Conflicts of interest: A practical approach for small firms

Editor: Stephen P. Valenti, CPA

Tax practitioners are required by both the AICPA Code of Professional Conduct and Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), to screen for and address conflicts of interest related to professional services. It is prudent for even small firms to have a policy in place to identify and deal with potential conflicts because Circular 230 holds tax leaders within a firm responsible for establishing procedures that ensure firm members comply with the rules. While Circular 230 applies only to practice before the IRS, the AICPA standards apply for all professional services. Additional local or jurisdictional rules may apply.

When conflicts are readily apparent, they have to be dealt with, but there are also circumstances in which practitioners have an affirmative duty to seek to discover potential or actual conflicts. This means that even if the conflict is not self-evident, the practitioner should take steps to determine whether a conflict might exist presently or arise later. Such situations are most likely to present themselves when the firm is onboarding a new client; firms should take steps to ensure that there is not a conflict with an existing client or the staff or firm itself.

It can be difficult for practitioners to identify what circumstances rise to the level of a potential or immediate conflict of interest. Specific circumstances might not be addressed in the standards or the examples provided in additional guidance. Circular 230, Section 10.29(a), states that a conflict of interest exists if the representation of one client will be directly adverse to another client or 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, to a former client, or to a third person, or by a personal interest of the practitioner.

The guidance in the AICPA standards, found here, falls under the “Integrity and Objectivity Rule” (ET §1.100.001), which states that a practitioner shall be free of conflicts of interest and maintain objectivity and integrity. Since the standard does not fall under the “Independence Rule” (ET §1.200.001), which can never be waived, it is possible for some conflicts of interest to be waived and for the engagement to continue.

Categories of conflict

The AICPA divides conflicts into three general categories: adversarial conflicts, transactional conflicts, and relational conflicts.

Adversarial conflicts occur when two clients of the firm have directly opposing interests in a matter. The firm cannot provide adequate representation regarding the matter to both clients because the representation of one client will necessarily harm the other client. This type of conflict generally cannot be waived by consent.

Transactional conflicts are present when the firm is representing two clients who are involved in the same transaction. If the nature of the transaction is not directly adversarial, the conflict may be waived with informed consent. The conflict may change during the course of the transaction, becoming adversarial in nature and therefore nonwaivable.

Relational conflicts arise when the clients have a relationship of some sort, either through marriage, co-ownership of a business, or another existing relationship. The practitioner’s relationship with the opposing clients may give the appearance of impaired objectivity on the part of the practitioner, and the clients should be properly advised and consent should be obtained.

Practitioners must use professional judgment to determine whether there is a conflict of interest in a given situation, taking into account whether a reasonable and informed third party who is aware of the relevant information would conclude that a conflict of interest exists. Additionally, the AICPA standards take into account whether the perception of a conflict of interest may exist. Given these standards, when might a conflict arise?

Common conflicts

Examples of common conflicts in a smaller firm environment include:

• A couple for whom the firm has filed a joint return is going through a divorce:
  • The practitioner’s knowledge of each spouse’s financial situation could affect the integrity or objectivity of advice.
  • The spouses may have directly conflicting interests, such as an innocent-spouse claim or opposing interests in how a deduction is claimed.
• An entity and multiple owners of the entity are the firm’s clients:
  • Owners may have opposing interests in elections made at the entity level.
  • Owners may have disputes with opposing interests.
• A client is selling a portion of their business to an existing or potential client:
  • The buyer and seller may have opposing interests in classification of the sales price or in the valuation of the assets.
  • The firm has a vested interest in retaining the work after the sale.
• The firm has multiple clients in the same industry with competing interests or who are in direct competition with each other:
  • Confidential knowledge of a client’s business may affect the advice given to another client in that industry.
  • The client may perceive the objectivity of the practitioner to be compromised.
• A client is in litigation or anticipates litigation with another client:
  • Either client may request forensic accounting engagements for data to be included as part of the litigation.
  • The client may perceive the objectivity of the practitioner to be compromised.
• Multiple members of a family are clients:
  • The firm has confidential data that should not be disclosed to related parties.
  • Related parties may have opposing interests in matters.
• The firm or firm staff members enter into a business relationship with a client (i.e., leasing office space to the client, investing in an opportunity with the client, or selling an asset to the client):
  • The firm may have opposing interests on reporting and elections.
  • The client may perceive the objectivity of the practitioner to be compromised.
• A tax return prepared for a client is audited:
  • The client’s defense may include improper representation by the firm.
  • The client may perceive the practitioner’s objectivity to be compromised since the firm has an interest in defending the practitioner’s work.

