Avoiding tax malpractice. (TaxPractice Management).

The possibility of being sued for malpractice is a major problem for tax practitioners. However, there are several basic steps practitioners may take to diminish this possibility.

Tax Malpractice

Malpractice occurs when a practitioner fails to adhere to generally accepted professional standards. Depending on the degree involved, it may include ordinary negligence, gross negligence or fraud.

Ordinary negligence. Ordinary negligence is an absence of reasonable care, as in neglecting to consider all the facts or to ask the right questions. For example, in Cohen & Stafford v. Shaines, DC NH, 4/25/01, accountants failed to inquire about prior stock transfers and their effect on a client's unified estate and gift tax credit.

In the case, Irene Levy was the majority shareholder of a closely held corporation. After her husband's death in the late 1980s, Mrs. Levy relied on her attorney for estate planning decisions, which included transferring stock in the corporation to her son. These transfers exhausted nearly all of her unified tax credit.

Over the course of many years, Mrs. Levy elected to have her salary and dividends carried as shareholder loans; by 1993, these loans totaled $900,000. Mrs. Levy and her accountants met with her attorney to discuss capitalizing these loans to the corporation as an estate planning device. At no time during the meeting did her accountants inquire about the status of Mrs. Levy's unified tax credit, and at no time did her attorney mention it.

When Mrs. Levy found she owed $135,000 in taxes and interest, she sued her accountants (but not her attorney) for malpractice, for failing to ascertain the status of the unified credit and not informing her of the tax implications.

The accountants settled with Mrs. Levy and sued the attorney for failing to inform them of the status of the unified credit, implying that the attorney must have known that Mrs. Levy had filed previous gift tax returns reporting the stock transfers. The court denied the attorney's motion to dismiss the suit.

Gross negligence. Gross negligence is the absence of even slight care. Streber, 138 F3d 216 (5th Cir. 1998), rev'g TC Memo 1995-601, is an example of gross negligence, which occurred when an attorney did tax research in preparation for litigation six years after he gave tax advice.

Terry and Tracy Parker were the beneficiaries of a trust agreement created by their father. In 1985, each received $1.7 million dollars and $225,000 in real estate. Their immediate reaction was to get advice on their tax obligations. Their stepfather referred them to an attorney who was a tax specialist. The attorney advised them to:

1. Pay no taxes and hope the IRS did not find out about the transaction within the statute of limitations;

2. Treat the transaction as a 1981 gift and pay capital gain taxes on the income received in 1985; or

3. Treat the transaction as a 1985 gift, in which case their father would be liable for the gift tax and they would be liable for nothing.

They were also advised that, if they chose the second option and paid the capital gain taxes, the Service might suspect they had arranged with their father to pay the lower capital gain tax (as opposed to the higher gift tax).They were never advised that they could pay the capital gain tax and sue for a refund, which would have established who owed the taxes and would have stopped interest accrue.

In 1991, the IRS issued deficiency notices to Terry and Tracy. Although the sisters lost in the Tax Court, on appeal they were able to get the penalties waived; the Fifth Circuit ruled that they were not negligent in relying on the attorney's advice. In 1997, they began malpractice litigation against the attorney, for which they were awarded damages.

Fraud. Malpractice via fraud is knowingly and willingly making false statements with the intent to deceive. The simplest examples of this type of malpractice are tax professionals who provide their clients with tax evasion strategies (e.g., converting hobbies into businesses to generate substantial deductions in the absence of meaningful income, and creating off-shore trusts to hide assets, income or both).

Avoiding Malpractice

Today, accountants are all too familiar with lawsuits stemming from tax practice, which accounts for approximately half of all malpractice claims against public accounting firms.

Accordingly, they must exercise extreme caution. Even if clients are happy with a CPA's services, when faced with additional taxes and penalties, they often bring suit. Today's tax professionals must consider therefore that each tax engagement may result in litigation. What can tax professionals do to protect both themselves and their practice from unwarranted charges of malpractice? While no course of action will provide full protection, certain procedures should reduce the likelihood of a successful claim being asserted.

Screening. The first control step is screening clients adequately. Some questions to be considered in the screening process are:

* Why is the client coming to the firm for tax work?

* Does the client's appearance and demeanor make the tax professional uncomfortable?

* Why did this client leave his prior tax accountant?

* Has the client been involved in (or is he currently involved in) a lawsuit with a prior accountant over tax services?

