Tax Return Processes: The Intersection of Due Diligence and Quality Control

CPAs are in the midst of another filing season: sending out tax organizers and engagement letters, receiving (they hope!) an influx of client information, implementing recent tax law changes, using tax research services, keeping computer systems operational and current, checking data security, and overseeing staff and personnel as they follow office procedures and processing practices for client data and tax returns.

These processes seem normal since many CPAs have been doing the same things year after year, and they are routine to everyone involved in the process. Many times, CPAs associate the concept of due diligence with matters that arise during actual return preparation, and they think of quality-control issues as arising before and after return preparation. However, these two practice concerns actually overlap from before returns are prepared through delivery of returns to clients and beyond. Many practice matters become ethical matters during an engagement.

This column explores the interrelationship of ethical and practical considerations that start before client data come into the office and continue after the return is e-filed or a hard copy is delivered to the client for filing. Ideally, these practice management and ethical responsibilities are best addressed before the start of filing season, but even in preparing and filing returns, CPAs must be aware of these considerations and the need to adhere to ethical standards.

CPAs have to consider the relevant standards and pronouncements issued by both the IRS and the AICPA. Some are mandatory; others are not mandatory but would be considered best practices, and liability insurers suggest that firms comply with them. These standards include:

• Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10) (available at irs.gov/pub/irs-pdf/pcir230.pdf).
• AICPA Code of Professional Conduct (the AICPA Code) and its answers to frequently asked questions (FAQs) (the searchable AICPA Code is available at pub.aicpa.org/codeofconduct).
• AICPA Statements on Standards for Tax Services (SSTSs), Interpretations 1-1 and 1-2, and the FAQs (available at www.aicpa.org); and
• Statement on Quality Control Standards (SQCS) No. 8, A Firm's System of Quality Control (available at www.aicpa.org).

Circular 230

Many sections of Circular 230 concern the processes involved in the planning and preparation of tax returns. These include:

• Section 10.22, Diligence as to Accuracy;
• Section 10.33, Best Practices for Tax Advisors;
• Section 10.34, Standards With Respect to Tax Returns and Documents, Affidavits, and Other Papers;
• Section 10.35, Competence; and
• Section 10.36, Procedures to Ensure Compliance.

Recent judicial decisions have questioned IRS authority to regulate return preparers. Questions have arisen on whether these decisions extend to CPAs only engaged in tax return preparation services in comparison to CPAs who also represent clients in IRS examinations. CPAs will have to monitor their individual practice, court decisions, and IRS announcements concerning these topics.

CPAs should already be familiar with Section 10.22:

(a) In general. A practitioner must exercise due diligence —

(1) In preparing or assisting in the preparation of, approving, and filing tax returns, documents, affidavits, and other papers relating to Internal Revenue Service matters;

(2) In determining the correctness of oral or written representations made by the practitioner to the Department of the Treasury; and

(3) In determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.

It is important to recognize that the ethical duty in Section 10.22 is all-inclusive in the tax return process. Exercising due diligence begins in the planning and preparation stages of return preparation and continues through the actual preparation and review of tax returns. For example, the choice of questions to include in tax organizers and other information requested of taxpayers to be furnished to the CPA for preparing the returns is a matter of due diligence. These questions should help the CPA identify areas that may require special attention and additional due diligence in preparing the return. A CPA who notices during the filing season that some organizer questions are unclear or are not eliciting the intended information should consider modifying the organizer at that time or supplementing it to acquire the desired information.

Similarly, the other sections of Circular 230 mentioned above are part of the overall tax return process and quality control, and they should be considered by practitioners in planning for filing season and in conducting return preparation and review. For example, a CPA who notices that some internal tax practice oversight processes are not as effective as anticipated should consider modifying or changing them to ensure they comply with Sections 10.34 and 10.36 of Circular 230.

