we recognize that the debt indicator pilot program is voluntary: no practitioner is required to enter into it. The program gives affected practitioners something they do not presently have (a debt indicator), but requires a higher preparation standard in exchange (screening and coding returns, and reporting fraudulent or abusive ones to the IRS).

However, the program raises several issues that you, as an AICPA member, need to be aware of.

What is a RAL Return?

Under the terms of the IRS/e-file preparer agreement, reporting to the Service is required only for "fraudulent" or "potentially abusive" returns involving a RAL. In the words of the agreement: "The Participant will provide the Service with a report for each abusive return it receives where the taxpayer requests a RAL, the preparer offers a RAL to this taxpayer or the taxpayer signs a RAL Application." Thus, if one of the above RAL criteria is met, and the return also satisfies the definition of "fraudulent" or "potentially abusive" (see below), the e-file preparer is under a reporting obligation. However, there is no limitation in the agreement to cases where the preparer actually completes the return. Since reporting is required for returns "received" by the practitioner that meet the RAL and abuse criteria, the definition would seem to include situations where you ultimately decide not to prepare the return (because, for example, your interview with the taxpayer leads you to question his or her honesty), but the taxpayer has—early in the interview—asked you to make a RAL available. Thus, under the IRS definition, you may be obligated to report on a taxpayer who never signs an engagement letter with you and whom you may ask to take his or her business elsewhere. (Of course, in these situations, you also may have very little detailed knowledge of the taxpayer to report to the IRS.)

"Fraudulent" and "Potentially Abusive" Returns

For purposes of the debt indicator pilot program, the Service defines a fraudulent return as one "which the individual is attempting to file using someone else's name or SSN on the return or where the taxpayer is presenting documents or information that have no basis in fact." As the IRS notes in its agreement form: "Fraudulent returns should not be filed with the Service." We could not agree more. However, if such a situation presented itself to you, under the agreement, you would be obligated to report that individual to the IRS, if you believed one purpose in coming to you was for the taxpayer to obtain an RAL—even though you informed the taxpayer you cannot help him or her, or advised him or her to seek legal counsel.

A "potentially abusive return" is one that (a) is not a fraudulent return, (b) a taxpayer is required to file and (c) "may contain inaccurate information" about a limited range of subjects and "may lead to an understatement of a liability or an overstatement of a credit, and production of a refund to which the taxpayer may not be entitled."

It is important you understand that a return is potentially abusive only if the inaccuracies relate to specific items spelled out in the IRS/e-file preparer agreement—not to every item on the return. These items are primarily directed at uncovering improper claims for the EITC, but the agreement does not limit the definition to EITC returns only. For example, among the items covered would be: concerns about the taxpayer's primary social security number; the fact that a duplicate primary, secondary, dependent or EITC qualifying social security number is found within the e-file preparer universe of returns; the e-file preparer's suspicions about changes in filing status; "no substantiation" for Schedule C items on the return; a dependent's last name that is different from the taxpayer's, etc.

However, even with the limited scope of issues that could bring a return within the program's definition of "abusive," CPAs should be cautious before signing a return that comes within the contractual definition requiring reporting. An abusive return "may" contain inaccuracies that "may" lead to an understatement of tax. This language has some similarity to the civil aiding and abetting penalty language of Secs. 6701, which applies to preparers or advisers who know that their preparation or advice will "result in an understatement of the liability for tax of another person."

Sec. 6701 is clearly more focused than the debt indicator definition: for example, the penalty provision requires knowledge; the debt indicator program does not. Further, Sec. 6701 is a statutory civil penalty ($1,000); no financial sanction is specified for failure to follow the reporting requirement. Nonetheless, the language of the two provisions has enough similarity that you should be cognizant of one other feature of a Sec. 6701 violation.

Under IRS guidelines, any CPA subject to a Sec. 6701 penalty will have his or her name referred to the IRS Director of Practice for disciplinary action (which can result in a reprimand, or suspension or disbarment from practice before the IRS). While less clear, we see some real risks that a CPA signing what IRS determines to be a "potentially abusive" return under this program could also face action from the Director of Practice. The referral could be from an examining agent who finds a taxpayer's return to be abusive. It may also be from a taxpayer who discovers that a preparer included his or her name on a "fraudulent or potentially abusive return" report to the IRS and is trying to "get even."

Confidentiality

Another important issue for AICPA members who enter into a debt indicator program agreement with the IRS involves the question of confidentiality. Rule 301 of the AICPA's Code of Professional Conduct holds that: "A member in public practice shall not disclose any confidential client information without the specific consent of the client." This simple statement implicates several concerns.

