Practical Approaches to Common Conflicts of Interest

Editor: Thomas J. Purcell III, CPA, J.D., Ph.D.

This column highlights some common conflicts of interest encountered by CPA tax practitioners and offers some practical means of properly addressing the consequential ethical issues.

To provide some context for this discussion, consider the following situation: In 1998, an attorney wrote several tax opinions for prospective benefit plan participants concerning the plan’s tax qualification, while at the same time he maintained an attorney-client relationship with the plan’s promoter. The attorney later became a co-trustee of the plan. When the IRS challenged the plan, the attorney represented individual plan participants before the IRS with respect to their individual tax disputes, while continuing to serve as the plan’s co-trustee.

Throughout this period, the attorney failed to advise his clients of his multiple engagements and roles, and, of course, he failed to obtain their informed consent to continue the representations. The IRS Office of Professional Responsibility (OPR) viewed these layers of conflicted representation as jeopardizing the rights of the various clients the attorney represented. In 2012, OPR censured the attorney because of these conflicts (see IRS News Release IR-2012-63, “Attorney Censured by the Office of Professional Responsibility for Mishandling Conflicts of Interest,” (6/22/12).

Relevant Ethical Provisions

A practitioner does not need to be an attorney with multiple layers of conflicts to be in the middle of a conflict problem. The AICPA Code of Professional Conduct (AICPA Code), which applies to all members of the Institute (and, by reference, to practitioners in those states where the governing board of accountancy has incorporated the AICPA Code into the state-specific code of conduct), and Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), which applies to professionals who are licensed to practice before the IRS, both speak to conflicts of interest and how to address them.

AICPA ethics interpretations state that a conflict may occur whenever the member or someone in the member’s firm “has a relationship with another person, entity, product, or service that could, in the member’s professional judgment, be viewed by the client, employer, or other appropriate parties as impairing the member’s objectivity” (AICPA Code, ET §102-2, “Conflicts of Interest”). The rule does not prohibit providing a nonattest service, such as tax services, where such circumstances exist, as long as “the member believes that the professional service can be performed with objectivity, and the relationship is disclosed . . . and consent is obtained” (id.).

Section 10.29 of Circular 230 spells out the following situations that are deemed to be conflicts:

(1) The representation of one client will be directly adverse to another client; or

(2) There is a significant risk that the representation of one or more clients will be materially limited by the practitioner’s responsibilities to another client, a former client or third person, or by a personal interest of the practitioner.

Section 10.29(b) provides that, even when a conflict exists, the practitioner may still represent the client if (1) the practitioner reasonably believes he or she will be able to provide competent and diligent representation to each affected client; and (2) assuming the representation is not prohibited by law, each affected client waives the conflict of interest and gives informed consent, confirmed in writing by each affected client, at the time the existence of the conflict of interest is known by the practitioner.

Note that Section 10.29(b)(3) of Circular 230 allows the written confirmation to be made within a reasonable time after the informed consent, but in no event later than 30 days. In addition, Section 10.29(c) requires practitioners to retain the written consents for at least 36 months from the date of the conclusion of the representation of the affected clients. The written representations must also be available to the IRS upon request.

Commonly Encountered Conflicts

Based on the authors’ experiences, the following are some of the more common conflicts encountered by CPA practitioners:

Example 1. Practitioner’s personal interest: D, CPA, is also a registered representative with ABC Securities Inc. D is the income tax return preparer for E, who has a 1-year-old child. When delivering E’s income tax return, D advises him that he would benefit from using a Sec. 529 qualified savings plan to save money for his child’s education. D points out that in E’s home state, he would benefit from a state income tax deduction of up to $3,000 per child per year. The state income tax rate for E’s home state is 7%. Therefore, if E were to contribute $3,000 per year for 10 years, his cumulative state tax savings (ignoring the time value of money) would be $2,100 ($3,000 × 7% × 10 years). E agrees, and D completes a new account form, opening a Sec. 529 qualified savings plan with E as the owner and his child as the beneficiary. E then invests $5,000 into the plan. As a result of this investment, D earns a 5% commission ($250) on the sale of the Sec. 529 plan security.

