Tax practitioners occasionally uncover or otherwise become aware of errors in the previously filed tax returns of their clients. As a general rule, tax practitioners in such situations should lose no time in communicating news of the error to the client. This general duty is embodied in rules applied by both the AICPA and the IRS. Nevertheless, principles governing this duty are often far easier to articulate in theory than they are to apply in practice.
To begin with, the scope of the duty and the extent of the obligations it places on practitioners are by no means clearly delineated, particularly in the gray areas that sometimes confront even the most scrupulous and ethical of tax practitioners. Moreover, the sheer brevity of the general rule, which appears straightforward on its face, all but requires practitioners to look beyond its letter in many cases and be governed by its spirit to arrive at an interpretation that reconciles reasonable administrability with rational professional conduct.
This first part of a two-part article begins by examining the two somewhat different versions of the rule on advising clients regarding erroneous tax return positions—one applied by the AICPA and the other by the IRS. The article then considers how these rules (which this article refers to collectively as “the Rule”) should be applied, both generally and in those particularly sensitive circumstances in which the error may be attributable to the tax practitioner’s own advice. Part II of the article, in the July issue, will discuss what practitioners should do when clients fail to heed their advice; other practical considerations; and what to do when the error is attributable to the tax practitioner’s own advice.
Background of the Rule
What Does the AICPA Generally Require?
The most comprehensive set of standards guiding the actions of tax practitioners who identify an error in a client’s previously filed return is enunciated in the AICPA Statement on Standards for Tax Services (SSTS) No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings. This standard specifically applies to tax practitioners who are members of the AICPA, most of whom are CPAs. Nevertheless, the standards have much broader applicability, both in their persuasive authority and their power to create industry norms, which directly or indirectly establish the general parameters within which tax practitioners operate.
Specifically, SSTS No. 6 states in relevant part:
A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken. 1
The explanation of SSTS No. 6 contemplates that an error in a previously filed return will be discovered by a tax practitioner “[w]hile performing services for a taxpayer.” 2 Nevertheless, the standard applies “whether or not the member prepared or signed the return that contains the error.” 3 Thus, the scope of SSTS No. 6 is relatively broad. 4
The standard’s coverage, however, is somewhat narrowed by the stipulation that “an error does not include an item that has an insignificant effect on the taxpayer’s tax liability.” 5 SSTS No. 6 grants a fair amount of leeway in this context, explaining, “Whether an error has no more than an insignificant effect on the taxpayer’s tax liability is left to the professional judgment of the member based on all the facts and circumstances known to the member.” 6
What Does Circular 230 Generally Require?
The Treasury Department on behalf of the IRS in Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), likewise has articulated standards governing situations in which tax practitioners discover an error in the previously filed tax return of a client. These standards, which are set forth in Circular 230, Section 10.21, are directly applicable to virtually all tax practitioners with respect to federal tax practice. This is the case because Circular 230 generally governs the activities of all professionals practicing before the IRS, with “practice” currently defined so broadly as to encompass not only the representation of clients in front of the IRS but also the preparation of clients’ tax returns for submission to the IRS. 7
While SSTS No. 6 is by no means verbose, Circular 230, Section 10.21, provides such a terse directive with respect to the discovery of an error in the previously filed return of a client as to make SSTS No. 6 appear encyclopedic by comparison. Section 10.21 states in its entirety:
A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States, must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.
The guidelines of Circular 230, Section 10.21, are direct and straightforward, leaving little latitude for doubt or interpretation. Nevertheless, room for substantial uncertainty remains at the margins, which is precisely where the questions that try practitioners’ souls—and livelihoods—typically are presented.
Differences in Approach Between SSTS No. 6 and Circular 230
Certainly, the basic terms of SSTS No. 6 and Circular 230, Section 10.21, are similar, and the principle behind them is the same. Both provisions generally desire and direct that a tax practitioner, once aware of an error in the previously filed tax return of a client, promptly inform the client of that error.
