The hows - and whys - of tax practice review.

Improving services and limiting liability are two reasons to focus on tax practice quality.

Reliable and accurate service is the hallmark of CPAs and the accounting profession, and consistent delivery of quality services is crucial to practitioners' survival. The American Institute of CPAs peer and quality review programs are one example of the profession's efforts to ensure the excellence of its work in the areas of accounting and auditing services.

Our 15-person firm in Vermont, like many other firms, also does a great deal of tax work. Tax services not only are important to our profitability but also are the cause of most malpractice suits against CPAs. We decided as a result that it was vital to institute our own internal tax practice monitoring system.

We fashioned our program after the AICPA's voluntary tax practice review (VTPR) program (see the sidebar on page 53). The AICPA program is not mandatory and there are no plans to require review for tax practitioners. However, we found internal review helped improve our own practice and that tax review became a new service to offer other CPAs.

SPECIFIC QUALITY CONTROLS FOR TAX WORK

Under VTPR, the nine elements of tax practice quality control are similar to those for auditing and accounting, except advocacy and integrity replace independence:

* Advocacy and integrity.

* Personnel assignment.

* Consultation.

* Supervision.

* Hiring.

* Professional development.

* Advancement.

* Acceptance and continuance of clients.

* Inspection.

The Guidelines for Voluntary Tax Practice Review (VTPR manual) contains sample tax quality control documents for use by CPA firms.

While general quality policies are important, it takes specific controls to ensure practice excellence. Our firm's adoption of' tax quality control policies began in 1989, when we decided to add a sentence to our auditing and accounting quality control document saying these policies apply to tax, management consulting services, personal financial planning--to everything we do. Finally, in 1992, we adopted specific tax quality controls.

After our first internal tax inspection just before the 1992 tax season, we knew we had to include specific tax control policies in our quality control document. We decided to apply them where the risks were highest, such as returns involving like-kind exchanges or corporate liquidations. High-income returns also were a concern, since an error can create substantial tax underpayments, accuracy-related penalties and possible litigation, ill will and lost clients.

The principal control we instituted was a second review right after the first. The second review took from 15 to 45 minutes, and it really works. We were rewarded immediately when the second reviewer changed selected tax strategy, detected incorrect data and challenged initial assumptions. The result was tax reductions of $5,000 to $10,000 in several tax returns. How could this happen? As Money magazine reminds us each year, different tax practitioners address the same set of tax circumstances in very different ways. The last time the magazine asked 50 practitioners to prepare one return, it received 48 different answers. With this much diversity, clearly our staff will have many different interpretations. The second reviewer narrows this range.

Likewise, we know alternative minimum tax, passive losses and gains and losses create complex tax situations best suited to handling by the most skilled practitioners. Specific quality controls focus our attention on high-risk areas of tax practice (see exhibit 1 on page 54).

Once controls are in place and used for a tax season, it's time to monitor them, in one of two ways.

PERFORM AN INTERNAL INSPECTI0N

The voluntary tax practice review manual has all the forms needed to perform an internal tax inspection or self-assessment to evaluate the effectiveness of a firm's tax quality control system.

Our firm selected as our internal tax inspector a CPA being groomed for partnership. Here are the steps she took.

* Obtained a complete list of tax clients segregated by entity type from our time and billing records.

* Chose random samples based on difficulty of tax return, trying to include all staff in the sample.

* Selected experienced staff not involved with the original return to review tax return files based on their specialty areas, if appropriate.

* Compiled all review comments and findings.

* Finished the inspection and wrote a report citing achievements and recommending improvements.

Here are the most important results of our internal inspection report:

Findings

* More tax quality controls needed.

* Inadequate supervision cited in some cases

* Not all quality controls followed.

Recommendations Rewrite quality control document to stress tax controls.

Develop second review criteria and use a tax checklist.

Establish a routing sheet to ensure all aspects of quality control policy are followed.

