Tax law is extremely complex and despite debate in Congress about fundamentally restructuring the Internal Revenue Code, it has not gotten simpler. The ongoing enactment of new laws, such as the 1997 Taxpayer Relief Act, continues to frustrate taxpayers and CPAs and makes it especially difficult for small and midsize accounting firms, which have fewer resources than large firms, to keep pace with the changes. The IRS and the Tax Court also are more inclined now than in the past to expect practitioners to verify client data before filing returns.
The added pressure has led to more frequent and more severe malpractice claims arising from tax planning and preparation. Audit-related suits get media coverage, but most tax-related lawsuits are settled behind closed doors, shielding CPAs from the unfortunate yet educational experiences of their peers.
We have culled the 10 most common areas of malpractice litigation from claims covering more than a decade. When combined with CPAs knowledge of recent tax code changes and awareness of the potential economic impact of large surges and dips in the stock market, this list can steer CPAs away from engagements that pose high risk.
THEN AND NOW
Based on the claims files of three large U.S. insurance carriers, tax shelter claims were the most common malpractice claims among small and midsize CPA firms between 1980 and 1986, prior to the 1986 Taxpayer Relief Act. A review of claims filed between 1986 and 1993 at another U.S. insurance carrier revealed that estate-tax claims ranked highest in the number of tax-related malpractice suits. We compared the data sets to select the most common ill-fated engagements. We also considered recent tax law changes that could have a future impact on CPA firms.
1 ESTATE TAX
In our sample, estate-tax claims were 11.7% of claims filed between 1986 and 1993. The average dollar settlement was $30,043. The most common cause for such claims was the failure to make the qualified terminable interest property (QTIP) election, or making the election when the taxpayer should not have done so. Late estate tax return filing was another major cause for claim. The claims files frequently showed that an attorney had played a large role in a returns being filed late; often, however, the CPA didn’t have the documentation to prove this. CPAs should protect themselves by sending return-receipt letters, setting up fax machines to print out confirmations and retaining confirmations that e-mail has been sent.
Estate-tax engagements will continue to be a high-risk area for tax litigation, given stock market results over the past several years and substantial appreciation in real estate in certain parts of the country. The 1997 acts new $1 million unified credit exemption should help mitigate the problem, but it will not be fully phased in until 2006.
2 PARTNERSHIP RETURNS
The partnership tax return was the second most common cause for malpractice claims, but ranked ninth in settlement size. In one claim, a CPA failed to make an IRC section 754 election on behalf of a partner. A review of that claim showed that not only should a section 754 adjustment in basis have been made, but partnership assets also should have been distributed directly to the partners, instead of the direct sale of partnership interests that took place. These errors cost the firms insurance carrier $155,000.
It is important to remember that partnership asset-distribution rules are complex. CPAs need to do a great deal of analysis before making distribution decisions. Consider the interests of all partners, limited as well as general. In court, CPAs often cannot even produce a copy of the partnership agreement, a document client files should always contain.
3 STATE TAX
While state tax return issues ranked third in number of claims, the mean settlement was a relatively low $10,458. A common problem was the failure to make appropriate state elections, especially when they differed from the federal election. In one claim, an accountant failed to capitalize research and experimental costs for state purposes when the state limited net operating loss carryforwards to 50% of the net operating loss. The accountant’s insurance carrier ultimately paid this claim.
Another reported problem was a failure to amend state tax returns to reflect federal adjustments resulting from an IRS audit. In some cases, the returns were not amended until the state followed up on information it received from the IRS. As a result, some taxpayers were charged interest and penalties they could have avoided.
Several states no longer have a statute of limitations for such adjustments. The amount of interest and penalties could be substantial if an amended state return is not filed immediately after a federal audit. Also, because the IRS is more likely to investigate information on IRS form CP 2000, information forwarded by third parties, CPAs must amend state tax returns if their client agrees to changes in his or her federal returns. Fortunately, CPAs are becoming more aware of situations where state rules differ from federal rules and/or greater federal and state tax conformity. Stay on top of this area.
|Tax Return Checklist |
Be sure you have considered the following before you sign and send your clients tax return.
4 LATE FILINGS
Failing to get returns filed on a timely basis has clearly become more costly. The mean settlement for late returns was $29,176. A third-party attorney or an attorney-client is often involved in the late filing. Estate taxes were particularly affected. Note that attorney clients are more likely to bring legal actions against CPAs than any other type of client.
Another client quite likely to bring a claim against a CPA is a professional athlete. Everyone has heard stories about well-known sports figures who failed to file tax returns or who are literally broke. The follow-up story that does not usually appear in the newspaper is the subsequent lawsuit against the athlete’s accountant. Always document your attempts to file returns on a timely basis. This is especially important when you are dealing with attorneys, who are trained to document their efforts.
