Current Tax Return Disclosure Issues Involving Sec. 7216

Sec. 7216 imposes misdemeanor criminal penalties on return preparers who disclose or improperly use taxpayer information. The penalties include a maximum fine of $1,000 or one year in prison or both. Exceptions are allowed for disclosures made to comply with other Internal Revenue Code provisions, a court order, or as part of state and local compliance requirements. Revisions were made to Regs. Secs. 301.7216-1, -2, and -3, effective Jan. 1, 2009, with additional revisions to -2 effective Jan. 4, 2010.

For purposes of Sec. 7216, Regs. Sec. 301.7216-1 prohibits disclosure of income tax return information only (thus providing a narrower scope than Sec. 6694, the penalty for tax return preparers’ understating a taxpayer’s liability) and defines a preparer as someone engaged in the business of preparing or helping prepare returns or providing auxiliary services as part of return preparation (which is a broader scope than Sec. 6694). Tax return information includes, but is not limited to, name, address, and identifying number of the taxpayer. This definition includes preparer-generated information from the preparation process. Disclosure is defined as an act of making the tax return information known to another person.

In limited situations, a return preparer can use or disclose covered information without taxpayer consent. Regs. Sec. 301.7216-2 allows an accountant or attorney in practice to use or disclose the information to another person within the same firm. However, this exception is limited to actions within the United States, and the “within the same firm” concept does not extend to related or affiliated firms. One exception allows limited use of information without the taxpayer’s consent when soliciting tax return preparation business. The amended regulation provides for additional exceptions to the general rule prohibiting use of statistical compilations. It is not a violation of Sec. 7216 to disclose information for the purposes of a quality or peer review, nor is it a violation to disclose information to the proper authorities incident to the investigation of a crime.

The basic rule is to allow use or disclosure of covered information only with prior taxpayer consent, as stipulated in Regs. Sec. 301.7216-3. A valid consent must include the names of both the preparer and the taxpayer and be:

• Signed and dated by the taxpayer;
• Knowing and voluntary; and
• Limited to one year.

The preparer cannot condition providing services upon receiving taxpayer consent to use or disclose covered information (unless it involves requesting disclosure to another preparer for auxiliary preparation services). The consent must identify the purpose for the disclosure and, for Form 1040 series returns only, identify the recipients of the information. If the consent covers the use of tax return information, such as for solicitations of products or services, it must describe each specific product or service. While the regulations require separate written consent documents for Form 1040 series return information (i.e., not just a sentence or paragraph in the engagement letter), for all other taxpayers the consent may be included in the engagement letter.

Rev. Rul. 2010-4 provides guidance on permissible disclosures of tax return information. A preparer can use information to contact taxpayers to inform them of tax law and regulation changes that may affect prior returns the preparer prepared. A preparer also can disclose the tax return information contained in Regs. Sec. 301.7216-2(n) (lists of names, mailing addresses, entity classifications, and form numbers) to third-party service providers that prepare newsletters or bulletins that provide clients with current tax information and general business and economic information.

Rev. Rul. 2010-5 provides additional guidance on permissible situations in which a preparer can use tax return information. A preparer is not liable for disclosures to professional liability insurance providers that are necessary to obtain professional liability insurance coverage. A preparer also is not liable for disclosures to its professional liability insurance provider that are relevant to a claim or potential claim of professional negligence.

It is important to note that practitioners might inadvertently violate Sec. 7216 through inappropriate use of social media (see Schamberger, “Social Media: Opportunities and Risks for Tax Practices,” 44 The Tax Adviser 326 (May 2013)). In addition, IRS Circular 230, Section 10.51(a)(15), indicates a practitioner may be sanctioned for disreputable conduct for willfully disclosing or using a tax return or tax return information in a manner not authorized by the Code. Since relevant revisions to Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), and the Sec. 7216 regulations are relatively recent, it is not clear what, if any, conflicts might exist in applying these provisions.

The Comfort Letter Dilemma

In the past several years, the practice of third parties requesting some corroboration from CPAs of the veracity or reliability of client tax or financial information has presented itself in a variety of contexts. Various parties request these “comfort letters,” “solvency opinions,” or “certification letters” to confirm information the client provided to those parties. Prior to responding to these requests, all tax practitioners should review the applicable standards and guidance on the subject (for further discussion of this issue, see Karl, “CPAs and Comfort Letters: The New Chocolate,” The Tax Adviser 476 (July 2013)).

In previous years, comfort letters were confined to mortgage lenders. Requests now commonly come from health insurance providers, adoption agencies, governmental agencies, and others. Some of these requests require the use of specific language in the responding letter, including use of the words “certify” and “verify.” These words are not associated with and are unrelated to the scope of a typical engagement for tax return preparation and would normally be used only as part of an attest engagement.

