Virtually all difficult tax practitioner ethical problems arise from conflicts between a practitioner's responsibilities to clients, to the tax system, and to a practitioner's own interest in remaining an ethical person while earning a satisfactory living. These ethical problems come to the fore in the context of Schedule UTP, Uncertain Tax Position Statement, a form introduced six years ago, and now generally applicable to all corporations having year-end assets of at least $10 million per Schedule L of Form 1120, U.S. Corporation Income Tax Return. To understand the ethical problems in the context of Schedule UTP, this column first reviews the advent of Schedule UTP and its purpose and design. It then considers the applicable ethical rules and concludes with some best practice tips and other considerations for practitioners.
Purpose of Schedule UTP in the Framework of the U.S. Tax System
The U.S. tax system depends on voluntary compliance—taxpayers, and not the government, fill out their own returns. Inherent in this self-assessment system—its foundation—is the presumption that a taxpayer will prepare a transparent and forthcoming tax return. Prior to the issuance of Schedule UTP, there was no requirement to disclose uncertain tax positions (i.e., tax return positions taken on the return for which the ultimate outcome is uncertain) if the position was supported by substantial authority, was not a reportable transaction, and was not a tax shelter. As a result, to identify uncertain tax positions, the IRS needed to select a return for examination and expend a substantial amount of effort through its field agents to determine whether a return contained any underlying uncertain tax positions (preamble to REG-119046-10).
To improve tax administration concerning the largest and most complex taxpayers, the IRS released Schedule UTP in 2010, touting it as a principled and balanced approach that would provide earlier certainty for uncertain tax positions, while preserving important taxpayer protections and taxpayers' relationships with their tax advisers and independent auditors (see IR-2010-98, "Prepared Remarks of IRS Commissioner Doug Shulman to the American Bar Association" (9/24/10)). The IRS thus created a tool it could use a priori in selecting returns for examination (with the hope of making field agents' work much more efficient).
What Information Is and Is Not Disclosed on Schedule UTP
Schedule UTP disclosures were intended to be drawn from information used for financial reporting purposes under FASB Interpretation No. (FIN) 48, Accounting for Uncertainty in Income Taxes (now incorporated into FASB Accounting Standards Codification (ASC) Subtopic 740-10) (see IR-2010-13, "Prepared Remarks of IRS Commissioner Doug Shulman to the American Bar Association" (1/26/10)). That financial reporting rule was instituted to address the concern that a diversity of practice had developed with respect to financial statement reporting of tax exposures related to identical uncertain tax positions taken on corporate tax returns.
In line with this financial reporting link-up, a Schedule UTP is filed only when either a reserve is recorded with respect to a U.S. income tax position in a corporation's (or related party's) audited financial statements, or the corporation (or related party) did not record a reserve for that tax position because the corporation expects to litigate the position. Schedule UTP also requires the taxpayer to rank its uncertain tax positions from highest to lowest based on the size of the position, using the federal income tax reserve amounts, which themselves are not disclosed on Schedule UTP. (Uncertain tax positions in the expected-to-be-litigated bucket, which do not have reserve amounts, can be given any rank.) This ranking is designed to make Schedule UTP a more effective examination selection tool.
The IRS pointed out that it purposely chose less disclosure than it might have (under the empowering Sec. 6011 regulations), in choosing not to require a taxpayer to disclose its assessment of the strength of its uncertain tax positions, the amounts it reserved on its books, and its risk assessment analysis or process (see IR-2010-13). Rather, Schedule UTP requires taxpayers to disclose a concise description of each uncertain tax position and the ranking mentioned above. The description must provide sufficient information to identify the issue and the relevant facts and, as noted above, does not require information related to the corporation's assessment of the hazards of a tax position or an analysis of the support for or against the tax position. See the exhibit below for a comparison of a sufficiently concise description to one that is considered insufficient.
IRS Restraints Regarding Schedule UTP
The IRS (T.D. 9510) stated further that Schedule UTP disclosures were not intended to raise questions of waivers of privilege with respect to confidential communications related to the disclosed tax positions, and that it would otherwise retain its long-standing policy of restraint as it applies to tax accrual workpapers (see Internal Revenue Manual (IRM) §126.96.36.199). This policy of restraint, officially called the modified policy of restraint (see IRM §§188.8.131.52.2 and 184.108.40.206.2.1), provides that a document's disclosure to an independent auditor in a financial statement audit will not waive its privilege (i.e., that which otherwise exists under the attorney-client privilege, the Sec. 7525 tax advice privilege, or the work product doctrine).