AICPA Code of Professional Conduct

The current version of the AICPA Code of Professional Conduct became effective Dec. 15, 2014. Members should be familiar with these sections of the Code that would affect all engagements, including tax engagements:

• Section 1.100.001, Integrity and Objectivity Rule;
• Interpretation 1.110.010, "Conflicts of Interest," of Section 1.100.001, Integrity and Objectivity Rule, for members in public practice; and
• Section 1.300.001, General Standards Rule.

These complement similar sections in Circular 230 and reinforce the necessity for due diligence and quality control throughout the tax return preparation process.

AICPA Statements on Standards for Tax Services

The SSTSs are enforceable standards for all AICPA members in both public practice and industry and are meant to complement and expand on matters not covered in Circular 230 and statutes and regulations. The standards are intended to assist members in all tax matters—federal, state, local, and international. SSTS No. 1, Tax Return Positions; SSTS No. 2, Answers to Questions on Returns; SSTS No. 3, Certain Procedural Aspects of Preparing Returns; SSTS No. 4, Use of Estimates; SSTS No. 5, Departure From a Position Previously Concluded in an Administrative Proceeding or Court Decision; and SSTS No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, all should be considered in the preparation of current and amended tax returns. Interpretations 1-1 and 1-2 provide additional authoritative guidance.

Nonauthoritative FAQs have been and continue to be developed by the SSTS Guidance Task Force (sponsored by the AICPA Tax Practice Responsibilities Committee) in response to questions that were presented during the SSTSs' public exposure period and since that time in administering them. The FAQs are available on the AICPA website.

SQCS 8, A Firm's System of Quality Control

AICPA principles of quality control are outlined in SQCS No. 8, A Firm's System of Quality Control. While they are not mandatory in tax practice, these principles provide guidance for tax practitioners on quality control.

Before the Return Preparation Process

A common misconception is that due-diligence and quality-control considerations apply only during the return preparation process. In reality, the exercise of due diligence and quality control starts well before the firm works on its first return of filing season.

Each practice unit has to prepare for filing season in such ways as choosing tax return preparation software, evaluating tax research systems and materials, reviewing filing procedures, revising engagement letters, and training and assigning staff. The exercise of due diligence and quality control comprises all of these activities. As previously indicated, Sections 10.35 and 10.36 of Circular 230 require the exercise of quality control in all these office procedures and practice management steps.

A practice unit that does not have tax return preparation software necessary to prepare returns for all clients or that does not have access to adequate research tools would in all likelihood not meet the requirements of Sections 10.35 and 10.36 of Circular 230. The Patient Protection and Affordable Care Act, P.L. 111-148 (as amended by the Health Care and Education Reconciliation Act of 2010, P.L. 111-152), and its provisions, including the net investment income tax, additional Medicare tax, and individual shared-responsibility payment, reinforce the need for adequate preparation software to serve all clients. Complex financial products and client transactions create the need for adequate research material to determine the tax effects of these items.

Additional practice management procedures to consider include:

• The use of checklists;
• Engagement letters customized for client needs;
• Client acceptance and retention policies;
• Procedures for rendering and documenting oral advice;
• Procedures to ensure confidentiality of client tax return information (e.g., Internal Revenue Code Sec. 7216); and
• Adequate knowledge by staff to serve client needs.

Tools to assist practice units in these considerations that are available on the AICPA website include:

• 2015 Annual Compliance Kit, available at www.aicpa.org; and
• Due Diligence in Tax Services; Guidelines for Conflicts of Interest in the Performance of Federal Tax Services; and Overview of the Federally Authorized Tax Practitioner: Client Privilege Under IRC Sec. 7525, which are available to AICPA members on the Tax Ethics & Professional Standards webpage at www.aicpa.org.