Conflicts involving new clients

As demonstrated by the above list of common conflicts, conflicts of interest can occur both in the acceptance of new clients and in the changing circumstances of existing clients, so firms should have policies in place to identify potential issues in both scenarios. The process for identifying conflicts arising from new client engagements is often easier to manage through set policies during the onboarding stage. The act of accepting a new client engagement can be the evaluation trigger for determining conflicts between the new client and existing clients.

For smaller firms, the onboarding process can include a step, prior to the start of any new engagement, to discuss the possible acceptance of a new client during weekly management meetings. Alternatively, small or moderate-size firms may prefer to handle the matter through written submission of potential new clients for weekly evaluation by other team members. Client managers with intimate knowledge of their clients’ businesses and activities are the most likely members of the firm to be able to identify potential conflicts between new and existing clients. This issue is more difficult when a firm acquires a new practice and accepts a large number of new clients with little knowledge of the clients and their activities; special care should be taken in this situation before beginning any work for the new clients.

In addition to considering all existing clients when accepting a new engagement, the firm should consider whether a former client or former engagement may cause a conflict with a potential client. Practitioners may have confidential knowledge of a former client’s activities or business practices that could impair integrity or objectivity in the engagement with the potential client. Duties to a client related to confidentiality of data survive both the termination of the engagement and the termination of the client relationship, and the perception of the former client as to existence of a conflict is still a consideration.

Existing clients with new conflicts

The entire firm should be involved in identifying conflicts that arise with clients after the onboarding process. When a staff member recognizes a current conflict or becomes aware of a potential conflict, such as a negotiation for the sale of a business or a married couple going through a divorce, the staff member should alert the management team so that they can determine what steps to take. A firm’s policy for the identification of conflicts as they arise should include educating all staff members regarding circumstances that may trigger a conflict. Senior members of the firm should take continuing education classes to keep the firm apprised of updated standards and should regularly discuss conflicts of interest with the staff to keep members vigilant in watching for potential conflicts.

Mitigating conflicts

When a conflict or potential conflict is identified, the firm should evaluate the threat to the individual practitioner’s and the firm’s integrity and objectivity. Is the threat to principles of professional conduct at an acceptable level taking into account the third-party standard, which looks at whether a reasonable and informed third party would conclude that the practitioners are compliant with the rules governing integrity and objectivity? If the threat is not at an acceptable level, are there safeguards the firm can put in place to bring the threat to an acceptable level? Some potential safeguards a firm might consider are:

• Segregation of data to ensure confidentiality: Separate the location of the relevant data and limit access to the client files to staff members who are working on that engagement.
• Segregation of professionals working on the engagements, if the firm is large enough to differentiate the specialties of the engagements: Assign the conflicting clients to separate professionals and build an information barrier so that the professionals are not aware of the decisions and advice given to the opposing client or of the information received from the opposing client.
• Policies and procedures limiting access to client data, especially in the case of related parties: Put policies in place to ensure that clients do not have access to confidential data related to an opposing party or a related party.
• Regular review of safeguards by a senior member of the firm not involved with the client or the engagement: Conduct manager-level review to determine if the safeguards that were discussed have been implemented and are continued throughout the engagement.
• Review of the work by a senior member of the firm not involved in the engagement to determine the appropriateness of the judgments or conclusions: Act as an independent judge of whether the conclusions would be appropriate if the conflict did not exist.
• Consultation with legal counsel, ethics or professional boards, or another CPA: Receive independent verification of the ability to waive the conflicts and act with integrity and objectivity.

If the practitioners cannot implement sufficient safeguards, the firm should consider declining or terminating the engagement and not proceeding with the work.