If a field agent requests "tax reconciliation workpapers," Announcement 2010-76 explains how to redact information related to Schedule UTP. Field agents receive training that Schedule UTP is not intended as a device to shortcut other parts of the examination process and that the IRS exam is not to be an audit of Schedule UTP (IRS, "Remarks of Steven T. Miller, IRS Deputy Commissioner, Service and Enforcement, Before the Tax Executives Institute, Mid-Year Conference" (March 26, 2012), available at www.irs.gov). In general, a protocol for the Large Business and Industry examination team was issued in 2011, reflecting all of the above (see IRS, "LB&I Schedule UTP Guidance" (Nov. 1, 2011) available at www.irs.gov).
Types of Undisclosed Tax Positions So Far
The uncertain tax positions that have been disclosed on Schedule UTP are quite common and relevant to many practitioners. According to the latest UTP statistics (tax year 2013, published April 2015), Sec. 41 (research credit) leads the issues reported and appears on about one-third of the nearly 2,100 Schedules UTP filed; Sec. 482 (transfer pricing) is second, appearing on about 20% of Schedules UTP. Other areas cited include Sec. 199 (the domestic production activities deduction), Sec. 263 (capitalization), and Sec. 162 (trade or business expenses). An average of 2.5 positions have been reported per Schedule UTP. With the threshold of Schedule UTP having been lowered from $50 million to $10 million of end-of-year assets as of tax year 2014, the number of UTP forms filed and positions reported are expected to be higher.
Practitioner Dilemma: The Relevant Ethics
Circling back now to the practitioner dilemma, in terms of risk, 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 when necessary.
The question therefore is, how much leeway does one have as a tax practitioner, given a practitioner's desire and responsibility for acting as a client advocate, given the simultaneous expectation to act ethically by the AICPA Code of Professional Conduct (the AICPA Code) and other ethical authorities, and given that tax law is complicated and the answers are often gray?
While many of the ethics rules emanating from various state boards, the AICPA, and the IRS standards overlap, in practice, a risk-averse practitioner probably complies with the most stringent combination of all of them. Some of these potentially relevant to Schedule UTP are:
- Tax return positions (Section 10.34 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), and Statement on Standards for Tax Services (SSTS) No. 1, Tax Return Positions);
- SSTS No. 2, Answers to Questions on Returns;
- SSTS No.3, Certain Procedural Aspects of Preparing Returns;
- Knowledge of error—return preparation (Circular 230, Section 10.21, and SSTS No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings);
- Information to be furnished (Circular 230, Section 10.20);
- Diligence as to accuracy (Circular 230, Section 10.22);
- Standards in respect of written tax advice (Circular 230, Section 10.37, and SSTS No. 7, Form and Content of Advice to Taxpayers);
- Disreputable conduct (Circular 230, Section 10.51, and AICPA Code §1.400.001, Acts Discreditable Rule);
- Preparer understatement penalty (Sec. 6694): In the case of willful or reckless conduct, the penalty is $5,000 or, if greater, 75% of the return fees;
- Abetting an understatement (Sec. 6701): Penalty for corporate liabilities is $10,000;
- Nonreporting of reportable transactions (Sec. 6707): Penalty is $50,000 ($200,000 for listed transactions or, if more, 50% of gross income from the transaction (75% if intentional));
- Willful delivery/disclosure of fraudulent documents (Sec. 7207): $10,000 penalty ($50,000 penalty in the case of a corporation); one year imprisonment; and
- Conspiracy to commit offense or defraud the United States (18 U.S.C. §371).
Practitioner Responsibilities: The General Framework
Inherent in all of these ethical rules is the general principle that a practitioner cannot ignore actual knowledge and cannot avoid making reasonable inquiries into information (whether provided by the client or a third party) that raises questions (i.e., "don't ask, don't tell" is not permitted under Circular 230, Section 10.34(c), or SSTS No. 1 and SSTS No. 3).
However, the practitioner need not have a subjective belief that the tax position taken on the tax return is sustainable before the practitioner advises the client to take a position on a tax return. Rather, a signing preparer is only required to believe that the standards are met (otherwise, a Sec. 6694 preparer penalty potentially applies).
For a nonsigning preparer, under Regs. Sec. 1.6694-2(d)(3)(ii), it is sufficient for the preparer to advise the taxpayer regarding penalty standards and the ability to avoid them through disclosure and to contemporaneously document that advice. This also accords with Circular 230 (Section 10.34(d)) and SSTS No. 3, respectively.
