Errors and omissions in preparing tax returns can occur easily. You might accidentally enter a number incorrectly, misinterpret a law, or misconstrue the client’s facts. Later, before an IRS audit, you might discover the mistake, raising gut-wrenching questions: Do you call the mistake to your client’s attention? Do you advise the client to file an amended tax return? If so, by acknowledging the mistake, have you essentially conceded that you have committed malpractice? What, if anything, can you do to limit your professional liability?
No matter when or how you become aware of a mistake, what makes it all the more exasperating is that the outcome is not within your direct control. For example, when a prior-year understatement of tax liability is discovered, notwithstanding your counsel, the client, being primarily responsible for the understatement, ultimately dictates whether to submit an amended return. A client’s recalcitrance to do so may exacerbate the mistake, resulting in the client’s incurring perhaps even more interest and a larger penalty. Sometimes you might even “inherit” a mistake if an error made by another preparer on a prior return has a continuing effect going forward, including on a return you are preparing.
Unfortunately, many of the foregoing error and omission discoveries are all too commonplace. In fact, in the case of one accounting malpractice insurance carrier (that is, CAMICO), tax-related claims were the most frequently encountered (“Major Risk Management Issues and Resources,” IMPACT, Fall 2008).
This article examines CPAs’ and other preparers’ ethical duties with respect to errors and omissions. It also explores return preparers’ potential malpractice damages exposure and possible legal defenses.
MISTAKES AND THE CPA’S ETHICAL OBLIGATIONS
While taxpayers have a legal duty within any applicable statute of limitations to pay the correct tax, neither the IRC nor the Treasury Regulations require them to unilaterally correct tax return submission errors or omissions. Instead, the regulations state that upon discovering an error or omission involving an understatement of income or an overstatement of deductions, a taxpayer “should” file an amended tax return and pay any tax due (Treas. Reg. §§ 1.451-1(a) and 1.461-1(a)(3)). In Badaracco Sr. v. Commissioner, 464 U.S. 386 (1984), the U.S. Supreme Court said that a taxpayer is under no legal obligation or duty to file an amended return even after an error or omission is discovered.
Ethical standards applicable to practitioners, moreover, make clear that ultimately the taxpayer, not the practitioner, must decide whether and how to correct an error. Section 10.21 of Treasury Circular 230, which dictates practice before the IRS for CPAs, attorneys, enrolled agents, enrolled retirement agents, and appraisers, instructs tax practitioners who know of an error or omission on a client’s tax return to promptly notify the client and advise the client of the consequences of such an error or omission under the Code and regulations.
In addition, the AICPA Statements on Standards for Tax Services (SSTSs, as revised effective Jan. 1, 2010), dictate the professional standards of AICPA members with respect to all tax engagements, not just federal tax. Most state boards of accountancy refer to them and to Circular 230 in setting forth their own requirements for CPAs. The SSTSs set forth a similar directive to that of Circular 230: “It is the taxpayer’s responsibility to decide whether to correct the error” (SSTS no. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, paragraph 8).
If the client chooses to file an amended return, a member may continue representation. If, however, the client declines to file an amended return, the member must confront several issues. First, except “when required by law” (that is, the client is poised to commit a future crime or fraud), the member may not disclose an error or omission to the IRS without the client’s permission (SSTS no. 6, paragraph 4). Second, while there is no blanket requirement that the member withdraw from representation, withdrawal may be appropriate if, in the member’s judgment: (1) a client’s failure or refusal to file an amended return or otherwise correct an error “may predict future behavior that might require termination of the relationship” (SSTS no. 6, paragraph 8), or (2) future tax return preparation by the member will perpetuate the original error or omission (see SSTS no. 6, paragraph 12—for example, the original tax return reflects an inaccurate tax basis associated with business equipment that the client intends to depreciate going forward). If the member decides to continue the relationship with the client, the member should take appropriate measures to make sure not to repeat the error in subsequent returns (paragraph 5). For purposes of SSTS no. 6, an error does not include a mistake or omission that does not significantly affect the taxpayer’s tax liability, which the member, in his or her professional judgment, may determine (paragraphs 1 and 13).
During an audit by a taxing authority, a client’s failure to file an amended return to correct an error or omission can cast a dark shadow. More specifically, section 10.51(a)(4) of Circular 230 provides for sanctions against practitioners who provide false and misleading information to the IRS, which could put the tax preparer in an untenable situation. On the one hand, the tax preparer has an obligation to be forthright to the investigating agent; on the other hand, he or she also has an obligation to maintain the confidentiality of client communications within the limits of the practitioner-client privilege of IRC § 7525. Under these circumstances, SSTS no. 6 requires that, unless the accountant can convince the client to disclose the error or omission, the member “should consider whether to withdraw” (paragraph 6).
