Setting Proper Boundaries With a Clear, Concise Engagement Letter

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

Although tax engagement letters are often the topic of discussion in professional journals and presentations, in many situations CPAs neglect to use this tax management tool. As a result, the importance of reviewing this method to reach an understanding with clients is always relevant. Every CPA (and client) needs to know what is expected of both parties in a professional engagement.

Ralph Picardi, a risk management consultant to North American Professional Liability Insurance Agency ­(NAPLIA), stated in an April 2014 interview with Alexandra Swan of NAPLIA that for malpractice claims against CPAs, “[i]ndustry statistics have generally shown that the largest number of claims comes out of the tax side of the practice, while the highest severity claims come out of the accounting and auditing side of the practice.” Because of the legal cost of defending tax malpractice claims, accountants’ risk management programs need to include a good understanding between both parties to the engagement.

CPAs in practice are constantly reminded by their professional liability carriers to issue engagement letters and request that their clients read them and indicate they understand and accept the terms presented. In professional liability litigation, the first question from the defense attorney is usually, “Did you have an engagement letter?” To help reduce their exposure to malpractice claims, many professional liability insurance carriers will present free risk management seminars, and some include a premium discount for attending. Most of these seminars specifically cover tax services engagement letters.

This column considers the contractual nature of engagement letters. In addition, it addresses some common criteria that should be considered, and terms that should be included in, most engagement letters.

Contractual Status of Engagement Letters

An “engagement letter” is not a “contract”—or is it? An engagement letter can form a basis for an enforceable contract (see “Engagement Letters for the Individual Tax Practitioner,” 217 Journal of Accountancy 32 (January 2014)). However, even if a court concludes that the engagement letter is a contract, only certain terms may become the subject of a malpractice suit. In the cases cited below (Apple Bank for Savings v. PricewaterhouseCoopers, 18 Misc. 3d 1137(A) (N.Y. Sup. Ct. 2008), rev’d, 895 N.Y.S.2d 361 (N.Y. App. Div. 2010), and Tayebi v. KPMG, 18 Misc. 3d 1139(A) (N.Y. Sup. Ct. 2008)), sections of the engagement letter were called into question. These rulings reinforce the importance of careful wording.

Regardless of the contractual status of engagement letters, it is clear that these communications serve the important function of communicating with the client, from the accountant’s perspective, the professional work to be performed, the terms and conditions of performing that work, any limitations on that work, and what the professional expects from the client, including the terms and conditions for payment.

In addition to clarifying the services to be performed in the agreed-upon engagement, the engagement letter can also be used to promote possible related extended services arising from the subject matter that are beyond the specific scope of the engagement and for which the accountant has not in fact been engaged.

Mentioning other, related, extended services that are available strongly implies that these services are not a part of the present engagement as the CPA understands it. A provision excluding all other services except those specifically described should effectively limit the scope of services.

The need to solicit the client’s understanding of, and agreement to, the terms of an engagement letter cannot be overemphasized. As in any business transaction, all concerned parties should understand the expectations of each party as to their contribution in completing the task at hand. All aspects of the engagement should be included. If a formal tax engagement proposal was submitted to the client, the specific obligations usually have already been stated, and the engagement letter operates as an acceptance, with any changes noted, to the terms of the proposal. For this reason, the terms presented in the formal proposal should be reviewed in conjunction with the drafting of the tax engagement letter to reduce any potential misunderstandings. While a proposal can include promotional ideas such as a discussion of how competent the CPA is, the timeliness of the CPA’s service, and other laudatory ideas, the engagement letter should stick to objective criteria. These promotional claims may be useful marketing tools during the engagement proposal process, but they should not be part of an ­engagement letter.

Professional liability malpractice claims may be based on procedural errors, such as late filings or missed elections (e.g., partnership basis step-ups or S elections), but, in the author’s experience, often these procedural responsibilities are not specified, but are left implied in the engagement letter. Obviously, there should be agreement on these matters if they are to become, or could become, part of the engagement. For example, in compliance engagements, someone must actually file the completed return.

The engagement letter should specify whether the CPA engaged to prepare a tax return also will file it for the client or whether the client will be responsible, even though in most cases the client will be required to sign the form. If the CPA will be filing the return (e.g., electronically), there is an implied understanding that the filing will be timely. When a new corporation that will elect S status is formed, someone (the CPA, the attorney, or the client) must file Form 2553, Election by a Small Business Corporation. It is often understood that whoever has this responsibility will complete the filing in a timely fashion. In some engagements, there will be a specific undertaking to do some procedural task on behalf of the client. Thus, it is crucial that the letter include specific procedural undertakings and that there be agreement on who, if anyone, is responsible for performing the specific tasks. If the procedural task is identified but will not be specifically undertaken, it could be included in the listing of additional services not being performed under the agreement, but the agreement can note that the service is available if requested.