Consent

Even if safeguards can be implemented or it is determined that the current threat level is acceptable, clients should be notified of the conflict and be required to give informed consent for the work to continue. The nature of the conflict and level of threat to the practitioner’s integrity and objectivity will impact the type of notice required. Threats that are at an acceptable level without the implementation of any safeguards may only require a general notification if that is deemed sufficient in the practitioner’s professional judgment.

For instance, the firm can notify clients that the firm serves multiple clients in any given industry and therefore may have a client’s direct competitors as other clients, without disclosing the clients’ names or notifying existing clients every time the firm accepts a new client in that industry. Such a general notification may be disclosed in the engagement letter and informed consent given by the client through the signing of the engagement letter.

Conflicts that require additional safeguards generally require a more specific disclosure. The disclosure must be enough to allow the client to give informed consent regarding the conflict. For such an informed decision to be made, the client has to know the nature of the conflict and how that conflict will be handled, including what safeguards will be implemented to maintain integrity and objectivity. The firm members should be cautious to avoid disclosing confidential information during these discussions.

Circular 230 is in the process of being revised, with updates expected in the near future, but it currently requires written consent to waive a conflict of interest on federal tax matters. While the AICPA guidelines still allow for verbal consent, the best practice in such matters is to have all waivers in writing and signed by all involved parties. The AICPA has sample waivers included in the guidelines released in 2015 here. Practitioners should consult with legal counsel to determine what wording is appropriate for specific uses.

If the client is unwilling to give consent to waive the conflict of interest, the firm should either change the circumstances surrounding the conflict in order to obtain consent or consider terminating the client or the engagement. Possible changes that could make the client comfortable giving informed consent would be to alter the safeguards, apply additional safeguards, terminate a portion of the relationship, or dispose of the relevant interest. If consent still cannot be obtained, the practitioner should consider terminating the relationship or the engagement subject to the conflict.

Firm policies regarding conflicts

In addition to obtaining the written waiver, firms and practitioners should document all discussions members of the firm have with clients regarding the potential conflicts, the safeguards being implemented within the firm, and the information relayed to the clients in the efforts to obtain informed consent. Clients may minimize potential conflicts while everything is going well and they are profiting, but when problems arise, the conflict may become a matter of great importance to them. This may lead to professional liability claims, which are best refuted by contemporaneous written documentation.

Firms should also have written policies for identifying and processing conflicts of interest, including verification of signed informed consent before accepting or continuing engagements. These policies should be revisited at least annually for updates, ideally after a continuing education class attended by a senior member of the firm, or whenever a situation occurs to warrant a policy update. This policy should be available to all staff with regular reminders to watch for, identify, and escalate conflicts within the firm. The AICPA is in the process of updating the Guidelines for Conflicts of Interest in the Performance of Tax Services and is expected to release them in 2022; these guidelines are a valuable resource and should be shared with all staff members. In addition, the firm’s professional liability insurance provider may be a good resource for templates of written policies and waivers, as written policies and informed consent are best practices for reducing professional liability.

Another cornerstone safeguard against professional liability claims related to conflicts of interest is clear identification of the client and the work to be provided. Clients, especially those of smaller firms, may develop a mentality of “you’re my tax guy,” believing that the firm or the practitioner can and will handle everything that arises without consideration of the possibility of conflicts. Specific engagements naming the client (such as which LLC member the firm represents) and the work agreed upon (such as preparation of tax returns but not identification of tax planning strategies) will help define where conflicts may arise.

Practitioners who have ignored or who have been unaware of the issues surrounding conflicts of interest should evaluate their current policies and their current engagements. They should take affirmative steps to implement changes that are consistent with best practices for handling conflicts of interest. Firms should also evaluate existing client relationships to identify potential issues and determine the appropriate course of action moving forward. It is important to address any identified conflict immediately, before an issue emerges, whether through obtaining waivers, altering the engagement, or terminating the client relationship.

Summary of best practices

Here is a summary of best practices related to conflicts of interest:

• Draft an engagement letter defining the client and the work involved and disclosing general conflicts.
• Have written policies to identify and resolve potential conflicts, and revisit the policies frequently.
• Provide continuing education and training for the entire firm.
• Require contemporaneous documentation of any conflicts, safeguards, and communications regarding these matters with the clients.
• Obtain written, informed consent from clients to waive any conflicts of interest.