However, from this common starting point, the provisions then follow somewhat different paths. As mentioned above, SSTS No. 6 establishes a materiality threshold in identifying an error and leaves the definition of “material” to the discretion of the tax practitioner. By contrast, no such de minimis provision exists under Circular 230, which by its literal terms demands that upon discovering a $5 error on the return of a multibillion-dollar corporate client, the tax practitioner must immediately disclose it, even if the client likely would have little interest in the disclosure. Circular 230 grants the tax practitioner no discretion in this context.
Interestingly, however, Circular 230, Section 10.21, adopts a somewhat lighter tone regarding the extent of the follow-up advice that tax practitioners must provide in connection with the disclosure of the erroneous position. It simply directs that “[t]he practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.”
On the other hand, SSTS No. 6 not only mandates that the tax practitioner inform the client regarding the consequences of the error but also that the practitioner recommend the corrective measures to be undertaken. 8 Moreover, if the client declines to adopt the corrective measures recommended by the practitioner, SSTS No. 6 suggests that the practitioner contemplate disassociation from the client:
If a member is requested to prepare the current year’s return and the taxpayer has not taken the appropriate action to correct an error in a prior year’s return, the member should consider whether to withdraw from preparing the return and whether to continue a professional or employment relationship with the taxpayer. 9
Accordingly, given the de minimis rule of SSTS No. 6, its provisions will apply somewhat less universally than those of Circular 230, Section 10.21. Nevertheless, where they both come into play (which will be most of the time in the federal tax practice of an AICPA member), SSTS No. 6 may well require more of the tax practitioner than its Circular 230 counterpart.
Definitional Distinctions Between the Two Standards
SSTS No. 6 provides that the term “error” includes a position taken on a prior year’s return that no longer meets the accuracy standards “due to legislation, judicial decisions, or administrative pronouncements having retroactive effect.” 10 In contrast, Circular 230, Section 10.21, does not provide a definition of “error” or “omission,” and its text is silent on whether awareness of a retroactive change in the law affecting a client triggers any professional responsibility on the part of a practitioner.
In addition, other differences between the texts of the two standards may at first seem minor but in particular fact patterns may take on significance in assessing professional responsibilities. For example, the AICPA standard is framed by reference to a return. In interpreting what constitutes a return for this purpose, practitioners should give some consideration to the discussion in SSTS No. 6, paragraph 1, which refers to “the taxpayer’s tax liability.” 11 It appears that the AICPA version of the Rule would reach original and amended returns, claims for refund, and, presumably, information returns. 12
By contrast, Circular 230, Section 10.21, applies to “an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States.” Thus, the scope of Section 10.21 may well be more expansive than SSTS No. 6 by encompassing disclosure statements and information returns with no impact on a taxpayer’s liability. Circular 230, however, is not universally broader than its AICPA counterpart. SSTS No. 6’s coverage extends beyond federal tax practice, 13 while Section 10.21 is restricted to matters administered by the IRS.
The impact of the definitional differences between the two standards often depends upon the context in which the tax practitioner is acting and the credentials held by the practitioner. For example, the AICPA rules are intended to cover only practitioners acting in their capacity as a CPA. Nevertheless, a CPA who is subject to the AICPA standards is also subject to Circular 230 when acting in connection with a matter administered by the IRS. When both SSTS No. 6 and Circular 230 speak to an issue, it is prudent to chart a course that will simultaneously satisfy both standards. Essentially, the tax practitioner is well served to adopt the ethical equivalent of a “highest common denominator” approach and to conform to the most stringent standard set by either iteration of the Rule for any given circumstance.
There are no tax-specific American Bar Association (ABA) standards of which the author is aware relating to knowledge of a client’s errors. Lawyers facing these scenarios, however, would have to consider whether ABA standards or the standards of the relevant state bar address these matters in a broader context applicable to tax practice, including state and local tax practice, as well as to practice in other areas. The only specific guidance broadly applicable to enrolled agents (EAs) is Circular 230, Section 10.21, which applies to EAs practicing before the IRS and thus does not expressly address errors on state and local tax returns. 14 In any event, regardless of whether a professional standard is directly applicable to a specific tax practitioner, all practitioners facing a client error should be concerned about whether violating the Rule could expose them to a negligence claim, even if they are not specifically covered by the guidance in question.
