Week Fourteen

Professional Responsibilities in Tax Practice

The Nature of the Work

US fiscal system is built around taxes on individual and corporate income, levied by both Fed and state govt's, with an additional Federal tax on labor income to fund "social security" retirement system. The administrative burden is primarily on taxpayers themselves, rather than government. Tps must keep records and file periodic reports ("returns") that calculate tax liability. These get cross-checked against other reports from the payors of various items. Most wage payments have some tax withheld at the source by the employer, deposited with the Treasury and credited towards the employee's liability. Third party reporting in combination with wage withholding means that direct government enforcement can be limited to spot-checking: less than one out of 100 individual tax returns is looked at by a Revenue Agent, and only one Tp in 60,000 gets prosecuted for criminal evasion in any given year. There are always some opportunities for fraud and error, but official estimates put the US "tax gap" at a low 14%, meaning that the system we have brings in 86% of what perfect total compliance would yield, while administration costs the government only about 1% of what's collected.

Since the introduction of the income tax in 1913, the rules for determining liability have become enormously complicated. They link the goverment to a complex economy where hundreds of millions of taxpayers engage in billions of transactions having many shapes and forms. In addition to raising revenue, the tax laws have also become a favorite way to implement policies or politics so as to subsidize some and penalize others, while the interaction of so many intertwined rules creates unintended consequences -- loopholes and traps. The Tax Code has been called "software written by lawyers."

Such a system naturally offers work for specialists who assist and represent the many sorts of Tps whose lives are affected by the government's need for revenue. But Tax is not a profession. It is an area of practice where several career types co-exist and sometimes collide. The range is very wide. Tax work includes the part-timers entering data at an H&R Block franchise in a low-income neighborhood so that poor, hard-working customers can claim tax benefits to help their families (the EITC). Tax work also includes the well-dressed suits in high office towers who spend their waking hours structuring corporate equity reduction transactions as "A" reorganizations so as to avoid the Section 172(b)(1)(E) restrictions on net operating loss carrybacks.

The types of practice

Q: Who can legally prepare an income tax return for someone else. A: Anyone.

Q: Who can legally prepare an income tax return for someone else for pay? A. Anyone, except in CA and OR.

Q: Who can prepare for pay in CA?

According to the CTEC there are still about 10,000 illegal tax preparers in CA

Q: Are there any things that all paid preparers must do? A: Yes. Put their i.d. number on the return, sign it, give a copy to the client, keep a list of clients, and be diligent in screening for EITC eligibility. Tax Code Sec. 6695.

Q: Who can represent others as agents in dealing with the IRS? A: Attorneys, CPAs and Enrolled Agents. The standards of practice are set forth in Circular 230, issued by the IRS Office of Professional Conduct.

Q: Do preparers and representatives have to verify what their clients say?

A: "A practitioner advising a client to take a position on a tax return, document, affidavit or other paper submitted to the Internal Revenue Service, or preparing or signing a tax return as a preparer, generally may rely in good faith without verification upon information furnished by the client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete." Circ. 230 Sec. 10.34(d):

Why Accurate Returns Matter: the Penalty Regime

The Problem

low audit rates => returns understating tax have a good chance of not being caught. Especially for some types of income, like cash business proprietors, that don't involve withholding or 3rd party reporting.

Tax shelters: Fake deals sold by reputable names. According to a US Senate committee report:

"The investigation found that by 2003, numerous respected members of the American business community had been heavily involved in the development, marketing, and implementation of generic tax products whose objective was not to achieve a specific business or economic purpose, but to reduce or eliminate a client’s U.S. tax liability. By 2003, dubious tax shelter sales were no longer the province of shady, fly-by-night companies with limited resources. They had become big business, assigned to talented professionals at the top of their fields and able to draw upon the vast resources and reputations of the country’s largest accounting firms, law firms, investment advisory firms, and banks.

