Imagine this scenario—after many years of pursuit, a CPA finally lands the income tax preparation work for a key prospect. During preparation of the current-year return, the CPA discovers the client's former preparer claimed the domestic production activities deduction under Sec. 199 on nonqualifying income. Furthermore, the former preparer did not include an addition modification for bonus depreciation on the client's state income tax return. Both errors resulted in a significant understatement of taxable income.
Obviously, the client will be less than thrilled with this news and, although the CPA may not be enthusiastic about telling a brand-new client that she owes additional federal and state tax for prior years, the CPA is bound by professional responsibilities. So what is the next step? Since the CPA did not prepare the erroneous returns, can he just "let sleeping dogs lie" and not inform the client? Under both Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), and professional standards, the answer is clearly "No."
Many CPAs have likely experienced this situation, or perhaps they have discovered an error on a previously filed return that they prepared. In either case, Section 10.21 of Circular 230 requires a practitioner who knows that the client has made an error in, or omission from, any return, affidavit, or other document submitted under the revenue laws of the United States to advise the client promptly of the error or omission. As a practitioner, the CPA also must advise the client of the potential consequences of the error or omission.
Furthermore, as an AICPA member, the CPA is subject to Statement on Standards for Tax Services (SSTS) No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, which also requires the CPA to notify the client of the error or omission and potential consequences. Additionally, SSTS No. 6 requires a CPA to recommend to the client the corrective measures to be taken. Under SSTS No. 6, a CPA may provide the notification and recommendation orally or in writing, but this communication is required only if the error or omission is significant. However, Circular 230 does not provide an exception for materiality. Regardless of whether the CPA provides this communication orally or in writing, the communication may not be protected by accountant-client privilege and, therefore, could be subject to discovery in litigation. Legal counsel should be consulted for matters involving potential litigation.
While a tax practitioner and AICPA member has a duty, as described above, to notify the client, the client is responsible for deciding whether to correct the error. The CPA is not required to inform the IRS or other taxing authorities of the client's error and can only do so with the taxpayer's permission, unless otherwise required by law. If the client decides not to correct the error, SSTS No. 6 advises the CPA to consider whether to terminate the client relationship, as it could indicate issues with the client's integrity. The CPA may also consider withdrawing from the engagement if the tax return cannot be prepared without perpetuating the error made on the prior-year return.
The exhibit below provides a summary of the rules under both Section 10.21 of Circular 230 and SSTS No. 6.
SSTS No. 6 FAQs: Practical Guidance
An SSTS Guidance Task Force—made up of Tax Practice and Responsibilities Committee members—drafted frequently asked questions (FAQs) for various statements in the SSTSs. The purpose of the FAQs is to address questions presented during various public exposure periods in the SSTSs and additional questions raised since that time in administering them. The FAQs are not authoritative and are meant to provide practical guidance to assist members in analyzing various fact patterns that arise in practice. In addition to the SSTSs and the related FAQs, members should also consider the requirements of the IRS, other tax regulatory bodies, and state boards of accountancy, as those rules may differ from AICPA rules.
The FAQs for SSTS No. 6 (available at www.aicpa.org) were posted on June 27, 2016. This column summarizes the three FAQs drafted by the task force for SSTS No. 6.
FAQ No. 1: Insignificant Effect
A member exercises professional judgment to evaluate the existence and impact of an error or omission. The significance of the error or omission must be considered. SSTS No. 6 provides that "an error does not include an item that has an insignificant effect on the taxpayer's liability." However, as previously noted, Circular 230 does not have a similar materiality threshold for an error. FAQ No. 1 lists the following criteria for members to consider when evaluating the significance of an error or omission:
- The amount of the item affected by the error in comparison with the amount of other items on the return;
- The effect on taxable income and tax liability;
- The effect of the item on prior and future returns; and
- The nature of the item and possible adverse consequences that result from the nature of the item (e.g., interest from a foreign bank account).