Prior to responding, CPAs must consider the applicable ethical issues and standards contained in the AICPA Code of Professional Conduct. However, practice management matters also need to be considered, such as client retention, client satisfaction, and client expectations. Both clients and the requesters of this information have misconceptions as to the scope of CPAs’ professional responsibilities when they are engaged solely to prepare the client’s income tax returns. Tax returns are prepared for filing with the IRS and not for loan documentation, procurement, or other non-tax-related functions. The information contained in a tax return has not been developed or tested using any procedures that enable the CPA to render assurances to third parties. Nor has the information been developed for purposes beyond assisting the client taxpayer in meeting reporting requirements to a government agency.

The requesters of these letters are generally unaware of the applicable professional ethical issues and standards and, in many instances, are attempting to shift the responsibility for anything that could go wrong in the future with the loan to the tax return preparer for misrepresenting the client’s financial position. There is a communication gap between the requesters of this information and CPAs as tax preparers; no resolution appears to be on the horizon.

Mortgage Company Requests

The most common requests are from mortgage companies or other lenders. These requests may include:

• A statement that the client is self-employed and the number of years of self-employment;
• The amount of income from self-employment;
• Ownership percentage of the business entity;
• Explanation of the profitability of the business; and
• Effect on the business if money is used for the purchase being financed.

Prior to responding to these requests, tax preparers should undertake a careful review of the applicable form letters that are available, review applicable ethical and regulatory pronouncements (AICPA, IRS, and Federal Trade Commission), and possibly have a discussion with their professional liability insurance carrier. If the CPA agrees to provide a comfort letter, it should include:

• A statement that the original client engagement was limited to preparing income tax returns for filing with the IRS (or states or other agencies) from information the taxpayer furnished and in accordance with applicable rules.
• No attestation or assurance function associated with the return preparation engagement was completed, nor is any such undertaking inherent in providing the letter.
• The information the taxpayer furnished was not verified, nor have any steps been taken to verify the information as part of providing the letter.
• The taxpayer’s creditworthiness was not assessed, nor was there any responsibility to do so at the time the returns were prepared.
• It is the lender’s responsibility to assess the taxpayer’s current financial position incident to the decision to extend credit to the taxpayer.
• The CPA is under no obligation to update any forms or filings concerning the taxpayer’s information, nor has any effort been taken to update the information as part of providing the letter.

Of course, if the letter requests the disclosure of covered tax return information, the CPA must consider the application of Sec. 7216 and obtain appropriate consents from the client. It also is important to note that, based on representations made in any such letters from tax preparers, lenders may seek legal recourse against the preparer if problems arise with payment of the loan. It is beyond the scope of this column to address the current state of the law in this area.

Guidance and suggested forms for letters are available on various professional liability insurance company websites, and many articles have been written on the subject. The AICPA has extensive resources available to address concerns associated with comfort letters.

FSA/USDA Certifications

In 2012, a new issue for comfort letters arose when the Farm Service Agency (FSA), a branch of the U.S. Department of Agriculture, began requesting “certification” of income from individuals who receive certain farm program payments. The term “certification” in the legislation for this program included a requirement that the “certification” be prepared and submitted in a letter drafted by a CPA or attorney. In addition to the letter from a CPA or attorney, the FSA required the individuals to submit three years of income tax returns.

The FSA request clearly conflicted with the scope of the engagement in preparing an income tax return and AICPA standards. The AICPA worked diligently with the FSA to resolve this issue and created a resource center to assist members in preparing these letters. The resource page includes:

• A sample of the letter issued by the FSA;
• The FSA requirements;
• Sample certification letter;
• Sample engagement letter; and
• Sample Sec. 7216 consent form.

As a quote from the website indicates, this is a very complex area:

CAUTION: The provisions containing the income limitations are found in 7 U.S.C. §1308. These are complex provisions outside of the scope of both the Internal Revenue Code and normal tax services provided by members. Before providing certification letters, members should carefully review these provisions. The definitions of terms such as “person” and “farm income” are complex and may require legal interpretation. Members are encouraged to seek assistance from legal counsel to properly interpret these provisions. While the certification letters are authorized under federal statutes, it is possible that the certification process may be construed as the unauthorized practice of law in some jurisdictions.

Legislation has been introduced in Congress to correct the issues and problems with these letters, but no relief had been enacted as this column went to press.

Other Requests

Additional requests for tax return information have been issued by FedEx, the Federal National Mortgage Association (Fannie Mae), and the Government National Mortgage Association (Ginnie Mae), among others. For example, requests may ask for some indication of solvency or assurance that the proposed action will not place undue financial strain on the taxpayer’s business. Again, these requests are beyond the scope of income tax return preparation, and any responses should be carefully considered before issuing a letter using the criteria discussed in this column. Specifically, the practitioner should consider AICPA Standards for Attestation Engagements No. 10, Attest Engagements, and AT Section 9101, Attest Engagements: Attest Engagements Interpretations of Section 101, Appendix B, No. 2, ¶25 (regarding solvency assurances).