Our internal inspection covered a sample of 43 engagements. We spread the reviews among our entire staff, gave them the AICPA voluntary tax practice review checklists and asked for them to be completed within two weeks. This taught the staff what the inspections were seeking and generated ideas for improvement in each review. Major changes to our tax controls were

1. Creating a routing sheet to ensure all quality control steps are taken (see exhibit 2 on page 54).

2. Requiring a checklist for all tax returns (one-page short version).

3. Assigning one staff member as tax coordinator.

4. Conducting a second review by a highly skilled tax practitioner, selected by our tax coordinator.

5. Designating specific tax specialists as consultants in key tax areas.

HIRE AN OUTSIDE REVIEWER

It's possible to hire another CPA to review a tax practice just before or after the auditing and accounting practice quality review. Because we feel confident about what we've learned in our own internal tax inspections, we now offer to perform tax reviews for other CPAs. We propose a tax review on all quality reviews we perform. Since it's an extension of the quality review, it should be very cost-effective. We usually charge $1,000 and spend about one extra day doing the on*site tax review.

We use the new voluntary tax practice review manual and its workpapers as the principal resource and practice aid. When I perform reviews, I ask how the firm does its tax returns and what checklists it uses and examine the tax returns for the largest taxpayers and the firm's written tax policies and procedures. Finally, I choose six to eight tax engagements to review. It's interesting to see a firm's tax policies and procedures at work and, since our firm has developed specific tax controls, it's also easy to see when tax quality controls are not applied.

Common recommendations might include

1. The firm should establish specific tax quality controls focusing on high-risk returns.

2. The firm should better document its tax advice. In one case, for example, tax planning letters were rarely found in client files.

3. The firm should use its computers and tax software to the maximum. Firms seldom use the computer to type transmittal letters, do billings and perform other tasks using the database it builds as it processes tax returns.

4. The firm should use a prospect sheet to search for further services to offer each tax client, such as personal financial planning, risk management, estate planning, incorporation and better recordkeeping. We prepare an additional-services evaluation form for each substantial taxpayer. We discuss, and often get, additional work from this form because we follow up later in the year.

5. The firm should develop a tax specialist who concentrates his or her energies on the tax practice all year long.

THE REWARDS

Maintaining quality is a challenge, but we found many benefits, including more accurate tax products, better and more precise tax advice, higher self-esteem, lower risk, higher employee morale, greater fee realization and more fun. Here are some of the reasons we advocate an internal review:

* Meet professional standards. The AICPA statement on responsibilities on tax practice and the Code of Professional Conduct set forth many quality goals for tax practitioners. Often, staff aren't always aware of these standards and don't design their actions to meet them. A quality control system keeps goals in focus.

* Organize the tax practice. Creating or using forms and checklists to document our tax procedures and implement our quality controls helps organize our tax practice. We know how to tackle each step and what's expected of our staff. We recommend the AICPA Tax Practice Management, which has practical suggestions on every phase of tax practice. In addition, the Institute's Tax Practice Guides and Checklists contains great checklists, permanent file tax indexes, tax letters, organizers, etc.

* Prevent preparer penalties. Quality work obviously helps prevent not only the $250 and $1,000 tax preparer penalties but also the 20% accuracy-related tax penalties. A tax practice quality control system that incorporates consultation and supervision policies creates the control environment needed to produce high-quality, accurate tax returns.

* Prevent tax lawsuits. According to Rollins Burdick, the Institute's professional insurance underwriter, malpractice suits involving tax services arise more fre* quently than any other type, even though the settlement amounts are lower. Better controls reduce the chance of such suits and help defend against ones that do occur.

* Enhance firm image and reputation. Confidence undoubtedly increases when the practice is based on quality work, expert advice and well-documented review. CPAs know they are relying on a team of experts working together to give clients accurate and complete tax advice and returns.

THE CHOICE

In our firm, we believed that before we could brag about the high quality of our tax practices, we had to face the challenges and reap the rewards of an internal tax practice review. Any review usually offers firms some of the first feedback they've ever had on their services. Since tax services are so important to so many firms, an efficient quality control system for tax is well worth implementing.