Specific to Schedule UTP, as with Form 8275, Disclosure Statement, and Form 8275-R, Regulation Disclosure Statement, there is no specific penalty for failing to file Schedule UTP or to make adequate disclosures of uncertain tax positions (although the IRS issues a taxpayer notification when a Schedule UTP contains a description that is not sufficiently concise). Penalties could apply, however, correlative to the jurat for the Form 1120, U.S. Corporation Income Tax Return, the corporate return to which Schedule UTP is attached, which includes the following statement above the officer signature line:
Under penalties of perjury, I declare that I have examined this return, including accompanying schedules and statements, and to the best of my knowledge and belief, it is true, correct, and complete. [emphasis added]
For a practitioner, this jurat applies to the extent of information regarding which a practitioner has knowledge. Accordingly, a Schedule UTP that is knowingly false, incorrect, or incomplete (or missing altogether, when required) would violate this oath and would subject the practitioner to the general gamut of potential civil and/or criminal penalties, including:
- Willful failure to file a return and supply information (Sec. 7203) (however, it is generally viewed as difficult for the IRS to prove "willful failure";
- Filing a false return (Sec. 7206);
- Engaging in tax obstruction (Sec. 7212); and/or
- Showing conspiratorial intent to defraud (18 U.S.C. §371).
Practitioner Approach to Recalcitrant Client Risk
Circular 230, Section 10.34, prohibits a practitioner from willfully, recklessly, or through gross incompetence signing a tax return or claim for refund that the practitioner knows or reasonably should know contains a position that lacks a reasonable basis or is an unreasonable position as described in Sec. 6694(a)(2). Sec 6694 allows for the imposition of a preparer penalty with respect to an understatement due to an unreasonable position. Tax shelters aside, a position is unreasonable if it is undisclosed and there is or was not substantial authority for the position and, if it is disclosed, there is or was not a reasonable basis for the position.
SSTS No. 1 adjures the practitioner to determine and comply with the standards imposed by the applicable taxing authority. At a minimum, the standards require, for an undisclosed position, that the practitioner have a good-faith belief that the position has at least a realistic possibility of being sustained and, for a disclosed position, that the practitioner concludes that there is a reasonable basis for the position. The practitioner may also not recommend a tax return position or prepare or sign a return reflecting a position that either exploits the audit selection process or serves as a mere arguing point. Accordingly, not only should the tax practitioner seriously consider whether Schedule UTP should be included with a return filing (and how the uncertain tax position should then be described and ranked on the Schedule UTP), he or she also must consider the above authorities related to tax positions taken in the return but not included on Schedule UTP.
In addition to considering how to advise a client to comply with Schedule UTP generally, a practitioner also needs to consider situations where a prior return did not contain Schedule UTP. For example, suppose a corporate client has had an uncertain tax position with a reserve in its audited financials, which upon inquiry would seem to be subject to Schedule UTP disclosure but which has not been disclosed on any prior return. The practitioner, now aware of the omission, advises the taxpayer to disclose, but the taxpayer refuses to do so, concerned that such a filing in the current year would raise questions at the IRS regarding prior years' nondisclosures. In this case, SSTS No. 6 nevertheless requires the practitioner to insist that Schedule UTP be prepared and filed in the current year, although such insistence could easily imperil even the most collegial practitioner-client relationship. The SSTSs point out that in such a situation, it may very well be proper for the practitioner to withdraw from the relationship; however, a practitioner who decides to continue with the client must remain steadfast with respect to Schedule UTP disclosures. In any case, this client discussion should be contemporaneously documented in a memorandum to the file.
Practitioner Best Practice: Documentation
In addition to the need to document advice to comply with the various ethical standards, documenting advice is also advisable in protecting against professional liability. In dealing with errors contained in previously filed returns, although a tax practitioner may not be responsible for the original error, after having become aware of that error, the failure to properly notify and counsel the client—or even the inability to evidence such a communication—would potentially violate both Section 10.21 of Circular 230 and SSTS No. 6 and thus could arguably become the basis of a professional liability claim.
In contrast, notifying and counseling the client and documenting that communication would protect the practitioner. In that case, any negative consequences flowing from a client's decision to forgo corrective action, including, for example, a practical inability to obtain reasonable-cause abatements of penalties, would be the client's responsibility and would not generate damages recoverable from the tax practitioner. Given the range of civil (and criminal) penalties that could easily be imposed on a taxpayer where Schedule UTP is viewed as causing an underpayment (e.g., the 75% civil fraud penalty and the accuracy-related penalties), it is conceivable for a client to take aim at the practitioner, and it is therefore advisable for the practitioner to carefully document his or her advice to the client.