Criteria for Engagement Letters

The basic parts of the engagement letter should include:

• The formal, legal name of the client (individual or entity) for which the services will be performed;
• The specific time period or periods for and during which the services will be performed;
• The specifics of what is expected of the client to facilitate the engagement;
• A statement that the CPA is performing the tax services based on the information and records the client provided or from an alternative source, such as the client’s attorney, if that is the understanding;
• A statement of the scope of the work, including any limitations or adverse circumstances known at the onset of the engagement;
• A statement regarding the CPA’s expectations for compensation for the services to be provided; and
• A request for the client to indicate, by his or her signature, the agreement to the understanding outlined in the engagement letter.

These criteria are discussed in detail below.

Identity of the Client

It is critical to specifically identify the client or clients. Sometimes in a tax engagement, any number of entities—corporations or limited liability companies (LLCs)—can be affiliated with one another. In addition, the owners of closely held entities may expect personal services as well as services for their controlled entities. A listing of all entities and any individuals involved in the work requested can prevent misunderstandings. After all parties to the engagement are considered, the balance of the terms and conditions of the engagement letter are easier to describe.

If, in the course of the engagement, additional entities are discovered that may be related to the subject matter, discussions with the client representative should be held to determine whether the new entity should be included, and whether the existing engagement letter should be modified or a new engagement letter should be created. In addition, over the time frame of the engagement, underlying factual changes may necessitate a reconsideration of the original terms of the engagement letter. For example, where a single-member LLC (a disregarded entity) has evolved into a multimember LLC, a separate return would probably be required, possibly with a separation of the transactions that have been commingled with the parent company.

Period Covered

Whenever possible, open-ended engagements should be avoided because they create uncertainty. A properly drafted engagement letter would eliminate this uncertainty. There is a significant correlation between the time frame covered and the scope of services to be provided.

Engagement letters that fail to specify the time period, or only specify one year, create problems with determining the scope as well as other items, such as the billing terms. The usual expectation is that clients will prosper and, thus, increase over time both the scope and the complexity of their tax-related business concerns. This expected prosperity in all likelihood would change the scope of the services to be rendered in the time frame from those included in the initial engagement letter. Therefore, it is important to reconsider every year the changes in the client’s business and the changes in the client’s professional needs. Failure to properly monitor the combination of the time frame and scope may result in “engagement creep,” in which the initial engagement letter becomes totally disconnected from the client’s current professional needs.

In Apple Bank for Savings, a bank filed a lawsuit alleging it received improper tax advice relating to stock buybacks. An engagement letter produced by the bank specified the tax years for return preparation, but the period for which PwC would perform “recurring tax consulting services” was not specific, thus leaving the consulting time period open-ended. Under New York law, a suit alleging professional malpractice was required to be filed within three years of the termination of the engagement. PwC claimed the engagement terminated upon delivery of the tax returns. The court found that because PwC continued, by preparing the bank’s tax returns for subsequent tax years, to advise the bank with regard to the issue for which advice was rendered, there was continuous representation, which prevented the running of the three-year statute of limitation from the date the tax return was delivered.

The N.Y. Supreme Court Appellate Division, however, overturned the trial court’s ruling, stating that the trial court “erred in finding that the statute of limitations was tolled under the continuous representation doctrine.” The court went on to say that PwC “never had any express, mutual agreement to advise plaintiff on the effect of the stock buyback, after the original advice.” Nonetheless, the case illustrates the contentious and expensive litigation that can result when an engagement letter is vague as to the scope and time frame of services. 

In Tayebi, the defendant, KPMG, was found to have provided inaccurate tax advice with regard to a tax shelter and failed to inform its client, Sean Tayebi. The period covered by an opinion letter was left open. KPMG claimed that the delivery of an opinion letter ended the engagement. The engagement letter stated that “unless you specifically engage [KPMG] to do so in writing, we will not update our advice for subsequent changes or modifications to the law and regulations.” The running of the three-year statute of limitation was tolled, since KPMG was engaged in continuous representation.

Ruling in favor of Tayebi’s continuous representation argument, the court stated that the engagement letter included language “indicating that the parties may have contemplated further services” pertaining to the tax shelter transaction that were the subject matter of the lawsuit. The court determined that “it was only as to updates about changes in the laws and regulations that KPMG was excluding from its future services,” and the language “hardly indicates an intent by KPMG to disassociate from plaintiffs’ ” future transactions.

The only issues for which the engagement was considered ended were for changes in the law and regulations; the engagement constituted “continuous representation” for other services. Thus, it is very important to state specifically the time periods for which services are being rendered and the point at which the engagement is concluded.