Policy Implications of the Rule
Notwithstanding the differences between SSTS No. 6 and Circular 230, Section 10.21, they share overriding policy goals or imperatives. At its core, the Rule is concerned with preserving the self-assessment system, protecting the interests of the client, and establishing the practitioner as the keeper of a duty to the tax regime.
Both standards want the client to be quickly informed regarding the discovery of an error and its consequences. The interesting question, however, is why? As a threshold matter, the answer has little to do with the concept of retributive justice and the notion that tax practitioners should staunchly step forward and take responsibility for errors of their own making on a prior return. While such ethical behavior is indeed admirable, its compulsion is not the reason for the Rule.
SSTS No. 6 specifically states that it applies “whether or not the member prepared or signed the return that contains the error.” 15 Thus, the Rule is imposed equally on all tax practitioners discovering an error, regardless of whether they had anything to do with the original promulgation of the error. Likewise, the broad reach of Circular 230, Section 10.21, makes no distinction between such preparers and evidences no concern whatsoever with culpability.
Rather, the overriding interest served by both articulations of the Rule is that information with respect to the error and its potential consequences be quickly conveyed to the client. The dual policy goals pursued by this imperative are the simultaneous preservation of the self-assessment system and the protection of the individual client. Toward this end, the Rule places the respective interests of the system and the individual in a state of uneasy equipoise.
Both SSTS No. 6 and Circular 230 require not only prompt disclosure of the error to a client but also that this information be accompanied by a discussion of the consequences flowing from the error. Interestingly, both formulations of the Rule adopt the term “consequences,” which connotes something vaguely malfeasant and sinister. The subtext is that all good people, having been informed of an error, will beat a path to the door of the IRS to self-report and square things.
SSTS No. 6 goes one step further: Practitioners who discover an error are required not only to identify the error to the client and discuss its consequences but also to “recommend the corrective measures to be taken.” 16
Accordingly, one of the primary policy goals of the Rule is unquestionably the preservation of the self-assessment system, which more often than not has the concomitant effect of increasing the collection of tax revenues. In doing so, however, SSTS No. 6 likewise acknowledges the policy goal of protecting the interests of the client. Indeed, SSTS No. 6 states explicitly that the ultimate decision regarding the subsequent corrective measures to be taken—or not taken—is solely the client’s: “It is the taxpayer’s responsibility to decide whether to correct the error.” 17
Moreover, SSTS No. 6 cautions tax practitioners that they are “not allowed to inform the taxing authority without the taxpayer’s permission, except when required by law.” 18 Interestingly, this concern for the interests of the client evidenced in SSTS No. 6 is not overtly echoed in Circular 230, Section 10.21, which neither explicitly places final decision-making in the hands of the client nor admonishes tax practitioners regarding their duty of confidentiality to the client.
Nevertheless, a central element of the Rule, recognition of which is key to understanding its provisions and reasonably applying its terms, is the overriding purpose of placing information and advice in the hands of clients, so that they can make an informed decision regarding how to proceed with respect to their own tax return, even if that decision is not to amend their return or otherwise remedy an error. Simply put, there is no generally applicable affirmative duty imposed on taxpayers to amend their returns. A foundational principle of the self-assessment system is that taxpayers are the masters of their own returns and that the role of a tax practitioner is to inform and, insofar as is ethically appropriate, to facilitate the client’s self-assessment process, even if that process does not culminate in corrective action. At bottom, the Rule exists for the specific purpose of reiterating this basic principle and perpetuating this relationship between tax practitioner and client in the narrow but important context of errors on previously filed returns.
Toward that end, both iterations of the Rule generally conceptualize the tax practitioner as a disinterested and detached purveyor of information and advice. That said, however, at a more nuanced level, the Rule—particularly as formulated by the AICPA—also contemplates certain duties owed by tax practitioners directly to the self-assessment system that could compete with their duties to their clients.
