Failure to advise clients (or providing improper advice) is the most frequent cause of claims in the AICPA Professional Liability Insurance Program. Often, these disputes are a result of scope-of-service disagreements between firms and their clients. Engagement letters are the first and most critical line of defense against scope-of-service claims, helping to prevent claims by establishing clear responsibilities and managing client expectations as well as defending against claims by defining the scope of services and establishing limitations on the services to be provided to a client. Using engagement letters is also associated with reducing the severity, i.e., the dollar amount, of claims (see "Professional Liability Spotlight: Setting Expectations," JofA, Oct. 2017; see also "Professional Liability Spotlight: Overcoming Obstacles to Engagement Letter Use"). Unfortunately, small firms and sole practitioners are the least likely to regularly use engagement letters.
While firms may be reluctant to send multiple-page engagement letters to clients (the sample AICPA letter for individual clients is eight pages, with an additional eight-page addendum of terms and documents) and may have difficulty getting clients to sign and return the letters, best practice standards in Section 10.33 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), require "[c]ommunicating clearly with the client regarding the terms of the engagement."
Limiting scope of services
Engagement letters should be used to limit the scope of services by specifying the returns and other services for which the firm is responsible. It is just as important to specify the services for which the firm is not responsible. For example, a firm may want to include language regarding whether bookkeeping services required to prepare a tax return are included in the engagement, or whether the firm will prepare partner or shareholder basis schedules as part of an engagement. Firms should generally exclude from a compliance engagement any tax consulting and tax planning, as well as correspondence with taxing authorities, and use separate letters for those services if a client requests them.
Care should be taken to specify the client taxpayer or taxpayers to which the engagement services are being provided, particularly if an individual taxpayer has an ownership interest in business entities or trusts. Separate letters should be used for business engagements and individual engagements, as well as for adult children of clients, and should specifically include or exclude filing responsibilities for minor children.
Model engagement letters available to AICPA Tax Section members (available at aicpa.org as part of the Annual Tax Compliance Kit) suggest specifically noting not only which federal and state returns will be prepared as part of the engagement, but also the specific tax years involved. Using form numbers and years (e.g., "2018 Form 1040 and applicable schedules") is an effective way to clearly articulate the firm's responsibilities. Responsibility for filing the returns and the subsequent termination of the engagement should also be discussed in the letter. For electronically filed returns, language should typically specify that firm responsibilities end with the electronic filing of the return (and subsequent acknowledgment by the taxing authorities). For paper-filed returns, it is critical to note whether the client or the firm is responsible for mailing the returns.
Firms should avoid using engagement letters that do not require a client's signature but instead specify an automatic acceptance by a client when a client provides tax information to the firm. Instead, engagement letters should be updated and signed by clients annually. This is important in limiting potential liability resulting from clients' allegations of continuous representation by a firm. Annual letters also are beneficial in starting the running of the statute of limitation for claims.
For a detailed discussion of the issues in this area, see "Tax Practice Responsibilities: The Importance of Engagement Letters for Small Firms" in the November 2018 issue of The Tax Adviser.
— Roby B. Sawyers, CPA, Ph.D.
The Tax Adviser is the AICPA's monthly journal of tax planning, trends, and techniques.
Also in the November issue:
- A discussion of Sec. 1202 small business stock after tax reform.
- Part 2 of a look at recent developments in estate planning.
- An analysis of using Excel to model investment tax planning.
AICPA members can subscribe to The Tax Adviser for a discounted price of $85 per year. Tax Section members can subscribe for a discounted price of $30 per year.