Expected Client Responsibilities

The engagement letter should not only express the CPA’s obligations in performing tax services, but should also describe the data and other items of information that the CPA can expect the client to supply to facilitate completion of the engagement. In addition to what is needed from the client, the engagement letter can set out the details (e.g., statements of wages, interest and dividends, and securities brokerage statements) of specific information and data sources that are needed. If the CPA uses tax organizers, the expected completion of that form should be included. For a business entity, the list of possible data sources, while extensive, usually includes general ledgers, journals, bank statements, property acquisition and disposition information, and depreciation and other schedules.

To meet filing deadlines for tax returns and other time schedules for completing the services outlined in the engagement letter, a timetable for clients to provide information for which they are responsible should be included in this section. This should also include alternatives if these schedules are not met, such as the filing of an extension request for the tax return. Listing these obligations reinforces with the client that his or her active participation is essential for the CPA to timely complete the engagement.

Reliance on Client Records and Assurances

In the engagement letter, the CPA should specify the extent to which he or she will rely on the client’s records to prepare the tax return or perform other services as a part of the engagement. Clients should be informed that client records are usually accepted at face value, and that the accuracy of the monetary amounts, as well as the underlying facts supporting a transaction, is the clients’ responsibility. While clients should be able to rely on their CPA for the application of the tax laws, the engagement letter should include an affirmative statement that clients are responsible for the accuracy of all information provided.

Scope of Services

Properly drafted, engagement letters are considered contracts, so certain provisions within the engagement letter may be referred to in litigation over a client’s (or most likely a former client’s) claim of professional malpractice. The scope of services to be provided is one area that is of particular relevance to both sides in a lawsuit. The plaintiff would likely argue that the particular services were covered in the scope of services specified in the engagement letter, while the CPA would likely claim that he or she was not engaged to perform the service that the plaintiff alleges was either omitted or performed incorrectly.

Not all services that might eventually be performed can be anticipated at the commencement of an engagement. During the course of the engagement, it may become necessary to address the need to prepare additional related-party tax returns, delinquent returns, and payroll and property tax returns. In these cases, addendums or revisions to the original engagement letter may become necessary, or a new engagement letter may need to be prepared. Continuous comparison of the services being rendered to those specified in the original engagement letter can greatly improve the management of the engagement.

As previously pointed out, not only is it important to describe what services will be performed, but also which services will give rise to additional fees. Services that require additional fees need to be listed so the client cannot claim that a particular service was included under the terms of the engagement letter presented. Since the CPA is a professional with significantly more knowledge and experience in considering the scope of a tax engagement, it is reasonable to expect that the CPA would have the burden of considering these details.

An engagement letter should also describe services that may become limited if certain situations arise that would, or could, create conflicts of interest. A good knowledge of the client’s business can help with determining which items should be included. All limitations on the CPA firm’s services or responsibilities should be described. If there is any missing information of which the client is aware, it should be documented in the engagement letter so that the client acknowledges these limitations.

Fee Arrangements

Clients must understand the extent of their financial responsibilities to the CPA. The engagement letter should explain the fees in a way that makes them predictable depending on the services rendered and include a formula for computing fees that is easy for clients to understand. If these basic rules are followed, the client should not be charged an excessive amount based on the work performed. Keeping clients abreast of the amounts that will be due can greatly reduce problems with collecting fees. A “no surprises” approach to billing is an effective method for helping clients feel as if they are being treated fairly. Charges should be estimated upfront with assurances that any changes to the initial estimate will be disclosed when discovered and that the client will have an opportunity to discuss or negotiate any changes to the fee structure. Additional fees for additional services are much easier to collect when clients are not surprised with an unexpected invoice at the end of the job.

Common methods for billing include some combination of a fixed fee, hourly charges, or a charge for each type of tax form completed. It is important for the fee arrangement to also address reimbursement for the CPA’s out-of-pocket expenses, if appropriate. The fee section of the engagement letter might also address the timing of billing, expected payment dates, and any methods for resolving disputes.

Acceptance by the Client

A properly drafted engagement letter should require that the client sign and return the letter as a confirmation that he or she has read, understood, and agreed with the terms therein. The signed engagement letter should be obtained before the CPA begins the work. If the signed engagement letter is not received before the work commences, a certified letter, with a return receipt, might be sent to the client requesting immediate return of the signed engagement letter. This certified letter might indicate that if the engagement letter is not signed and returned, the CPA will assume that the client agrees with the terms of the engagement letter. A signed engagement letter is always better than a negative confirmation. The size and complexity of the tax services engagement, as well as the fees involved, should dictate the degree to which the CPA will seek positive confirmation of the engagement terms.

Summary

Best practices in the performance of tax services support the use of engagement letters in almost all engagements. If properly prepared, the engagement letter allows the CPA and the client to have a good understanding of all facets of the engagement. Furthermore, it mitigates any potential confusion over the services rendered, prevents unnecessary professional liability lawsuits, and promotes timely collection of fees.