If the tax preparer recognizes a mistake he or she has made and calls it to the client’s attention, persuading the client to submit an amended return could help ameliorate the problem. To encourage the client to submit an amended return, a practitioner should prepare the amended return, send it to the client, and strongly suggest the client file it. In some cases, however, the mistake may involve a method of accounting, and the taxpayer must request permission from the IRS National Office to make a change. Often, issues involving methods of accounting are those pertaining to timing—for example, whether an expenditure should be expensed or capitalized—rather than issues of includability, excludability or deductibility.
DETERMINING PROFESSIONAL LIABILITY
Tort principles instruct that professionals have a duty to exercise a level of care, skill and diligence commonly associated with that of other members of their profession under similar circumstances. Contract principles require practitioners to competently perform the task undertaken. Notwithstanding the differences between these two principles of malpractice law, courts have generally applied them interchangeably.
For a plaintiff to prevail in a malpractice action against a tax preparer, the plaintiff must prove: (1) the tax preparer owed a duty to the taxpayer, (2) there was a breach of that duty, (3) the plaintiff suffered injuries, and (4) there was a proximate cause between the injury suffered and the duty.
In cases of tax return preparation, illustrating these four elements and their interconnectedness is usually straightforward. The first element is typically memorialized in an engagement letter that delineates the scope of the accountant’s duties and responsibilities to the taxpayer; alternatively, the tax preparer verbally agrees to prepare the taxpayer’s tax return and undertakes this task. The second element arises when the tax preparer makes a significant error or omits salient information that results in the preparation and submission of a flawed tax return. The third element, explored in further detail later, includes the direct and consequential damages that stem from a tax preparer’s failure to fulfill his or her duties and responsibilities. The fourth element draws a causal connection between the second and third elements (which is commonly easier in tax return preparation than in other tort-related injuries, such as medical malpractice).
But not all tax practitioner mistakes necessarily constitute malpractice. Practitioners may be exonerated if their advice is incorrect as a result of a mere error in judgment concerning a doubtful or unsettled area of the law. Put differently, the law does not require tax practitioners to guarantee particular outcomes. A case that helps illustrate the application of this rule is Smith v. St. Paul Fire & Marine Insurance Co., 366 F. Supp. 1283 (M.D. La. 1973), aff’d, 500 F.2d 1131 (5th Cir. 1974). In Smith, an attorney asserted upon a decedent’s death that a will beneficiary was permitted to use the alternate valuation date in computing the basis of inherited property, a position that was proven incorrect by subsequent case law that was not knowable at the time the original advice was rendered.
Examples of culpable mistakes include those when preparers fail to file returns or file them late (see, for example, Jerry Clark Equipment, Inc. v. Hibbits, 612 N.E.2d 858 (Ill. App. Ct. 1993)), are negligent in return preparation (see, for example, Bick v. Peat Marwick & Main, 799 P.2d 94 (Kan. Ct. App. 1990)), or render incorrect tax planning advice (see, for example, Brackett v. H.R. Block & Co., 166 S.E.2d 369 (Ga. Ct. App. 1995)).
Once a mistake has occurred, consider that many malpractice insurance policies require the insured to notify the carrier before the insured’s next renewal date of any potential claim. A failure to fulfill this requirement can constitute a breach of contract, enabling the insurance carrier to decline coverage. Since every tax return mistake could result in a charge of malpractice, each instance might require such notice.
Although courts employ no single, all-encompassing rule to determine damages, as articulated by one court, they might be appropriately measured as the amount the taxpayer owes because of the preparer’s negligence, beyond what he or she would have owed if the tax return or returns had been properly prepared, plus incidental damages (Thomas v. Cleary, 768 P.2d 1090, 1092, note 5 (Alaska 1989)). Within this framework, the scope of recoverable
damages can have several components:
Taxes . In general, the tax that a taxpayer owes does not constitute a recoverable damage component. Thus, if a tax practitioner’s mistake results in an understatement of tax, he or she is generally not liable for the additional tax due, although the practitioner might be held responsible for payment of related interest and penalties (see below).
But in some cases, a tax practitioner can be held liable for taxes overpaid if the taxes can no longer be recovered from the government by filing an amended return.
Interest . Regarding recovery of interest paid on a tax deficiency, three points of view have emerged. One, embraced by the majority of courts, is that such interest may be recoverable to the extent a taxpayer has suffered actual damages from the interest charged.
Some courts, however, have held that such interest is not a recoverable damage component. They have theorized that while interest accrued, the taxpayer had free rein over the unpaid tax dollars and thus suffered no economic harm. Under these circumstances, these courts believe that awarding the taxpayer interest recovery would result in or be tantamount to a taxpayer windfall. See, for example, Alpert v. Shea, 559 N.Y.S.2d 312 (N.Y. App. Div. 1990).