Before opening an account for E, D should recognize that E might view her potential commission as possibly affecting her objectivity. This is the type of situation ET Section 102-2 identifies as a possible conflict of interest, and D must determine whether she can be objective in making the recommendation to E. Similarly, Section 10.29 of Circular 230 requires D to be confident that she can provide competent and diligent representation to E. Some questions she should ask herself regarding the materiality of the personal interest and her duty of objectivity include:

• Do the potential tax savings for the client justify paying a commission?
• Is the home state’s Sec. 529 plan more suitable for the client than that of any other state, especially one whose securities may not be sold by ABC Securities?
• Is the Sec. 529 plan more suitable than other higher education savings strategies that may be available, such as a Coverdell education savings account?
• If E were to take D’s advice but buy the investment from another broker, could D still diligently provide him with tax preparation services?
• Is the $3,000 recommended contribution a material amount to E?
• Is the $250 commission a material amount to D, such that it would influence the advice she is rendering on entering into any Sec. 529 plan?

If D is satisfied that she can objectively, competently, and diligently make a recommendation to E, ET Section 102-2 requires her to inform E that she will receive a commission if E invests in the plan through D and to obtain E’s written consent. The Circular 230 rule permits D to make the recommendation and open the plan even if she thinks there is a significant risk that her dual role could materially limit her ability to represent E, provided that D captures E’s informed consent in D’s files so as to completely satisfy Sections 10.29(b)(2) and 10.29(c). For example, D may explain that she is familiar with other plans or investment opportunities that may be available, and E may decide that the convenience of having D open the account outweighs the actual or perceived benefits of alternative solutions.

ET Section 102-2 does not require the consent to be in writing, and Section 10.29 requires a written consent only when there is a significant risk that D’s dual role would materially limit her ability to represent E. D, however, may wish to eliminate the risk of questions arising in the future by obtaining E’s written consent. At first blush, this seems to be an easy exercise (i.e., just have the client sign a consent), but there is more to it than meets the eye.

What Is “Informed Consent”?

Informed consent rules may vary by jurisdiction and by various rules of professional practice (see, e.g., American Bar Association Model Rules of Professional Conduct 1.9 and 1.10; see also ABA Formal Ethics Opinion 08-450 (4/9/08)). ABA Model Rule 1.4(b), for example, states that a client must be provided information “to the extent reasonably necessary to permit the client to make informed decisions regarding the representation.” The key is to ensure that the client understands what is involved in the transaction and the scope of risk being undertaken in having the practitioner provide services in the face of a conflict of interest.

In Example 1, D should prepare a waiver form similar to the one shown in Exhibit 1. This will allow D to discuss the issue with E and obtain his approval after ensuring that he satisfactorily understands the conflict to provide informed consent. D should then obtain E’s signature and retain the written consent in accordance with Circular 230.

Example 2: Interplay between conflict-of-interest and independence rules: For a number of years, F, CPA, has provided services for G, and they have developed a friendly relationship. G is the general partner in a successful real estate and rental property business based in a nearby oceanside town. F prepared G’s personal income tax returns as well as those of the partnership. F also has prepared the partnership’s reviewed financial statement for the last several years. Both G and the partnership have executed annual engagement agreements for the services rendered. G informs F that his family is considering buying a house on the beach with another family as joint owners so that the respective families can divide the cost and time of having a weekend beach house. G asks F whether F would be interested in joining. Can F join G in buying the house and continue to provide him tax services?

F should recognize that entering into such a joint venture with G poses several possible conflicts of interest that have not been addressed in the engagement agreements. There could be a threat to his objectivity in both fact and appearance regarding the nonattest services that he provides. F may believe that if he jointly owns a vacation home with G, he can continue to be objective (ET §102-2) and that he is not materially limited from being able to provide competent and diligent representation to G and the partnership (Circular 230, §10.29). By obtaining the appropriate written informed consent from G, the partnership, and other partners, F may be able to continue tax return preparation and tax planning work.

However, F may be unable to continue to review the partnership’s financial statements because the AICPA rules requiring independence cannot be satisfied through disclosure and consent. An ethics ruling published in the AICPA Code expressly provides that a jointly held vacation home can be considered a joint closely held investment and, if material to the covered member, can impair the required independence for attest services (ET §191.184).

In this instance, if F elected to withdraw from the reviewed financial statement engagement, he could prepare a written informed consent documentfor G and the other partners in the partnership to consider and execute. (It is the authors’ belief that the partnership’s tax matters partner (TMP) could waive the conflict on behalf of the partnership for purposes of compliance with Circular 230, although the TMP may be unable to legally bind the partnership for other purposes (see Gateway Hotel Partners, LLC,T.C. Memo. 2009-128, in which the court said the TMP serves as a ­fiduciary).)