The use of engagement letters is not only a common procedure, but, in recent years, it has been stressed by liability insurers. Effective letters, customized to the particular engagement situation, clearly delineate the responsibilities between practitioner and client. A sometimes overlooked aspect of the engagement letter is specifying when the engagement will be treated as concluded and what continuing responsibility, if any, the CPA will undertake at that point. Some firms indicate in engagement letters that the engagement ends with either the completion of the e-filing process or delivery of the return to the client.

The Return Preparation Process

The two most important factors in the tax return preparation process are engagement performance and human resources. Engagement performance will vary according to firm size and will include the following factors:

• Planning of the engagement.
• Supervision and review. For sole practitioners and small practice units, this is especially challenging. Outside tools such as checklists should be considered.
• Documentation of the items included in the return or other filing. Substantiation of such items as listed property, extension estimates, taxpayer elections, and answers to questions on the returns.
• Communication of the results to the client.
• Determination whether outside expertise is needed to conclude the engagement.
• Proper maintenance of the documents and findings of any research.

In terms of human resources, the tax practice must ensure both that it has adequate staff to complete engagements and that the personnel in place either have or are being trained to acquire the technical skills to meet the needs of the practice. Obviously, staffing adequacy is a critical consideration that should be addressed before accepting any engagements.

Although all tax personnel should be familiar with Circular 230, the SSTSs, and the penalty provisions of the Internal Revenue Code, it is especially incumbent on the CPA responsible for managing the tax practice to monitor processes to ensure these ethical and penalty rules are being followed.

While all the standards referenced in this column can apply in return preparation engagements, it is crucial that CPAs are sensitive to the fact that in tax return preparation, the CPA generally is advising clients to take tax return positions by including items on tax returns. In addition to common tax return positions, such as the deductibility of travel and entertainment expenses, some additional examples of tax return position situations include:

• Making an inquiry of the taxpayer and putting the answer on the tax return;
• Providing advice to a taxpayer based on information furnished by the taxpayer and entering the information on a tax return;
• Deciding to answer (or to not answer) specific tax return questions.

Before putting the information on the return and signing it as the preparer, the CPA must be satisfied that the appropriate standard has been met (e.g., under SSTS No. 1, a realistic possibility of success, unless the taxing authority has a higher standard, such as substantial authority for federal tax matters). In addition, the engagement is specifically for tax return preparation, and the CPA must exercise the necessary due diligence expected under the penalty provisions of the Internal Revenue Code, especially Sec. 6694. The applicable preparer of an item on a return could be subject to preparer penalties as a consequence of negligence in the exercise of due diligence and in advice furnished to the taxpayer.

After the Return Is Filed

The need for due diligence and quality control continues after the return is filed. Federal and state laws concerning retention and confidentiality of tax return information must be followed. Careful consideration should be given to the security of paper and electronic documents. Engagement letters may specify that copies of return documents will be retained for only a certain number of years. Document destruction policies should be adopted and strictly followed.

In terms of practice management, after the crush of busy season, office practices and procedures should be analyzed to assess whether they are sufficient and whether modifications should be made before the next filing cycle. Engagement letters, checklists, filing instructions, and other forms and frequently used documents should be scrutinized for problem areas that arose during the preparation process. Of course, during the latter part of the year, when specific new issues that will affect the next preparation and filing season are identified, these processes need to be reexamined to ensure they are current.

Perhaps an overlooked aspect of the preparation engagement is tax planning opportunities that are presented by the taxpayer's situation. The CPA should consider creating a planning workpaper or file for ideas that are suggested by preparation and review of the client's tax return. Once the filing engagement is completed, the CPA can then approach the client with these ideas while both the return and the facts are at the forefront of both the CPA's and the client's minds. The AICPA website includes a Tax Practitioner's Toolkit (available at www.aicpa.org) to assist members in elevating their practices.

Summary

The tax return process—prefiling, return preparation, and post-filing—requires considerable professional time for practice units of all sizes. While the above considerations may seem burdensome at first, the efforts to conform to due-diligence and quality-control processes are not only a professional imperative but also an opportunity for enhanced professional service quality.