A tax practitioner's guide to risk management.

How do you decide whether to take on a now client? Ideally, by identifying whether the reward (fees, referrals) justifies the risk (potential future litigation). This article provides a blueprint of issues to be considered and making and implementing the now client decision, including obtaining client background information, drafting proposal and engagement letters, monitoring client communications and other issues.

The following observations regarding risk management and practice protection have been made over the course of the past decade, while defending tax professionals in hundreds of lawsuits, threatened litigations, disciplinary proceedings, criminal investigations, depositions, subpoena matters and other legal proceedings. This article is not intended to be all-inclusive, but merely serves to highlight some of the areas that the tax practitioner should be sensitive to in conducting actions to be taken when his practice.

The costs of practice protection continue to skyrocket and the number of lawsuits brought against tax accountants remains staggering. Litigation risk should always be in the back of the practitioner's mind during the course of an engagement.

Awareness of the potential threat of litigation and conscious efforts to manage the risk serve as powerful deterrents to lawsuits and enhance the overall quality and ultimate success of a practice.

Litigation exposure can arise at any stage of an engagement. The risk management process begins at the client evaluation stage, when the professional elects to become associated with a particular client and agrees to undertake a specific type of engagement. It continues throughout the course of engagement and, quite often, even after the engagement is concluded.

The Client Evaluation Process

Client evaluations are a critical feature of risk management. By entering into a relationship with a client, the practitioner benefits from the rewards of bringing on a new client or engagement, but also bears the potential risks associated with the new relationship. Appropriate evaluation of the risk-reward equation is a fundamental feature of practice protection.

The first question a practitioner should ask when considering a new client relationship is, "Do I want to become associated with this client?" The natural inclination is to answer this question in the affirmative. However, the answer is not as clear-cut as first appears, and should not be arrived at without first determining whether the new relationship makes sense from a risk-reward standpoint.

Engagement Risk

Every new client relationship involves some engagement risk. The ideal arrangement is one that entails a high degree of reward and a low degree of risk. An engagement that brings with it high risks and low rewards should be avoided. In the long term, such undertakings cause far more problems than they are worth.

There are several key elements of engagement risk, the most important of which is the prospective client's integrity. Clients who are honest and reputable are generally more likely to be open, accessible and cooperative. It is thus usually easier to obtain complete, accurate and truthful information from them because they have nothing to hide. As a result, work is more likely to be completed in a timely and efficient fashion. Targeted deadlines are easier to meet and there tend to be fewer cost overruns. Such clients are more likely to pay their bills timely and work out any potential differences with the professional in an amicable fashion. They are also less likely to engage in vexatious litigation and less likely to find themselves embroiled in controversies with regulators, shareholders, employees and creditors, all of which can consume the professional's time--often without reimbursement.

Honesty and integrity alone, however, do not the perfect client make; a number of other significant risk factors should be considered before undertaking an engagement. It is important to consider the potential negative publicity or harm to professional image that may arise from being associated with a particular client, industry or project. For example, one would want to carefully consider whether it would be in the firm's best interests to perform work for a corporation that is accused of widespread employment discrimination. Would it be in line with the firm's goals to provide assistance to an individual who is under indictment for tax evasion? Would it make sense to be engaged by a foreign entity that has mysterious origins and a dearth of records? While these questions might not necessarily be answered in the negative, depending on the facts and circumstances, and the firm's goals and philosophies, the key is to analyze any potential negative ramifications before accepting the engagement.

The prospective client's financial condition is yet another factor. If the client is on the verge of bankruptcy or in serious financial trouble, it may affect the practitioner's ability to get paid for work performed. The practitioner may even find himself being dragged into a lawsuit for allegedly causing the failure of the business, even though he had no role in its failure. It is not unusual for this type of lawsuit to be commenced simply because those harmed by the business's failure are looking to recoup their losses from those who have "deep pockets" or insurance coverage.

Other factors that should be considered in evaluating engagement risk are: the client's level of tax and business sophistication; business conflicts or other conflicts of interest that may arise; the level of cooperation anticipated from the client and the ease of obtaining necessary information; issues related to fee realization; and whether the practitioner possesses the adequate resources, skills and experience to service the client competently and efficiently.