To illustrate, immediately after stating in no uncertain terms that it is the client’s responsibility to decide whether to correct an error, SSTS No. 6 goes on to instruct the tax practitioner to consider withdrawing from the engagement and terminating all future professional association with the client if the client chooses not to self-correct. 19
Likewise, SSTS No. 6, assuming that tax practitioners will secure client consent to undertake the contemplated corrections, directs practitioners regarding the time and manner in which certain of those corrections are to be made, so that the practitioners themselves are fulfilling not only their duties to clients but also to their sometimes competing obligations to the tax system itself:
Once the member has obtained the taxpayer’s consent to disclose an error in an administrative proceeding, the disclosure should not be delayed to such a degree that the taxpayer or member might be considered to have failed to act in good faith or to have, in effect, provided misleading information. 20
The ambiguity of a tax practitioner’s role likewise can be glimpsed from SSTS No. 6’s admonition to the tax practitioner that if a client chooses not to correct an error and the tax practitioner opts to continue representing the client, then at least the practitioner should remember his or her duty to the self-assessment system and make sure that the error is not repeated in subsequent years:
If a member decides to continue a professional or employment relationship with the taxpayer and is requested to prepare a tax return for a year subsequent to that in which the error occurred, the member should take reasonable steps to ensure that the error is not repeated. 21
Thus, although by requiring timely disclosure, the Rule serves the policy goals of preserving the self-assessment system and protecting the client, inherent in its application is the third policy goal or imperative: that tax practitioners themselves have a duty to the tax regime, a reality that in practice does much to shape how the Rule is applied.
Discovering an Error on a Client’s Prior Return
The Basic Rule
General application: In the classic case, while representing a client, a tax practitioner finds an error in a previously filed return of the client. The Rule generally requires the tax practitioner to promptly inform the client regarding the error and its potential consequences. Moreover, to comply with the letter of SSTS No. 6, the tax practitioner should recommend corrective measures with respect to the error: specifically, to amend the return or to otherwise remedy the situation, such as to apply for a change in method of accounting.
An interesting question is the extent to which this advice can take into account practical circumstances, such as whether the statute of limitation is about to expire.
Example 1: While preparing the 2012 federal income tax return of corporation XYZ a week before its due date (without extension) in 2013, a tax practitioner discovers an error in the corporation’s 2009 federal return, which was timely filed on its original due date without extension. The error does not involve a carryback or substantial omission of items under Sec. 6501(e). The Rule obligates the tax practitioner to promptly inform the corporation of this circumstance.
How does the tax practitioner deal with this situation where the apparently applicable three-year statute of limitation with respect to the 2009 tax year is due to expire in one week and the IRS may seem unlikely to assert a tax deficiency with respect to the error within that period? Does the tax practitioner withhold this information from the client, thereby risking the charge of inadequate representation? Does the tax practitioner provide this information to the client, thereby risking being charged with encouraging the client to play the audit lottery?
To be sure, the Rule does not provide an easy answer to this conundrum. Nevertheless, there is a reasonable way of cutting this ethical Gordian knot. Both iterations of the Rule in Circular 230, Section 10.21, and SSTS No. 6 mandate that the tax practitioner advise the client regarding the potential consequences of the error. In balancing the policy goals of the Rule and the tax practitioner’s superficially conflicting ethical obligations to the self-assessment system on the one hand, and to the interests of the client on the other hand, there is a middle course to be charted that appropriately serves both masters.
Continuing the present example, the tax practitioner is well justified and perhaps best served in disclosing the full range of potential consequences to the client, including the possible running of the statute of limitation or the potential assessment of deficiencies, penalties, and interest if the error is identified by the IRS within the applicable period. This full disclosure firmly positions the tax practitioner as the information conduit, providing the client with the disclosures and the advice necessary to make an informed decision regarding its own return.
As part of this information disclosure, in accordance with ethical obligations, the tax practitioner should also recommend that the client take corrective action. In this way, the client is provided with the full range of information and advice needed to make an informed decision, the policy goals of the Rule are perpetuated, and the tax practitioner is protected from assertions by the client that the client was inadequately counseled or allegations by the IRS that the tax practitioner advised an overly aggressive and unethical course.
Accordingly, when applying the Rule to facts arising with respect to clients, tax practitioners must take practical circumstances into account if they are to adequately serve both the interests of the client and the self-assessment system. These practical circumstances must be weighed with extreme care and judiciously analyzed in light of both the plain language of the Rule and the policy goals behind it.