Example 3. Multiple clients: H, CPA, prepares the income tax return for XYZ Inc., an S corporation owned equally by F and J. In addition, H provides income tax return preparation services for J but not F. J’s wife, K, with whom he files jointly, is starting a home business in the current tax year, for which she will report a substantial ordinary loss on Schedule C, Profit or Loss From Business (Sole Proprietorship). In the current tax year, F’s wife, L, won $1 million in the lottery. H advises XYZ Inc. to elect to expense $200,000 of certain depreciable assets for the current tax year. (Assume that $200,000 is under the maximum allowable Sec. 179 election limitation.) This election would considerably reduce income tax for F and his spouse, offsetting the overall impact of her lottery winnings, but it would not provide current-year tax benefits for J and his spouse’s business losses. J expects significantly higher personal income in the following year.

Either J or F could view H’s dual roles of advising XYZ and preparing its corporate return, in addition to advising J and preparing his return, as affecting her ability to objectively determine the appropriate elections for XYZ. H needs to determine whether she can maintain her objectivity while serving in both these roles (ET §102-2) and whether she is materially limited from being able to provide competent and diligent representation to XYZ and J (and J’s spouse) (Circular 230, §10.29).

Assume H has become comfortable with her ability to handle the dual representation. H also has determined that, regardless of how she advises XYZ, it is up to XYZ to make the election. She concludes it is within XYZ’s sole discretion whether to elect the amount of Sec. 179 expense deduction H recommends or to elect an amount higher or lower than her recommendation.

Since H has determined that she can fulfill her professional responsibilities, she does not need to obtain written consent from the relevant parties under the Circular 230 rules. Because of a possible appearance of a conflict however, under the AICPA Code, H should inform XYZ of the implications of the election to its owners on their individual returns, make the relevant parties aware of her role as return preparer for both XYZ and J and K, and make it clear that it is XYZ’s decision whether to make the election. The AICPA Code does not require written consent from the parties, but H should document her advice and disclosure and make it a part of her client file so as to avoid any appearance of a conflict of interest.

Example 4. Adverse clients: M is a CPA who has prepared a joint Form 1040, U.S. Individual Income Tax Return, for Mr. and Mrs. N for several years. This year, M receives a call from Mr. N, saying that he and his wife have started divorce proceedings. Mr. N wants to meet with M to discuss preparing a joint return for him and Mrs. N, and to discuss whether any tax positions could help him prepare for what he expects will be a bitter battle with Mrs. N over their marital assets.

The first step in the analysis, as in any potential conflict situation, is to consider whether anyone could view the arrangement as affecting M’s objectivity, or whether M’s service to one client would be materially limited by his responsibility to another. Here, a tax position that is advantageous for Mr. N likely will be disadvantageous to Mrs. N. M therefore will be unable to complete the return with 100% neutrality. Even if he were able to maintain neutrality, that may not be sufficient to meet the objectivity, competency, and diligence standards required by Circular 230 and applicable AICPA and state society professional ethics standards. M likely should not prepare a joint return for the Ns, even if both Mr. and Mrs. N are willing to sign consents.

Suppose the Ns agree to file separate returns for the year, and Mr. N asks M to prepare his. In that case, M’s duty of confidentiality to Mrs. N may affect his ability to provide services to Mr. N (ET §301, “Confidential Client Information,” and IRC Sec. 7216). M is prohibited from disclosing information that is confidential with respect to Mrs. N or using information received from Mrs. N in connection with the preparation of prior-year returns without Mrs. N’s consent. Provided that M believes it is possible to provide competent and diligent service to Mr. N without betraying any of Mrs. N’s confidential information, it would be prudent for M to seek Mrs. N’s consent before agreeing to complete Mr. N’s separate return. A sample of consent language may be found in Exhibit 2. Note if both Mr. and Mrs. N consent to the arrangement, M should also obtain a separate written authorization from Mrs. N to share tax return information under Regs. Sec. 301.7216-3(a)(1).

Conclusion

These scenarios suggest that every CPA tax practitioner must watch for potential conflict situations, regardless of the size or the scope of a practice. Open and direct conversations with clients are necessary to address potential conflicts in fact or in appearance, and it is prudent to document those conversations. When a conflict may have a material impact on a client’s representation, Section 10.29 of Circular 230 requires written documentation of the client’s informed consent. By spotting and addressing conflicts as they arise, a CPA tax practitioner can steer clear of the trouble described in the introduction of this column.