Assuming the potential client has passed muster, the practitioner must then ask whether the engagement is worth taking on from a risk-reward standpoint. For example, many accounting firms no longer accept prospective reporting engagements. Experience has taught them that the litigation risks and costs associated with these engagements far outweigh the advantages of taking them.

Red Flags

The following warning signs may warrant declining an engagement or reevaluating an existing client relationship:

* The client has gone through numerous CPAs in recent years.

* The client is experiencing significant financial difficulties or has a history of nonpayment of fees to professionals or other service providers.

* The client has undergone a significant change in management or other personnel.

* The client is faced with significant regulatory difficulties.

* The client has demonstrated propensity to be litigious or is currently involved in litigation.

* The client imposes unreasonable time constraints or other unusual scope limitations on the engagement.

* The practitioner has a negative visceral reaction to the client (i.e., a "gut feeling" that something is wrong).

Conducting the Evaluation

Today's high-technology environment and easy access to the Internet and computer information services make conducting a client evaluation much easier than in the past. Computer databases can be used to obtain pertinent background information regarding prospective clients, including financial reporting information, credit histories, reported legal decisions and news stories. This information should be used in conjunction with primary source information obtainable by speaking with predecessor CPA firms and other third-party references (e.g., bankers, attorneys, financial advisers and former management-level employees). When there is a lack of availability of sufficient information and the size of the engagement warrants it, a private investigation firm may be retained to obtain the necessary background information to facilitate an adequate client evaluation.

Proposal Letters

The proposal letter is very often a very effective marketing tool; it sets forth the firm's qualifications, capabilities and client service philosophies, often very persuasively. It can also be used against the practitioner in a lawsuit, if not carefully constructed. This is in part due to the inherent tension that exists between marketing philosophies and risk management strategies. The goal of the marketing department is to sell services; to accomplish this, the marketer tries to distinguish his firm's quality of service, standards of practice and scope of services from that of the competition. Sometimes, puffery exists; promises are made that are difficult (if not impossible) to keep. This plays into the hands of the plaintiff's lawyer, who seeks to discover evidence to support the plaintiff's position that the accounting firm did not deliver what it promised or otherwise did not satisfy its obligations to the client or meet the appropriate standard of care.

Proposal letters can be used by plaintiffs in litigation to exaggerate the scope of the engagement relationship. While proposal letters generally are not contractually binding, they can serve as persuasive evidence before a jury of the nature and extent of the services that the practitioner and client bargained for and demonstrate the client's appropriate expectation levels. Several rules should be kept in mind when drafting proposal letters. It is important not to oversell the nature and quality of services intended to be provided. Likewise, the practitioner should be careful not to elevate the standard of care that a CPA is ordinarily held to by promising to provide services "at a level higher than all others" or "meeting the highest standards of quality." It is difficult to prevail in a case when held to a standard of perfection, as opposed to that of a reasonable practitioner in the community.

For the same reasons, the practitioner should not unwittingly create a subjective standard of client satisfaction (e.g., "We know that you will be satisfied with the quality of our work or..."). It is impossible to win a case when the client is the sole judge of whether the practitioner lived up to appropriate expectation levels. Similarly, a practitioner should not ensure the quality of his work (e.g.,"we guarantee," "we assure you," "we promise you"). Many firms today refer to their audit practices as providing "assurance services." This sounds very much like "insurance" and may be latched on by plaintiffs' lawyers in the future to support the proposition that these firms were guaranteeing the results of their work. Finally, a practitioner should avoid making statements as to results or resources that cannot realistically be delivered (e.g., "We will provide all services necessary for achieving..."). The practitioner should not promise what cannot be delivered and should not promise results. Very few things are a certainty.

Engagement Letters

The engagement letter is perhaps the single most important document that a CPA can create in a client relationship. An engagement letter establishes the contractual relationship between the CPA and the client; it sets forth the terms and conditions of the engagement and delineates the scope of the practitioner's responsibility and the parties' respective obligations. An effective engagement letter minimizes the risk of misunderstandings regarding fee arrangements, expectation levels, scope of services to be provided and responsibilities of the client, the CPA and, perhaps, third parties.