Client Records

Suppose a CPA prepared the client’s tax returns for the current year, and that CPA receives a communication from the client saying he is engaging another CPA firm to provide tax planning and compliance services, and thus is requesting that the CPA transfer all of the client’s tax records to the new firm. The client includes the appropriate Sec. 7216 consent to disclose authorization to transfer the records. What are the CPA’s responsibilities and obligations?

Multiple authorities must be considered. First, the CPA should refer to Circular 230, Section 10.28. Section 10.28 states that a “practitioner must, at the request of a client, promptly return any and all records of the client that are necessary for the client to comply with his or her Federal tax obligations.” The practitioner may retain copies of the records that are returned to the client.

Generally, a dispute over fees does not relieve the practitioner of a responsibility to return the client’s records. However, if the applicable rules and regulations of the state board of accountancy allow or permit the retention of a client’s records in the case of a fee dispute over the services rendered, the practitioner needs to return only those records that must be attached to the taxpayer’s return. However, the practitioner must provide the client reasonable access to review and copy any of the records of the client that the practitioner has retained.

Section 10.28(b) defines records of the client as “all documents or written or electronic materials provided to the practitioner or obtained by the practitioner in the course of the practitioner’s representation of the client, that preexisted the retention of the practitioner by the client.” Client records include materials that were prepared by the client or a third party, such as an investment manager or a bank or a brokerage firm, and provided to the practitioner to prepare the requisite tax returns.

The term “records” also includes any return, schedule, appraisal, or other document the practitioner prepared that was presented to the client with respect to a prior representation if that document is necessary for the taxpayer to comply with a current federal tax obligation. The term does not include any return, schedule, or other document prepared by the practitioner if the practitioner is withholding the document pending the client’s performance of a contractual obligation to pay fees with respect to the document.

For example, documents that are created or prepared by the practitioner that are required to be provided to the client would include detailed depreciation schedules, passive loss carryover schedules, basis and at-risk calculations for partnerships, at-risk calculations for S corporations, etc.

Furthermore, Section 10.51 of Circular 230, “Incompetence and disreputable conduct,” may apply. For example, if a practitioner releases a client’s information to a third party without first obtaining the appropriate Sec. 7216 consent, the practitioner may be subject to sanctions under Circular 230 for an unauthorized willful disclosure of tax return information (Section 10.51(15)).

In addition, as a practitioner, the CPA should consider the AICPA Code of Professional Conduct, specifically ET Section 501.02, Interpretation 501-1, “Response to Requests by Clients and Former Clients for Records.” Under this section, when clients or former clients request that a member send their records either to them or to another CPA, the member’s failure to comply with the request would constitute a violation of this interpretation. “Client-provided records,” as defined in this interpretation, are “accounting or other records belonging to the client that were provided to the member, by or on behalf of, the client, including hardcopy or electronic reproductions of such records.” As can be seen, the definition of records for purposes of Interpretation 501-1 is much broader than the definition used in Circular 230, Section 10.28(b).

Unless a member and the client agree to the contrary, when a client makes a request for a member’s work product or member-prepared records that are in the custody of the member that have not been previously provided to the client, and are records relating to a completed and issued work product, the member must provide those working papers to the client, with the exception that the records may be withheld if fees are due to the member for the specific work product. The member may withhold work product if the work product is incomplete. If the client directs that the member send records to another professional, the member must obtain appropriate Sec. 7216 consent before forwarding the records.

In connection with any request for client-provided records, member-prepared records, or a member’s work products, the member may charge the client a reasonable fee for the time and expense incurred in retrieving and copying the records and require that the client pay the fee before the records are provided. The member may provide the requested records in any format usable by the client and may make and retain copies of any records returned or provided to the client.

In addition, the interpretation states that AICPA members must comply with the rules and regulations of authoritative regulatory bodies, such as the member’s state board of accountancy, when the member performs services for a client and is subject to the rules and regulations of that regulatory body. Therefore, if the rules of the authoritative regulatory body are more restrictive, failure to comply with those rules would constitute a violation of the interpretation by the member.

Complex Considerations

Practitioners face some difficult scenarios in properly disclosing or using client tax return information. Multiple professional ethics pronouncements and federal and state legislative and administrative pronouncements all must be considered before acting. In addition, with the recent expansion of third-party requests for taxpayer information, practitioners must consider the need to obtain opinions of legal counsel before acting on those requests.