Is tax return information "confidential?" It must be understood that there is a very real distinction between confidentiality and privilege. Clearly, most tax return preparation information is not privileged, either at common law for attorneys, or under Sec. 7525 for Federally authorized tax practitioners. However, information need not be privileged to be confidential. Where there is a clear intent that information given to a CPA is not to be disclosed outside of a specific, limited circle (such as information required to be disclosed on a Federal or state tax return), that information is confidential. Thus, in the absence of appropriate precautions being taken, a member could face an ethics complaint under Rule 301 for disclosing otherwise confidential taxpayer information to the IRS.

Rule 301 refers to confidential "client" information. While that clearly covers taxpayers with whom the CPA has a present client relationship, what about the individual who walks into a CPA's office for the first time, knowing that the CPA's practice encompasses making RALs available? The AICPA Professional Ethics Division interprets references to "clients" in the Code of Conduct to include prospective clients and former clients. Once the CPA begins having a substantive discussion with a taxpayer about the possibility of performing services for him or her, that taxpayer becomes a "prospective client" and the Rule 301 confidentiality provisions apply.

There is an exception to the nondisclosure general rule, stating that it shall not be construed "to affect in any way the member's obligation to comply with a validly issued and enforceable subpoena or summons, or to prohibit a member's compliance with applicable laws and government regulations." However, with respect to the debt indicator program, there is no law or regulation requiring the member to disclose taxpayer information to the IRS; nor is disclosure being compelled by a subpoena or summons. The e-file preparer and IRS enter into a voluntary contractual arrangement requiring the disclosure, and the exception to the Rule 301 nondisclosure requirement is not met.

Thus, to avoid ethical issues, it is important that there be taxpayer acknowledgment that the CPA will, in appropriate circumstances, be reporting specific problem information to the IRS where the taxpayer's return meets the IRS definition for a "fraudulent" or "potentially abusive" return (see "Recommendations," below).

Recommendations

1. Consider enhanced verification procedures for RAL returns. Circular 230 requires the exercise of due diligence in any matter involving representation of a client before the IRS. Section 10.22 of that regulation specifically mandates due diligence "in preparing or assisting in the preparation of, approving, and filing returns, documents, affidavits and other papers relating to Internal Revenue Service matters." Sec. 6695(g) and Temp. Regs. Sec. 1.6695-2T delineate specific due diligence requirements in determining eligibility for the EITC. ET Section 56.01, Article V—Due Care, of the AICPA Professional Standards: Code of Professional Conduct, notes: "Due care requires a member to discharge professional responsibilities with competence and diligence." Given these due diligence requirements, our knowledge that the questionable items leading to mandatory reporting to the IRS tend to be those involved with the EITC, and the loosely-worded IRS definitional language of abusive returns (may be inaccurate and may lead to an understatement of tax liability), prudence would dictate particular care being exercised in accepting taxpayer information for a RAL return. Failure to undertake appropriate quality assurance measures could expose the CPA to action by the IRS Director of Practice and to potential ethics charges arising from our Code of Conduct.

2. Be certain—early—that you have a client's or potential client's informed consent to report "fraud" or "potential abuse" to the IRS if a RAL return could be involved. This recommendation ties both to Rule 301 of the AICPA Code of Professional Conduct and to the IRS definition of a RAL return. Under Rule 301, you may not inform the IRS of a client's or prospective client's "potential abuses" without first securing that person's permission. Under the IRS agreement, you are required to inform the IRS about your client's or prospective client's "potential abuses" if a RAL is involved (even though you determine ultimately not to serve that prospective client).

In our view, this dilemma is best resolved by making sure—as soon as you have any hint the taxpayer is interested in a refund anticipation loan—that you immediately disclose to the taxpayer your obligation under the IRS debt indicator agreement to report on potential abuses (as defined in the agreement), and ask the taxpayer to execute a consent which, at the least, acknowledges your obligation to the Service and authorizes you to disclose appropriate information to them if circumstances so require. If this discussion comes early enough in the taxpayer interview, even if the taxpayer walks away after hearing of your obligation, you will presumably have no knowledge of abuse to report to the IRS. Obviously, the further along the interview has gone before disclosure of your obligation to the Service, the higher will be the risk that you have come into possession of information that would need to be reported, even though you do not finally prepare the return.

Finally, professional liability insurance policies may not cover "intentional acts." Even though your client may have acknowledged your obligations to the IRS under this program, you should still ask your professional liability insurance carrier what effect entering into an agreement with the IRS would have on your coverage, if any.

Note: The text of Mr. Lifson's memorandum, dated Feb. 29, 2000, can also be found at the AICPA website (www.aicpa.org), under "News for CPAs."