One of the goals of the plaintiffs lawyer in litigation is to expand the scope of the CPA's engagement as widely as possible, so that it can be argued that the CPA was responsible for whatever damages the plaintiff client allegedly suffered. Conversely, the defense lawyer's goal is to narrow the scope of the engagement. A well-drafted engagement letter can function as a valuable shield against the plaintiff's assault. The absence of an engagement letter can sometimes enable the plaintiff to prevail, even when it arguably should not have, because the contest becomes reduced to who is more credible.

Ideally, an engagement letter should be used for each new client engagement and for each new project or year of work. It is critical that the engagement letter delineate the specific scope of the work to be performed. The letter should identify the objectives of the engagement and the form of any reports or opinions to be issued. The letter should set forth the client's responsibilities, such as the type of assistance and access to information to be provided during the engagement. The engagement's terms should also be specified, including the type of fee arrangement (i.e., hourly, contingent (where appropriate) or fixed), and the specific rates or amounts to be charged. In some cases, it may be appropriate to specify the duration of the engagement or dates by which the work product will be delivered.

It is very important to fix responsibility on other professional advisers (e.g., lawyers, appraisers, actuaries, investment advisers), particularly if they are providing services that may overlap with the practitioner's work or may be confused with it. Many a tax accountant has been subject to liability for the negligent acts of the client's other professional advisers, when the tax accountant was providing, for example, generalized tax services, and the third-party advisers were providing more specialized tax services. If the tax accountant does not have documentary evidence to demonstrate that he was not engaged to provide advice on the more specialized tax project, he may be held comparatively liable for the client's damages, even though in reality he should not be held responsible at all.

The engagement letter should also identify the specific tax services being provided and, in appropriate circumstances, those not being provided (e.g., "We will be reviewing your 1997 Federal and state corporate tax returns. We will not be responsible for any other tax return filings that you may be responsible for (e.g., payroll, property, excise taxes).").

If the scope of the engagement changes, the practitioner should send a confirming letter, decreasing the likelihood of a later dispute. If an engagement is declined or the client has rejected a recommended course of action, the client should be sent a verifying letter. This serves the dual purpose of protecting the practitioner from a later claim that he should have advised the client to take the recommended action, and allows the client to reflect on the recommendation and perhaps change his mind.

If applicable, the engagement letter might address other significant issues, such as restrictions on the CPA's liability (when permitted by professional standards and regulatory authority). It may also contain any understandings regarding ownership of proprietary or intellectual property (e.g., computer software generated as a result of the engagement). Moreover, the engagement letter can include choice-of-law provisions and arbitration or other alternative dispute resolution clauses, if deemed to be in the firm's best interests.

Client Communications During the Engagement

Documentation of client communications is one of the most important elements of practice protection. A detailed trail of documentary advice to the client serves as persuasive evidence of what actually transpired during the course of the engagement, should a dispute arise between the CPA and the client, or the client and the IRS or other third parties.

Correspondence

It is important to document all significant advice provided to the client, to establish an evidentiary paper trail in case the practitioner has to defend his work, to avoid misunderstandings and to ensure that the client comprehends the advice provided. The order of preference in terms of effectiveness is: (1) a letter to the client; (2) a memorandum to the file, copied to the client; (3) a memorandum to the file; and (4) handwritten notes to the file.

It is difficult for clients to dispute that certain advice has been provided if they have been sent a letter detailing such advice or have been copied on a memorandum to the practitioner's files. While other contemporaneous documentation is often valuable evidence of the advice communicated, plaintiffs sometimes argue that they were not told what was memorialized in a memorandum that was not furnished to them. Such a memorandum also does not necessarily establish that there was a meeting of the minds on the subject matter of the document, because the client has not seen it and therefore had no opportunity to respond.

A lack of documentation to support the professional's advice tends to be very disadvantageous from a jury standpoint. juries tend to hold professionals to a higher standard than laypersons when it comes to documenting client communications. While the client's failure to document a conversation with its accountant is rarely fatal to its case, the CPA's failure to do so may very well be. It is very difficult to document all communications with clients, particularly during very busy periods, such as tax season; however, the practitioner should exercise his best judgment as to which advice is sufficiently significant to warrant documentation. For example, it takes little effort (and is good practice) to copy clients on communications sent to third parties, such as the IRS. It is also prudent to advise the client in writing of all significant filing deadlines and to obtain the client's written consent to file extensions, elections and refund claims.