Several courts have adopted an intermediate position of allowing as recoverable damages the amount of the interest owed to the government over the return the taxpayer was able to achieve while the tax dollars remained unpaid. See, for example, Ronson v. Talesnick, 33 F. Supp. 2d 347 (D. N.J. 1999).
Penalties . Mistakes that result in penalty imposition—for example, the section 6662 accuracy-related penalty—are awarded as damages by almost all courts, barring an applicable defense (see below).
Corrective costs . Such costs can include accounting fees to prepare an amended return or legal expenses of challenging a penalty imposition.
Consequential damages . Indirect costs can include lost income and investment opportunities stemming from a tax deficiency that arises from a preparer’s mistake. Due to the speculative nature of such costs, many courts are hesitant to award such damages. For example, see Olson Clough & Straumann, CPAs v. Trayne Props. Inc., 392 N.W.2d 2 (Minn. Ct. App. 1986), regarding a claimed loss of investment opportunities. However, when taxpayers can offer compelling evidence of losses associated with tax return preparation flaws, other courts have awarded damages. For example, in Deloitte, Haskins & Sells v. Green, 403 S.E.2d 818 (Ga. Ct. App. 1991), the amount of the damage award was based on Green’s loss in selling a business where evidence indicated he would not have sold had he received correct tax advice. Punitive or exemplary damages have sometimes also been awarded (see Midwest Supply Inc. v. Waters, 510 P.2d 876 (Nev. 1973), which upheld a punitive damage award of $100,000 related to an H&R Block franchise’s allegedly false and misleading representations).
LIMITING PROFESSIONAL LIABILITY
Tax practitioners may be able to take corrective actions to eliminate or at least mitigate liability exposure. They should strongly encourage the taxpayer to correct the mistake or omission via an amended return. As stated earlier, not only does the practitioner have an ethical obligation to render such advice, but documenting the need to file an amended return may ultimately reduce any damage award. In most cases, taxpayers can avoid accuracy-related penalties under section 6662 by submitting a “qualified amended return” (Treas. Reg. § 1.6664-2(c)(3)). Furthermore, appropriate payment submitted with the amended tax return will curb the accrual of any further interest.
In some cases, a statute of limitations may bar taxpayers from commencing suit. Some state statutes are as short as two years (for example, Florida), whereas others are as long as six years (for example, New Jersey). Each state has its own rules regarding what circumstances commence the statute of limitations (for example, commission of the error) or toll it (for example, until discovery of the mistake is actually made). Some states have even recognized a “continuing representation” doctrine that can toll the statute of limitations indefinitely.
One more factor that may help limit professional exposure is whether the taxpayer contributed to the problem or assumed the risk of liability. Suppose the tax practitioner asked the taxpayer to review the prepared tax return for its accuracy, and the taxpayer either did not do so or did so negligently or recklessly. In such cases, despite the accountant’s mistake or omission, the taxpayer had the last clear opportunity to remedy the problem. Depending on the jurisdiction, such circumstances may absolve the tax practitioner from liability or reduce the amount of liability to that percentage for which each party might be deemed responsible.
Professional liability for CPA tax preparers and other tax practitioners can arise from mistakes or omissions in preparing clients’ tax returns. Courts have recognized limits on this liability, and, in many instances, tax practitioners may claim defenses and bars to legal liability.
An amended return correcting an error may ameliorate the consequences of the error. However, taxpayers are under no legal obligation to file an amended return, so whether to do so is within their discretion. Correcting errors that involve a method of accounting generally requires permission from the IRS to make the change.
Aside from the Tax Code and court jurisprudence, Treasury Circular 230 and AICPA Statements on Standards for Tax Services (SSTS) prescribe professional and ethical considerations and guidelines.
Generally, tax practitioners are expected under tort law to maintain an appropriate level of professional care, skill and diligence. Taxpayers claiming that a tax preparer breached a duty must also prove that the breach was the proximate cause of their injuries.
Not all errors necessarily give rise to actionable complaints, and plaintiffs generally may not recover as damages the correct amount of their tax liability. Related penalties may be included in damages arising from deficiencies. However, courts have split on whether interest on an underpayment may be recovered, with some allowing recovery by taxpayers. Preparers have sometimes been held liable for taxpayers’ incidental costs and even, in egregious instances, for punitive damages.
Practitioners’ professional liability may be limited by any contributory negligence or actions on the part of the taxpayer, or eliminated by the applicable statute of limitations; however, the latter differs significantly among states in length and when it begins or is tolled.
Jay A. Soled (email@example.com) and Leonard Goodman ( firstname.lastname@example.org) are both professors at the Rutgers Business School in Newark and New Brunswick, N.J. The authors thank professor Jacob L. Todres for insightful comments and suggestions.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at email@example.com or 919-402-4434.
The 2010 Cumulative Tax Guide
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AICPA Tax Center
Statements on Standards for Tax Services
The Tax Adviser and Tax Section
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