Documenting the advice: Both Circular 230, Section 10.21, and SSTS No. 6 are client-facing, in the sense that they are predominantly concerned with ensuring that the tax practitioner inform and advise the client regarding an error so that the appropriate corrective action can be undertaken. Indeed, SSTS No. 6 even specifies that “[s]uch advice and recommendation may be given orally.” 22 Nevertheless, good professional practice, as well as sheer self-preservation, dictates that the advice and the recommendations be properly documented and preserved by the tax practitioner. Moreover, in the tax world, memories can be short and misunderstandings can abound. As months and even years go by, parties can have astonishingly different recollections regarding the nature of the advice that was provided and indeed whether any advice was provided at all. Consequently, it behooves tax practitioners to document the information and recommendations they furnish to their clients as they comply with the Rule’s disclosure mandate.
This is particularly important in the context of Circular 230, Section 10.21, because a practitioner’s inability to establish that the requisite information and consequences had been communicated to the client could be construed as a violation of Circular 230 if the practitioner’s compliance were ever called into question. A Circular 230 violation could result in censure, suspension from practice before the IRS, or even disbarment or loss of license. Such sanctions could severely affect or even end a tax practitioner’s career. As a result, the ability to demonstrate that a tax practitioner has complied with the Rule is virtually as important as compliance with the Rule itself.
This is also the case in protecting against professional liability. Even if a tax practitioner is not responsible for the underlying error in a previously filed return, having become aware of that error, failure to properly notify and counsel the client—or even the inability to evidence such communication—could arguably become the basis of a professional negligence claim. If the tax practitioner was responsible for an error on a previously filed return, documentary evidence that the client had been properly informed and counseled on corrective action that could be undertaken would from that point onward likely limit the practitioner’s exposure to additional damages, even if the client opted not to take the corrective action. A solid argument would exist that thereafter, any negative consequences flowing from the decision to forgo corrective action, including, for example, a practical inability to obtain reasonable-cause abatements of penalties, would be solely attributable to the client’s decision and would not generate damages recoverable from the tax practitioner.
Accordingly, documentation of the information and advice provided pursuant to the Rule is essential. Some clients, however, may resist accepting written advice for fear that it would place them in a compromising position, particularly if they choose not to follow the practitioner’s advice. Moreover, such written communications inevitably require chargeable time for which many clients are unwilling to incur further costs. Finally, some tax practitioners may feel uncomfortable with the air of additional formality that such a written document would introduce into the client-counseling process. These considerations likely account for the express permission in SSTS No. 6 to provide the communications orally.
Of course, where the client is willing, the best approach is to provide a memorandum or other written summary to the client outlining the error on the previously filed return, discussing the consequences of that error, and recommending the corrective measures to be taken. A copy of that document should also be retained by the tax practitioner and preserved in the event that it is ever needed for reference.
In other cases, an oral communication may be more desirable or appropriate. In such circumstances, practitioners would be well served by a detailed conference memorandum to their files outlining the client conversation and describing the particulars of the information and advice that were orally provided to the client. This memorandum, which should be drafted contemporaneously with the client discussion, should likewise be carefully preserved in the event that it is needed in the future. If the circumstances warrant, the tax practitioner should consider the additional benefit and protection to be gained from having a colleague participate in the conversation with the client and countersign the contemporaneously prepared memorandum documenting the client meeting.
When Does the Rule Apply?
Although tax practitioners who discover an error in a previously filed tax return of a client are instructed to promptly inform the client of the error, in certain circumstances the standard application of the Rule is less than clear-cut.
Former clients: It is an open question whether the Rule covers an error in a previously filed return discovered when the taxpayer is no longer a client of the tax practitioner.
Example 2: Tax practitioner prepared Client A ’s and Client B ’s federal income tax returns for 2011 using software that automatically applied the ceiling for the mortgage interest deduction. In early 2013, however, the tax practitioner finds to her dismay that the software incorrectly set the ceiling too low, causing the 2011 returns of both Client A and Client B to understate their respective mortgage interest deductions. Assume that the tax practitioner is now preparing Client A ’s 2012 federal return, but that Client B has now moved on to a different service provider and has become ex-Client B . The Rule would unquestionably require the tax practitioner to promptly inform Client A of the error, its potential consequences, and the corrective actions that might be taken. But would this same obligation pertain to ex-Client B ?