Cognizance of Interaction Between FIN 48 and Rest of the Tax Return, and of Other Risks
Since the underlying factors that dictate the need to include Schedule UTP relate back to financial statement reserves, practitioners should consider the potential interaction of the FIN 48 analysis on other parts of a return, and the compliance process. One situation is the expiration of the statute of limitation. Regarding uncertain tax positions for which a taxpayer was required to record a liability under FASB ASC Paragraph 740-10-25-6, the taxpayer is able to record a tax benefit in the financial quarter in which the statute of limitation to assess tax on the uncertain tax position has expired. At that time, the taxpayer would derecognize the FIN 48 liability by recording a current tax benefit, thus resulting in a permanent benefit. But, for example, if a Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations, contains a single minor error in reporting of any required item, that error could bar the company from derecognizing the uncertain tax liability at the end of the ordinary three-year statute of limitation. The statute of limitation would toll with respect to the taxpayer's entire return (see Glunt, "Form 5471: Dispelling Seven Common Myths," 24 J. Corp. Tax'n 1 (January 2013)).
Practice experience indicates that taxpayers also may be stretching to the limit the leeway in determining required disclosures for Schedule UTP, by aggressive application of accounting standards. Because accounting standards allow an exception for accepted administrative practice (which Schedule UTP respects but does not define), some taxpayers have chosen not to book reserves for some positions, have chosen to use the same unit of account (thereby aggregating certain positions with uncertain ones and effectively burying the disclosure requirement), and have ignored positions that they deem are actually either immaterial or as sufficiently certain to the degree where no reserve would be required under financial statement standards (technically referred to as "highly certain").
Other potential conflicts with clients arise when taxpayers argue that filing Schedule UTP is not required when a reserve that was booked to their financials was elective and not required. Taxpayers also might believe it is more likely than not that they may prevail either in settlement or in litigation (i.e., not exclusively in litigation), reasoning that the cheaper settlement route may be actively pursued.
Schedule UTP is now generally applicable to corporations with assets of $10 million or more at the end of the tax year, and the IRS continues to consider whether and to what extent it should extend Schedule UTP reporting requirements to other taxpayers (see Internal Revenue Service Advisory Council 2014 Public Report). The ethical practitioner will learn well the map of risks, ethics, and penalties so as to continue to strike the appropriate balance among them all. Although Circular 230 remains the applicable IRS authority, recent cases have seriously restricted the scope of IRS return preparation oversight authority to the point that some commentators express skepticism that the IRS has the authority to regulate tax return preparation by covered practitioners in the absence of congressional enabling legislation (see Garofalo, "The Application of the Circular 230 Ethical Rules to Corporate Tax Departments," Practical Tax Strategies (Jan. 2016)). While the authors neither agree nor disagree with these commentators, the relevant Circular 230 provisions are included in this discussion to provide completeness for the reader. In the authors' opinion, even if Section 10.34 of Circular 230 applies, the confluence of Sec. 6694 and SSTS No. 1, Tax Return Positions, would guide practitioners to adhere to the higher Sec. 6694 standard of substantial authority for undisclosed positions (since this is a higher standard than that contained in SSTS No. 1), rather than the lower reasonable-basis standard of Circular 230.
Thomas Purcell is a professor of accounting and the chair of the Department of Accounting at Creighton University in Omaha, Neb. Dan Wise is a director in CohnReznick's National Tax office and a tax risk officer. Joe Scutellaro is a partner with CohnReznick in Eatontown, N.J. Prof. Purcell is the chair, and Mr. Scutellaro is a member, both of the AICPA Tax Practice Responsibilities Committee. For more information on this column, contact firstname.lastname@example.org.
Although Circular 230 remains the applicable IRS authority, recent cases have seriously restricted the scope of IRS return preparation oversight authority to the point that some commentators express skepticism that the IRS has the authority to regulate tax return preparation by covered practitioners in the absence of congressional enabling legislation (see Garofalo, "The Application of the Circular 230 Ethical Rules to Corporate Tax Departments," Practical Tax Strategies (Jan. 2016)).
While the authors neither agree nor disagree with these commentators, the relevant Circular 230 provisions are included in this discussion to provide completeness for the reader. In the authors' opinion, even if Section 10.34 of Circular 230 applies, the confluence of Sec. 6694 and SSTS No. 1, Tax Return Positions, would guide practitioners to adhere to the higher Sec. 6694 standard of substantial authority for undisclosed positions (since this is a higher standard than that contained in SSTS No. 1), rather than the lower reasonable-basis standard of Circular 230.