"This report focuses on generic tax products developed and promoted by KPMG, PricewaterhouseCoopers, and Ernst & Young, auditors and tax experts comprising three of the top four accounting firms in the United States….Each of these products generated hundreds of millions of dollars in phony paper losses for taxpayers, using a series of complex, orchestrated transactions, structured finance, and investments with little or no profit potential..”

The Response

Add-on penalties for those who are caught -- both taxpayers and preparers -- so as to deter others. Problem, tho: the law may be ambiguous, non-existent or cryptic [it's called the Internal Revenue Code for a reason], and there will be honest mistakes. So there is a need to distinguish between tax return positions that are "fully defensible if completely exposed" and those that are simply wrong or stretch too far. In last 25 years, Congress has struggled to find the right words to express this difference in a law that is capable of everyday administration. There have been many changes in the standard of correctness.

Taxpayer penalties: Sec. 6662

Preparer Penalties Today: Sec. 6694 (as amended 10/08)

If return understates tax, in part due to an "unreasonable position" known to preparer, then penalty = 50% of what preparer earned from the return (w/ $1,000 minimum), unless preparer shows reasonable cause and acted in good faith.

A "position" is "unreasonable", unless:

  • if "tax shelter", it's "more likely than not" to be sustained on the merits. (Note that FIN 48 interpreting FASB 109 uses this standard for recognizing income tax uncertainties on financial statements. More here and here.)
  • If not tax shelter, it's disclosed and has a reasonable basis, or
  • It's not disclosed, but is supported by substantial authority.

Reasonable basis is a relatively high standard of tax reporting, that is, significantly higher than not frivolous or not patently improper. The reasonable basis standard is not satisfied by a return position that is merely arguable or that is merely a colorable claim." Regs. 1.6662-3(b)(3)

"The substantial authority standard is an objective standard involving an analysis of the law and application of the law to relevant facts. The substantial authority standard is less stringent than the more likely than not standard (the standard that is met when there is a greater than 50-percent likelihood of the position being upheld), but more stringent than the reasonable basis standard... The possibility that a return will not be audited or, if audited, that an item will not be raised on audit, is not relevant in determining whether the substantial authority standard is satisfied." Regs. Sec. 1.6662-4(d)(2)

Before 2007, the preparer standard was realistic possibility, which according to the IRS meant:

"A position is considered to have a realistic possibility of being sustained on its merits if a reasonable and well-informed analysis by a person knowledgeable in the tax law would lead such a person to conclude that the position has approximately a one in three, or greater, likelihood of being sustained on its merits (realistic possibility standard). In making this determination, the possibility that the position will not be challenged by the Internal Revenue Service (e.g., because the taxpayer's return may not be audited or because the issue may not be raised on audit) is not to be taken into account..."(Former Regs. Sec. 1.6694(b)(1))

So what is "substantial authority"? Kleuner v. Comm'r case

The Future of the Profession

Some General Trends

The "death of bookeeping" and the rise of the machine

Data-management technology replacing the medium-skill jobs. What's left is low-end data entry and hi-level data interpretation

The instability of independence

"Independence" is the key to auditing, and what distinguishes it from advocacy. Are auditors really less independent today than in the past? Can an auditor be a "free professional"? Does an auditor add or subtract value from the firm being audited?

The triumph of "best practices"

In order to audit effectively, a firm must develop some sort of database of business 'best practices'. Over time, this database is likely to become more valuable than the audit practice which it supports. Aren't consultants more valuable than auditors?

Is Accounting still a "Profession"?

Does the linkage of audit and accounting - as in the Moore case and the Cal Board of Accountancy CPA requirements -- still make any sense? How long until "regulatory capture" comes to the PCAOB? What's left of a "free profession" when standards of conduct and public obligations are not set internally, but are defined by an external political process?

The Audit Industry: Position and Momentum

Discussion of our research summaries

Concluding thoughts

Notes (c) 2008 Robert H. Daniels