FAQ No. 2: Taxpayer Representation
FAQ No. 2 addresses the scenario where a member is representing a taxpayer during a federal tax examination, and during the course of drafting a response to an information document request, the member discovers a deduction was overstated.
- Question A: What is the appropriate course of action when the member determines the overstated deduction is insignificant? On this point, SSTS No. 6 and Circular 230 are not consistent. Circular 230 does not have a materiality threshold; therefore, as this is a federal tax examination, the member should inform the taxpayer of the error and the consequences of the error.
- Question B: What is the appropriate course of action when the member determines the overstated deduction is significant? SSTS No. 6 and Circular 230 are consistent regarding a significant error or omission: The member should inform the taxpayer of the error and the consequences of the error. In addition, in accordance with SSTS No. 6, the member should recommend the corrective measures to be taken.
- Question C: What should the member do when the overstated deduction is significant and the taxpayer will not allow the member to disclose the overstated deduction to the taxing authority examiner? SSTS No. 6 provides that it is the taxpayer's responsibility to correct or disclose the error. SSTS No. 6 also provides that the member should take reasonable steps to ensure the error is not repeated. Where a taxpayer does not take appropriate action—in this case, disclose the error to the taxing authority—the member should exercise professional judgment, consider the facts and circumstances, and follow other applicable professional standards when considering whether to withdraw from representation of the taxpayer and whether to continue the professional relationship with the taxpayer. Paragraph 10 of SSTS No. 6 also provides that a member should consider consulting with his or her own legal counsel before continuing the representation of the taxpayer where potential conflicts arise.
FAQ No. 3: Impact on Current-Year Return
FAQ No. 3 considers a fact pattern where a taxpayer had net operating losses (NOL) in the early years of the taxpayer's business. Upon review of prior-year returns, the member discovers the taxpayer erroneously expensed loan costs that should have been capitalized and amortized. Had the loan costs been capitalized and amortized in prior years, the taxpayer would still have been in a loss position.
The member informs the taxpayer of the errors, and the taxpayer states he does not want to amend the previous years' returns because there would be no tax impact. How should the member prepare the current year's return with respect to the loan costs previously expensed? SSTS No. 6 provides that the member should take reasonable steps to ensure that the error is not repeated. The member should also determine whether the deduction is a "method of accounting" requiring IRS consent to change. If IRS consent is not required, the current-year return should be prepared, reflecting the correct treatment of the loan costs for the current and prior years. For example, the NOL carryforward would be corrected for the prior years' amortization, and the current-year return would properly reflect the current-year loan amortization amount.Conclusion
In the course of providing tax services, there likely will be instances where a CPA discovers an error, omission, or missed filing. As a member of the AICPA, a CPA can find guidance on the appropriate standard of conduct in SSTS No. 6 and Circular 230, Section 10.21. In addition, the FAQs present practical guidance to AICPA members by addressing scenarios CPAs may encounter in practice.
In summary, if in the course of his or her work a CPA discovers an error, omission, or missed filing, professional standards require the CPA to promptly inform the client of the error, the impact of the error, and the corrective measures to take. If the client does not take action as advised, the CPA should evaluate the engagement, consider whether to continue representing the client, and consult legal counsel as necessary. While documentation of required action is not required, the CPA should always exercise professional judgment in determining what documentation is prudent where notification and advice are provided orally. While such conversations may be difficult, they are not only required, but are also critical in maintaining the AICPA standards of high integrity and professionalism.
This column represents the views of the authors only and does not necessarily represent the views or professional advice of KPMG LLP or BKD LLP.
The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with a tax adviser.
Heidi Ridgeway is a director of Tax Practice Policy & Quality at Grant Thornton LLP in Chicago. Lea Fletcher is a partner with the Risk Management—Tax Practice at KPMG LLP in Philadelphia. Jesse Palmer is a partner and director of Tax Quality Control at BKD LLP in Springfield, Mo. Ms. Ridgeway, Ms. Fletcher, and Mr. Palmer are members of the AICPA Tax Practice Responsibilities Committee. For more information about this column, contact firstname.lastname@example.org.