This question could be particularly relevant to tax practitioners with a large volume of clients and some client turnover. Although somewhat ambiguous, SSTS No. 6 does provide guidance. Initially, in articulating the general rule, SSTS No. 6 states simply that a tax practitioner should inform a taxpayer promptly upon becoming aware of an error in a previously filed return. 23 However, when explaining the application of the Rule and the thinking behind it, SSTS No. 6 explicitly envisions the disclosure obligation arising out of a currently existing client relationship: “While performing services for a taxpayer, a member may become aware of an error in a previously filed return or may become aware that the taxpayer failed to file a required return.” 24
Lest this limitation of the Rule to ongoing client relationships be thought a merely anecdotal or illustrative statement, the explanation of SSTS No. 6 reemphasizes it in a different context:
If a member becomes aware of the error while performing services for a taxpayer that do not involve tax return preparation or representation in an administrative proceeding, the member’s responsibility is to advise the taxpayer of the existence of the error and to recommend that the error be discussed with the taxpayer’s tax return preparer. 25
Given the reiteration of this concept—that the obligation of disclosure arises when the tax practitioner discovers an error while performing services for a current client—it is difficult to dismiss the inverse proposition as well, that if the error is discovered when the tax practitioner is no longer representing the client, then no disclosure requirement is necessary.
Although more terse than SSTS No. 6, Section 10.21 of Circular 230 similarly qualifies the context in which the disclosure obligation is imposed: “A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error . . . .” While the language of Section 10.21 is somewhat opaque, perhaps the most significant point is that Section 10.21 and SSTS No. 6 both decidedly forgo imposing an absolute knowledge standard that would require disclosing an error to a former client. Instead, both standards appear to condition the applicability of the Rule on a current client relationship.
The policy considerations in this context are somewhat contradictory. On the one hand, both the interests of the self-assessment system and the interests of clients would be best served by an absolute knowledge standard requiring tax practitioners to track down ex-clients even unto the ends of the Earth to inform them of an error on a previously filed return. Nevertheless, at a certain point, the administrability of a mandate also becomes relevant, and an absolute interpretation of the Rule requiring tax practitioners to locate and inform ex-clients, many of whom may not be easily traceable, would impose a potentially unwieldy and unreasonable burden on tax practitioners. As a result, it may well be that Circular 230, Section 10.21, and SSTS No. 6 choose to adopt a middle ground by articulating the general Rule that tax practitioners should disclose errors to clients, but then clarifying that the intended scope for application of the Rule is in the context of a current client relationship.
Given that this question regarding the applicability of the Rule cannot be unambiguously resolved, the most prudent general course of action would be to inform even ex-clients regarding the existence of an error on a previously filed return when that step can be reasonably pursued. Nevertheless, where those ex-clients cannot be easily located or where such contacts would be otherwise administratively burdensome, a reasonable and ethically sound argument does exist for forgoing such disclosures when errors are discovered with respect to a previously filed return and the taxpayer is no longer a client of the practitioner.
Expired statute of limitation: Another situation in which applicability of the Rule is questionable is when the tax practitioner discovers the error after the statute of limitation for correcting the error has expired.
Example 3: Assume that an error resulting in an overpayment of tax occurred on Client X’s 2008 tax return, which was timely filed and tax paid by the due date. When the tax practitioner discovers that error in early 2013, is the tax practitioner required to inform Client X of that error?
Although not addressing this issue directly, the two standards contain elements suggesting that once the statute of limitation expires with respect to a given year, the requirement to inform clients with respect to an error for that year likewise is nullified. Specifically, where SSTS No. 6 is concerned, not all errors are created equal. In fact, an error is not an error for purposes of the disclosure requirement of SSTS No. 6 if it “has an insignificant effect on the taxpayer’s tax liability.” 26 Once a statute of limitation for a particular year expires, an improper inclusion or omission for that year has not just an insignificant effect but no effect whatsoever on a client’s tax liability for the year in question. Thus, an improper inclusion or omission in a closed year would arguably not be defined by SSTS No. 6 as an error and therefore would not require disclosure to a client.