5 PERSONAL RESIDENCE ISSUES
Personal residence issues ranked fifth in number of claims and fifth in average settlement ($28,842). Most problems arose in cases where a taxpayer purchased and sold multiple residences within the two-year replacement period. Other problems were due to improper application of the $125,000 exclusion to individual circumstances and poor advice on requirements for qualified replacement residences. It is likely this will continue to be an area with high tax malpractice potential because of the 1997 acts new $250,000 or $500,000 exclusion on the sale of a primary residence and the elimination of the rollover provisions. Many taxpayers still think they can avoid capital gains taxes by purchasing a more-expensive replacement property. Not so. CPAs should include information on this decision in all their client newsletters.
6 QUALIFIED PENSION PLANS
While the number of claims was rated sixth in our sample, the average settlement was comparatively high ($35,282). The cost of making a mistake has risen significantly. New age requirements under the 1997 act eliminated common averaging-provision problems; however, CPAs continue to have problems when terminating retirement plans and failing to establish a plan for high-income years or setting up one in low-income years.
Helping a client choose between a Roth IRA or regular IRA and deciding whether to convert to a Roth IRA are the new malpractice hot spots. If you have done any calculations regarding the decision to convert, you realize how sensitive the calculations are to the assumptions you make. Document that your clients have agreed to the assumptions being made about IRA conversions. Having your clients provide the assumptions in writing would be even better.
7 DIVORCE ISSUES
The average settlement for divorce-related claims was a relatively low $10,118. Ignoring the obvious claims, such as representing both parties, the most common problems leading to lawsuits were related to the allocation of assets, basis questions and the liability for signing a joint tax return. CPAs are more educated about divorce-related tax issues than they have been in the past, keeping settlement amounts low. Nonetheless, remember you can only have one client, and the spouse that gets the assets has a carryover basis. Also remind your clients the IRS will collect from whichever party it can.
8 S CORPORATIONS
The mean settlement for S-corporation claims has dropped over the past two decades to $13,197. If you were in practice in l985, you have likely educated yourself about S corporations, given passage of the 1986 Tax Reform Act. As a result of the S corporation’s popularity, the missed S-corporation elections and problems related to net passive income and built-in gains taxes of former C corporations with earnings and profits have declined significantly.
9 LIKE-KIND EXCHANGES
Five percent of the latest claims were related to IRC section-1031 exchanges. The average settlement was $47,936. Generally, the transactions were not reviewed correctly. Liability reductions were overlooked when computing the gain to be recognized. CPAs also forgot that the 180-day replacement period ends when the tax return is filed. For example, CPAs must put their clients on extension if the return due date for the exchange year is prior to the exchange or the expiration of the 180-day replacement period.
With so few options available to reduce or defer taxes, like-kind exchanges may continue to be an area of high malpractice potential.
10 ALTERNATIVE MINIMUM TAX
Claims related to the alternative minimum tax (AMT) have increased over the last two decades, and the average settlement was a whopping $25,921.
CPAs commonly failed to consider AMT in tax planning, often not selecting the correct year for paying state estimated tax payments, or failed to consider the differences in AMT vs. useful lives and depreciation methods.
AMT issues are expected to continue to be cause for malpractice claims because of recent changes under the 1997 act. For example, large capital gains will cause a phaseout of the AMT exemption amount, forcing many taxpayers to pay the AMT or an effective tax rate in excess of the expected 20%. Also, the IRS and members of Congress have publicly announced that more taxpayers will be subject to the AMT in the future. Take note.
OUTLOOK: LESS TIME IN COURT
Some of the problem areas CPAs encountered in the 1980s have been virtually eliminated in the 1990s, simply because CPAs have more experience with these engagements. For example, tax shelter claims, once the most common malpractice claim, have virtually disappeared. This is because the IRS has already challenged most of the tax-shelter-related suits and few if any new tax shelters are being created. Improvements by CPAs in other high-risk areas give the profession reason for hope.
Nonetheless, there are quality-control procedures CPAs can institute to avoid a clerical or procedural error that could result in a lawsuit and a large damage award against the firm. CPA firm managers and partners should establish standardized office practices for all employees to guard against suits based on clerical or procedural error. Most important, a CPA should trust his or her instincts and remain selective when accepting new clients: If you don’t feel right about a prospective client at the initial meeting or something said concerns you, don’t do business with them.
WILLIAM DONNELLY, CPA, PhD, is a professor at San Jose State
University, San Jose, California.
SUSANNE OCALLAGHAN, CPA, PhD, is an assistant professor at Pace University, Lubin School of Business, New York City.
JOHN P. WALKER, CPA, PhD, is an associate professor at Queens College, CUNY, New York City.