The implementation of Financial Accounting Standards Board Interpretations No.48 (FIN 48), Accounting for Uncertainty in Income Taxes, and the change in the tax return preparer penalty standards under Sec. 6694 have resulted in increased scrutiny of tax return positions taken by taxpayers and tax practitioners alike. This heightened scrutiny may result in the discovery of errors or omissions on prior-year tax returns. Both Circular 230, Regulations Governing the Practice of Attorneys, Certified Public Accountants, Enrolled Agents, Enrolled Actuaries, and Appraisers Before the Internal Revenue Service, and AICPA professional standards impose obligations on CPAs who encounter these errors or omissions.
Circular 230 §10.21 provides that a CPA, attorney, enrolled agent, or enrolled actuary retained to provide federal tax services who discovers an error or omission with respect to any federal tax (not just income taxes) must promptly advise the client of the error or omission and the consequences under the Code and regulations of the error or omission. The §10.21 obligations are not limited to practitioners preparing returns, so the discovery of an error or omission in the course of a tax consulting or advisory engagement will also trigger its requirements.
In addition to Circular 230, CPAs must consider the requirements of AICPA Statement on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation (SSTS 6). Like Circular 230 §10.21, SSTS 6 requires advising the client of the existence of an error or omission. SSTS 6 goes beyond §10.21 by requiring that the CPA recommend corrective measures. If the client refuses to take corrective action with respect to a prior-year return, SSTS 6 requires a CPA retained to prepare the current-year return to consider withdrawal from the representation.
While these two professional standards appear straightforward, a CPA must evaluate a number of issues to be able to advise a client of the consequences of a prior year’s error or omission. A methodical approach to evaluating and addressing these issues helps to ensure that the CPA fulfills these obligations.
- First, confirm that an error or omission in fact exists. While this would seem self-evident, it is not uncommon for practitioners to begin evaluating the matters described below before confirming the relevant facts. What may appear to be an error may simply be a misunderstanding caused by incomplete workpapers.
- Quantify the impact on the amount of taxes due for any prior-year return affected by the error or omission. A client’s ability to comprehend the consequences of an error and of a failure to remedy it depends in part on an understanding of the financial exposure for any tax understatement. Depending on the complexity of the issue, it may be appropriate at the outset to estimate the amount of any understatement. If estimates are used, it is important that the client understand that the final determination of the understatement amount may be different.
- Quantify the amount of interest and potential penalties that could result from any prior-year understatement. Consider the client’s penalty exposure both from accuracy-related penalties calculated as a percentage of any understatement and from other penalties that apply without regard to the amount of any understatement (e.g., the Sec. 6707A penalty for failure to disclose a reportable transaction). Of course, if the understatement amount has been estimated, the amount of any interest or accuracy-related penalty will also be an estimate.
- Evaluate penalty defenses, such as the reasonable cause defense under Sec. 6664 or the existence of substantial authority for a nontax-shelter position at the time the return was filed. While the Sec. 6664 reasonable cause defense normally takes into consideration all facts and circumstances, the regulations do establish requirements for certain positions. For example, the failure to file Form 8886, Reportable Transaction Disclosure Statement, for a reportable transaction or Form 8275-R, Regulation Disclosure Statement, in reliance on an opinion that a regulation was invalid will negate the reasonable cause defense.
- Evaluate whether penalties may be avoided or reduced by filing a “qualified amended return.” Amounts paid with a qualified amended return reduce the amount of the income tax understatement to which the accuracy-related penalties can apply (Regs. Sec. 1.6664-2(c)). For an amended return to be a qualified amended return, it must be filed before the taxpayer is contacted by the IRS regarding an examination of the return. There are special rules for undisclosed listed transactions (including those retroactively listed) under which the Service’s contacting a promoter or material adviser for the undisclosed transaction may cut off the opportunity to file a qualified amended return. For undisclosed listed transactions, it may be necessary to contact promoters and material advisers to determine whether a qualified amended return is a viable option.
- Consider the impact of the statute of limitation on the client’s exposure to an assessment for additional taxes, interest, or penalties. Generally, the limitation period under Sec. 6501 is three years from the filing of the return. This period is extended to six years if the return omits from gross income items in excess of 25% of the gross income on the return (Sec. 6501(e)). Since application of the six-year statute of limitation opens the entire return to examination and assessment, the CPA should consider whether there are other positions on the return unrelated to the error or omission that could trigger the longer period. The limitations period can be extended beyond six years in the case of undisclosed listed transactions (Sec. 6501(c)(10)).
- Consider the potential impact of the prior-year error or omission on current or future tax returns. If the prior-year error could result in an understatement on the current or a future return, it may require a return disclosure or even prevent the CPA from preparing the current/future return under Sec. 6694 and Circular 230 §10.34. Notice 2008-13 provides interim guidance concerning the application of the Sec. 6694 preparer penalty to returns filed on or before December 31, 2008.
- Determine the cause of the error or omission. Errors may result from weak accounting systems or lax internal controls, miscommunication, or good-faith mistakes by the client or the CPA. Understanding the cause will help to avoid repeating the mistake by strengthening systems and controls or improving communication. Not only should a CPA preparing the current-year return take reasonable steps to avoid repeating the mistake under SSTS 6; the existence of adequate processes for avoiding repetition of errors is a component of the reasonable cause defense in Regs. Sec. 1.6694-2(d). Understanding the cause of any error will also help the CPA appropriately address client relationship management issues.
- Evaluate other potential consequences of errors or omissions. A client issuing GAAP financial statements may be required to accrue the tax liability attributable to the error or omission, as well as a reserve for any penalties likely to apply. An exempt organization’s status under Sec. 501 could be adversely affected, and publicly traded companies should consider mandated disclosures for certain penalties.
Caution: It is not possible to list here all the potential ancillary consequences of a prior-year error or omission, so the CPA must consider the specifics of each client’s situation.
After evaluating the matters outlined above, the CPA must advise the client of the existence of the error, the potential consequences, and the CPA’s recommendations for corrective action.
Practice tip: Neither Circular 230 §10.21 nor SSTS 6 requires that this advice be in writing, and it is generally preferable to discuss the issues with the client before sending any written communication so as to allow the client the opportunity to ask questions and consider the merits and risks of various remedial actions. Once the client decides on a course of action, the CPA should document the advice to the client in writing by either a letter to the client or a file memorandum summarizing the advice. A client letter can help avoid any client misunderstandings regarding potential consequences.
If the client elects not to correct a prior-year error or omission, SSTS 6 states that the CPA should consider whether to continue the representation. If the client’s decision may predict future behavior that could result in a conflict between the client’s desires and the CPA’s professional obligations, withdrawal is appropriate. Even if the CPA concludes that he or she can continue to represent the client, the CPA should evaluate and document any procedures to avoid repetition of the error on future returns.
The application of the individual steps described above to a particular error or omission will depend on the specific facts, but this methodical approach will help the CPA to fulfill the ethical obligations under Circular 230 §10.21 and SSTS 6.
Nick Gruidl, CPA, MBT, Managing Director, National Tax Department, RSM McGladrey, Inc., Minneapolis, MN
Unless otherwise indicated, contributors are members of RSM McGladrey, Inc.
If you would like additional information about these items, contact Mr. Gruidl at (952) 893-7018 or firstname.lastname@example.org.