* Is the client placing any restrictions on communications with the prior tax accountant?

* Are prior-year's tax filings available?

While these questions may appear to be basic, accountants often overlook them during tax season, when they find themselves overworked and rushed. This may result in minimal client screening and the acceptance of clients who would have been rejected under normal circumstances.

Agreement letter. Having clients sign an engagement letter is another way to protect against litigation. The engagement letter serves as a contract and provides protection to all parties. It should clearly state the (1) services the practitioner will provide, (2) jurisdiction under which he will provide the services and (3) client's responsibilities. Without doubt, the single most important statement in the letter should indicate that the information and data contained in the tax return are the client's responsibility. In addition, the language should define in detail not only the services but also the jurisdictions involved. In today's business environment, many taxpayers must file tax returns not only in more than one state, but also possibly in more than one country.

To further protect against malpracrice, a practitioner should also consider including either a specific date or the completion of a service as signifying the termination of the relationship with the client. This can be pivotal in limiting the damages awarded by a court.

The engagement letter should explain the relationship between the timeliness of the client's delivery of tax information and documents to the accountant and the ability of the accountant to complete the returns based on the delivery date.

Documentation. The practitioner should document all oral and written communications with the client. Written communications can include both "snail" mail and e-mail. E-mail is convenient for the fast exchange of information and is easy for both the sender and recipient to save (either in an Internet mailbox or by downloading the exchanges onto a disk for storage).When an accountant presents a client with advice regarding two or more alternative ways of treating a situation, he should prepare a memorandum indicating which alternative the client selected and why. This is very important; if a dispute ensues, the accountant will have documents to support the client's decision.

Today, many tax practitioners at accounting firms require their clients to fill out and sign an interview form. The contents of the interview form include basic information, such as the client's Social Security number, address, phone numbers and deductions. In addition, the form should request information on all tax information required, including W-2s, self-employment, trusts, itemized deductions, investments, interest, dividends, farm income, IRAs, Social Security income and many other items. The form should ask whether the taxpayer has an interest in a foreign bank account or trust required to be reported on Schedule B and also include a request that the client disclose any other information not included elsewhere on the form that would be pertinent. Finally, the practitioner should ask clients to sign the form, indicating that by signing the form the client is confirming that the information contained therein is complete, truthful and accurate to the best of his knowledge.

Adherence to professional standards. The tax practitioner should comply with the AICPA's Statements on Standards for Tax Services (SSTS) and its Code of Conduct. These documents include two very important guidelines that can minimize the potential for a malpractice charge. First, a tax practitioner is not an expert in all areas of tax law and cannot answer all questions that may arise. Therefore, it is important for the practitioner to seek out the advice of a consultant when confronted with a situation for which he does not have adequate knowledge. Second, the personnel in the firm providing the tax services must be both adequately trained and sufficiently monitored. The tax practitioner is not only responsible for his own work, but also for the work of staff he supervises.

Finally, the practitioner should ensure compliance with the requirements of IRS Circular 230. Every practitioner who prepares tax returns or provides tax advice should be familiar with Circular 230.

Editor's note: Mr. Holub is a member of the AICPA Tax Division's Tax Practice Responsibilities Committee. He was formerly a member of the Member Tax Practice Improvement Committee and Chair of the Tax Practice Management Committee. Professor Adams is a member of the Member Tax Practice Improvement Committee.

If you would like additional information about this article, contact Mr. Holub at [phone] or [e-mail], Mr. Adams at [phone] or rdadams@ ubalt.edu, Dr. Pavelka at [phone] or [e-mail], or Dr. Fritsche at [phone] or [e-mail].

FROM RICHARD D. ADAMS, CPA, ASSISTANT PROFESSOR OF ACCOUNTING, ROBERT G. MERRICK SCHOOL OF BUSINESS, UNIVERSITY OF BALTIMORE, BALTIMORE, MD, DEBORAH D. PAVELKA, PH.D., CPA, PROFESSOR OF ACCOUNTING, DIRECTOR OF THE SCHOOL OF ACCOUNTING, ROOSEVELT UNIVERSITY, CHICAGO, IL, AND STEVEN R. FRITSCHE, PH.D., CPA, ASSISTANT PROFESSOR OF ACCOUNTING, ROBERT G. MERRICK SCHOOL OF BUSINESS, UNIVERSITY OF BALTIMORE, BALTIMORE, MD