* BECAUSE TAX SERVICES are not only important to CPA firm profitability but also the cause of most malpractice suits against CPA firms, one small firm decided to institute an internal tax practice monitoring system fashioned after the AICPA's voluntary tax practice review program.

* THE REVIEW PROGRAM is not mandatory and there are no plans to require review for tax practitioners. However, firms may find internal reviews help improve their practices and can become a new service to offer other CPAs.

* THE FIRM ESTABLISHED tax practice controls and then performed an internal inspection to see how they were working. Because of the findings, the firm created a tax return routing sheet, required a tax return checklist and a second review and designated a tax coordinator and tax specialists.

* COMMON RECOMMENDATIONS in tax practice reviews include better documentation of tax advice, improved use of computers and tax packages and use of prospect sheets to identify further services for tax clients.

* FIRM MANAGERS FOUND tax practice reviews help practitioners meet professional standards, organize the tax practices, prevent preparer penalties and tax lawsuits and enhance firm image and reputation.

HOW THE VOLUNTARY TAX PRACTICE REVIEW PROGRAM WORKS

The American Institute of CPAs voluntary tax practice review (VTPR) program was designed and created to help practitioners structure and improve quality controls in their tax practices. There are no plans to make the program mandatory.

CPAs who want to be involved in the program might take the following steps: Set up a tax practice quality control system and perform an internal review after the system has been in place about a year. Practitioners then would implement any recommended improvements and might hire an outside CPA for a firm-on-firm review after another year to determine whether they succeeded.

The VTPR program was introduced with the 1990 publication of the AICPA tax division's Guidelines for Voluntary Tax Practice Review, intended to help practitioners design and test tax practice quality control systems. It was created by and for local practitioners.

The guidelines contain sample tax practice quality control documents as well as all the necessary instructions, questionnaires and checklists to perform internal reviews. They also include a sample engagement letter if practitioners opt for a firm-on-firm review.

The guidelines can be obtained from the AICPA order department [(800) TO-AICPA; product no. 024016]. The price is $60.

More information on the VTPR program, and on a continuing professional education course on the subject, is available from James A. Woehlke, AICPA tax division, 1455 Pennsylvania Avenue, NW, Washington, D.C. 20004; [phone].

James A. Woehike, technical manager, American Institute of CPAs tax division.

Mr. Woehlke is an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily reflect the views of the AICPA. Official positions are determined through certain specific committee procedures, due process and deliberation.

EXHIBIT 1

One firm's tax services quality controls

1. Two reviewers are required for all individual tax returns over $100,000 in adjusted gross income.

2. Two reviewers are required for all corporate tax returns with gross income over $1 million. Two reviewers also are required for final corporate returns.

3. An American Institute of CPAs checklist should be used for returns with very complicated tax issues.

4. All tax returns subject to the alternative minimum tax will be reviewed by a senior tax expert.

5. Complex tax loss (especially passive loss) carryovers should be traced by two reviewers on new returns.

6. Reviewers should be independent of the work performed.

7. Differences of opinion among professionals should be resolved in accordance with specialty designations and good sense. The firm board of directors will resolve significant difficulties, if necessary.

IDEAS FOR IMPLEMENTING TAX QUALITY CONTROLS

* Join the AICPA tax division. Obtain Guidelines for Voluntary Tax Practice Review.

* Perform an internal tax inspection by performing reviews of a half-dozen tax engagements.

* Write a tax quality control document by adapting voluntary tax practice review models to the firm's needs.

* Incorporate the quality controls into the firm's tax procedures and use them through one tax season.

* Hire another CPA to perform a tax practice review. The review is voluntary, but it may be the best thing firm managers can do for the practice.

DOUGLAS E. HULL, CPA is president of Hull Fothergill Segale & Valley, Montpelier, Vermont. A member of the American Institute of CPAs, he was chairman of the Vermont Society of CPAs quality control committee and a member of the New England quality review executive committee.