A plaintiffs hindsight is always perfect. If the client has several options to choose among in structuring a transaction, the practitioner should document the reasons why the client ultimately chose one option over the other. Likewise, the client should be advised in writing when return positions have a significant chance of being disallowed or when penalties may apply. Documentation of this sort must be carefully formulated, given the IRS's potential ability to obtain this information during the course of an examination. It is also a very good idea to document a recommended course of action or a tax planning measure that the client has rejected. Providing a client with a copy of a document demonstrating that such advice had been communicated will serve to refresh the client's recollection and discourage baseless lawsuits.

Precautionary Language

Precautionary language should be considered when communicating significant advice to clients. Adding appropriate caveats and qualifications to opinion letters and other correspondence that may influence a client's course of conduct serves to further circumscribe the scope of the engagement.

The client should be advised of the limitations and restrictions that the practitioner is operating under in providing the pertinent advice. The client should also be informed of any assumptions that are being made in transmitting the advice. Moreover, the client should understand that the advice given reflects professional judgment based on a given situation and the stated or assumed facts. Clients should also be instructed that the opinion's validity can be affected if the facts are incomplete, inaccurate or change, if there are subsequent developments or if the law changes. Clients should also be made aware that the practitioner will not update them as to law changes that might affect the validity of the opinion, unless the practitioner is specifically engaged to do so. It is also wise to ask clients to confirm that they have reviewed the facts or assumed facts on which the opinion or advice is based and acknowledge that they believe them to be truthful, complete and accurate. The practitioner's advice might be correct based on the given facts, but if the facts are inaccurate or incomplete, the opinion could be materially affected.

Care must be taken when issuing opinion letters or other letters of advice to ensure that professional guidelines are adhered to. It is particularly important that your advice be directed only to the client and not to third parties (e.g., a client's shareholders, partners or banks). The practitioner should not create privity with unintended parties when it might not otherwise exist; to do so could increase potential exposure dramatically.

Workpapers

Workpapers are generally the property of the CPA, not the client. Laws vary among the states and should be examined to determine which documents in the CPA's possession belong to the client and which are the CPA's property. Workpapers are a helpful tool of both auditors and tax professionals; however, they are generally discoverable by regulators and the plaintiff in litigation and can often serve as an invaluable guide to plaintiffs in attacking the professional's work. They can also serve as a blueprint to the IRS or others in analyzing the client's tax or financial position. They show, among other things, the procedures that were and were not followed and who performed them; whether anyone reviewed the work; the issues that were raised and explored; the review comments made; and when work was performed (e.g., on an annual or periodic basis).

Thus, care must be exercised while preparing workpapers to avoid gratuitous remarks and superfluous comments. Likewise, extraneous and irrelevant information or materials should not be attached to workpapers. The workpapers do not serve as the practitioner's diary or as a means of social communication with colleagues. If the practitioner's work is ever challenged, comments made in jest in workpapers (e.g., "I smell a rat") might come back to haunt him.

Firm policies and procedures should be followed in preparing, signing off on, reviewing and retaining workpapers. These policies exist for good reason; moreover, failure to follow even self-imposed policies and procedures can be used against the practitioner's firm during the course of a legal proceeding. Even seemingly innocuous policies (e.g., initialing workpapers) should be dutifully adhered to. Plaintiffs' attorneys point to such failures as evidence of general carelessness and sloppiness in appealing to juries to sustain negligence claims; there is no reason to provide them free ammunition.

It is prudent to consult with an attorney whenever there is a request for workpapers, particularly when they are subpoenaed. Generally, workpapers should not be provided to clients without careful consideration. There are ethical and legal restrictions against voluntarily providing workpapers to third parties without the client's written consent. Even in the case of a civil subpoena, there may be restrictions against producing such documents. For example, Sec. 7216(a) makes it a criminal misdemeanor (with certain exceptions) to provide returns or return information to third parties without the client's written consent or a court order. Appropriate protections (e.g., an indemnification agreement) should be obtained when third-party access to workpapers is requested.

Finally, workpapers should not be altered or discarded after they are subpoenaed or summonsed. There can be serious civil (and potential criminal) consequences for such unwise behavior.