Similarly, Circular 230, Section 10.21, commences by articulating the general rule mandating disclosure of an error to clients. The regulation then goes on to direct that “[t]he practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.” Again, in cases where the statute of limitation has expired, there simply are no consequences or obligations of which to inform the client. Thus, if the first sentence of Section 10.21 is read in light of the second sentence, then a reasonable argument exists that errors in years closed by the statute of limitation do not need to be disclosed to clients.
While such analysis inevitably has a somewhat superficial feel, it is the unavoidable result of the Rule’s silence on how to address errors discovered after the statute of limitation has expired, a circumstance that, while not necessarily common, is by no means unheard of. Nevertheless, in this context, the policy goals underlying the Rule are in accordance with the notion that the application of the Rule and the operation of the statute of limitation are parallel.
As discussed above, the purpose of the Rule is not to visit retribution on negligent tax practitioners. Rather, the fundamental policy goals underlying the Rule and animating its operation are to provide clients with the information and counsel needed to determine how best to take corrective action with respect to their own previously filed tax returns and thereby perpetuate the self-reporting system and have tax practitioners fulfill their duties to the tax regime in that regard. Once the statute of limitation has run, no corrective action with respect to such tax returns is possible, and the policy goals driving the Rule are no longer served by the disclosure requirement. Thus, a reasonable argument exists that at the same time the statute of limitation for taking corrective actions expires, the Rule’s mandate for disclosure to clients also disappears.
Of course, some clients may assert that they have an interest in knowing everything about their tax returns indefinitely and without limitation. However, this type of transparency is neither contemplated nor sought by the Rule. If it were, then SSTS No. 6 would make the disclosure obligation absolute, rather than allowing for a materiality exception. Moreover, the issue of administrability again must be considered. Just as statutes of limitation serve the general principle of timeliness, a reasonable inference exists that the Rule is meant to apply only for so long as its goals can be served, not in perpetuity.
Just as in the case of ex-clients, tax practitioners discovering an error in a previously filed return after the statute of limitation has expired must proceed with great care and deliberation. In such a situation disclosure is always a safe policy. Moreover, such disclosure would represent the prudent course where the practitioner lacks reliable knowledge that the statute of limitation has indeed run. That said, depending upon the facts and circumstances of the particular case, a tax practitioner may be able to adopt a reasonable position, based on elements of the Rule and supported by the Rule’s underlying policy goals, that the disclosure obligation disappears when the statute of limitation expires.
Part II of
this article, in the July issue, will
discuss what practitioners must do if
their client fails to heed their advice;
other practical considerations; and what
to do when the error is attributable to
the tax practitioner’s own advice.
Author’s note: The author wishes to acknowledge and thank Edward Swails of Ernst & Young LLP from whose thoughts, input, and wide-ranging contributions this article benefited immensely.
4 Note that for simplicity’s sake, this article adopts the nomenclature of “an error in a previously filed return.” This terminology, however, is intended to encompass the various situations contemplated by the Rule, including errors on a return that is the subject of an administrative proceeding, nonfiling of a required return, and erroneous use of an improper return (e.g., a corporation using Form 1120S, U.S. Income Tax Return for an S Corporation, when it did not qualify as an S corporation).
7 T.D. 9527. However, the regulations’ definition of practice before the IRS to include preparing or filing a tax return has been struck down by a federal district court (Loving, No. 12-385 (D.D.C. 1/18/13)). The case is currently being appealed to the D.C. Circuit.
12 SSTS No. 6 likely should be read in light of SSTS No. 1, Tax Return Positions, which in relevant part states, “This statement sets forth the applicable standards for members when recommending tax return positions, or preparing or signing tax returns (including amended returns, claims for refund, and information returns) filed with any taxing authority.”
14 Practitioners should note, however, that there may be various state analogs of Circular 230 and the AICPA rules, along with other more general state laws, examination of which is beyond the scope of this article.
Michael Baillif is an adjunct professor of law teaching courses on tax law practice, ethics, and professional responsibility at the Georgetown University Law Center in Washington, D.C. For more information on this article, please contact Prof. Baillif at firstname.lastname@example.org.