Tax Elections

Tax elections are a high-risk, low-reward area for tax practitioners. There are hundreds of potential elections that can be made under the Code. A missed election can expose the CPA to enormous potential liabilities; thus, care must thus be taken in preparing or reviewing returns or transactions when an election may apply.

It is a good idea to obtain or refer to an election checklist to assist in determining the existence of potential elections. The practitioner should be conscious of potential elections when clients enter into significant transactions and should check the appropriate Code provisions and regulations to determine if any elections apply. The return instruction forms should also be scrutinized to see if they refer to an election. A specialist within or outside of the practitioner's firm should be consulted if there are doubts about an election applying; the client's written consent should be obtained before making or forgoing an election.

If the practitioner discovers he has missed an election, he should immediately consult with an attorney or tax controversy expert. There may be opportunities to obtain remedial relief under Regs. Sec. 301.9100-1 in the case of certain missed elections or other ways to mitigate the problem, such as by showing substantial compliance with the Code or regulations.

State Tax Issues

State tax malpractice claims can be as disruptive and expensive to practitioners as Federal tax malpractice claims. State tax issues should be considered when providing tax advice to clients. Most often, the state tax consequences of a transaction are not as significant as the Federal tax consequences, but they should not be overlooked.

In particular, the practitioner should be aware of state versus Federal tax differences. For example, in some states, the net operating carryforward periods and provisions are different from the Federal rules. The practitioner should determine what other Federal/state tax differences may exist in a particular jurisdiction, to avoid unintended consequences in transactional planning or compliance reporting, and should also be aware of multistate tax rules that may affect clients. Occasionally, practitioners fail to advise clients who conduct business in multiple states to file returns in all of the appropriate jurisdictions; this can later result in big problems for the client. The statute of limitations (SOL) for assessment or collection of tax does not generally start to run until a return is filed. However, SOLs for refund claims start to run regardless of whether a return is filed. The failure to file a state tax return in such situations could result in the client owing taxes in the jurisdiction in which it failed to file, but being potentially precluded from obtaining a refund or credit in the jurisdiction in which it would otherwise be allowed, if timely filed. The practitioner could be held responsible for the double payment of tax if he knew that the taxpayer conducted business in such other jurisdictions. A practitioner who is uncomfortable or unfamiliar with the tax laws of a particular jurisdiction should consult an expert.

State ethical rules may differ from those set forth, for example, in Circular 230(1) or the AICPA Statements on Responsibilities in Tax Practice.(2) The practitioner should recognize that there may be different rules and regulations on issues such as contingent fees.

Billings and Collections

The practitioner should carefully review bills for accuracy before sending them to a client. It is patently improper to overbill clients for services performed. Similarly, the practitioner should not embellish work descriptions on a bill that have no documentation or support in reality. While this may allow the client to Justify paying a large bill, it could be used against the practitioner in litigation to demonstrate that he was engaged to provide services that he was not actually engaged to provide.

The practitioner should also keep abreast of client billings and collect delinquent bills before renewing client engagements; this will prevent having to threaten collection action against a client. In some instances, a practitioner may be able to withhold workproduct from a client if the bill has not been paid. Clearly, it is unwise to bring a collection action without carefully taking into account the likelihood of being countersued, regardless of whether the counterclaim would be meritorious. The practitioner should consult with an attorney experienced in malpractice matters to determine the type of action warranted, if any.

Other Considerations

* There is no substitute for good judgment and common sense. Following the rules or going through a checklist will not protect a practitioner who failed to exercise good judgment.

* Ensure that junior staff professionals are adequately trained and supervised.

* Rotation of professionals off of an engagement should result in a critical examination of positions taken on prior returns. Just because other competent professionals have taken a tax position for a number of years does not mean that such positions are correct. If a position appears troublesome, explore it further.

* Keep the lines of communication open between the firm's tax and audit professionals; copy each other on significant correspondence and reports. Information that the auditors are aware of, for example, may be imputed to the tax professionals and disadvantage them in a lawsuit.

* Pay close attention to filing deadlines for returns, refund claims, elections, etc. Use a "tickler" system to avoid inadvertently missing such deadlines.

* Send all filings or payments to the IRS and other taxing authorities by certified mail, return receipt requested, or by other accepted tracking methods. The Service recently announced(3) that taxpayers can use Airborne Express, DHL Worldwide Express, Federal Express and United Parcel Service to timely file returns and payments.

Consulting With Counsel

Early, proactive consultation with counsel may save tremendous time, expense and aggravation later. It is prudent to consult with counsel experienced in accountants' liability and tax litigation matters in the following situations, among others:

* When the practitioner has been sued.

* When the practitioner is threatened with a lawsuit or disciplinary proceeding (including return preparer penalties).

* When the practitioner has received a subpoena or summons.

* When the practitioner is asked to provide client-related workpapers, affidavits or testimony.

* When the practitioner is evaluating whether to take legal action against a client.

* When criminal issues surface regarding a client.

* When attorney-client privilege issues arise.

* When a client's counsel seeks a consultation about an issue or problem in which the practitioner has been involved.

* When the situation warrants it.

Example: Potential client A wants to retain M, a CPA, to prepare complicated trust tax returns for a nominal fee. M has never provided services to A before and is not certain that the engagement will lead to significant additional work, A's law firm prepared the estate plan and drafted the trust documents for a significant fee. M has limited experience with the tax issues involved. M does not know that certain elections may apply that could save A's beneficiaries significant taxes later on. The failure to make such elections may expose M to significant liabilities far in excess of any fees that may be generated.

First alternative: A may be a worthwhile client, but the engagement itself is high-risk, low-reward. M decides to decline the engagement; A is not a long-term client and there is no guarantee that the engagement will lead to significant additional work. The potential reward does not justify undertaking the risk; moreover, it appears that M will not be able to service the client efficiently and effectively.

Second alternative: M would like to take on the engagement, because A may become a valuable client; he is well connected in the community and it may lead to other significant referrals. M elects to assume the engagement risk; thus, he should accept A with the following provisos:

1. A fee will be negotiated that is commensurate with the complexity of the issues involved and the concomitant risks entailed (i.e., improved fee realization).

2. M should advise A that M may need to consult with a partner or colleague who has more expertise in the area (i.e., using firm resources to limit risk and serve A competently).

3. A's law firm should be asked to review the tax returns (with A's approval) to ensure that they are in compliance with A's estate planning goals (i.e., fixing responsibility on others or, in this case, shared responsibility).

4. Specify in the engagement letter that M is responsible only for preparing the applicable tax returns. State that A's law firm will be reviewing the returns in question. Consider inclusion of arbitration and limitation-of-liability clauses, if appropriate (i.e., effective engagement letter).

5. As the engagement progresses, document A's intentions regarding whether to make or forgo any applicable elections (i.e., contemporaneous documentation of significant advice).

6. If M is later threatened with a lawsuit, he should consult with experienced counsel to manage the risk and to assist in mitigating any potential damages.

Conclusion

Careful attention to protective measures and risk management processes and enhanced sensitivity to potentially threatening situations serve as powerful weapons in the practice protection arsenal. Professional competence, quality client service, integrity and good judgment are critical elements of successful risk management. However, they do not suffice to protect the professional in today's litigious environment.

(1) Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Actuaries and Appraisers Before the Internal Revenue Service.

(2) AICPA Federal Taxation Executive Committee, Statements on Responsibilities in Tax Practice (1991 rev.).

Editor's note: Mr. Hill heads Brown & Wood's Tax Litigation and IRS Controversy Practice and was formerly Assistant General Counsel of KPMG Peat Marwick LLP.

RELATED ARTICLE: EXECUTIVE SUMMARY

* Some factors that should be considered in evaluating engagement risk are: the client's level of tax and business sophistication; business conflicts or other conflicts of interest that may arise; the level of cooperation anticipated from the client and the ease of obtaining necessary information; issues related to fee realization; and whether the practitioner possesses the adequate resources, skills and experience to service the client competently and efficiently.

* Computer databases can be used to obtain pertinent background information on prospective clients, including financial reporting information, credit histories, reported legal decisions and news stories.

* While proposal letters generally are not contractually binding, they can be serve as persuasive evidence before a jury of the nature and extent of the services that the practitioner and client have bargained for.