Advising clients regarding erroneous tax return positions.

• Author: Baillif, Michael E.

Tax practitioners occasionally uncover or otherwise become aware of errors in the previously filed tax returns of their clients. As a general rule, tax practitioners in such situations should lose no time in communicating news of the error to the client. This general duty is embodied in rules applied by both the AICPA and the IRS. Nevertheless, principles governing this duty are often far easier to articulate in theory than they are to apply in practice.

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To begin with, the scope of the duty and the extent of the obligations it places on practitioners are by no means clearly delineated, particularly in the gray areas that sometimes confront even the most scrupulous and ethical of tax practitioners. Moreover, the sheer brevity of the general rule, which appears straightforward on its face, all but requires practitioners to look beyond its letter in many cases and be governed by its spirit to arrive at an interpretation that reconciles reasonable administrability with rational professional conduct.

This first part of a two-part article begins by examining the two somewhat different versions of the rule on advising clients regarding erroneous tax return positions--one applied by the AICPA and the other by the IRS. The article then considers how these rules (which this article refers to collectively as "the Rule") should be applied, both generally and in those particularly sensitive circumstances in which the error may be attributable to the tax practitioner's own advice. Part II of the article, in the July issue, will discuss what practitioners should do when clients fail to heed their advice; other practical considerations; and what to do when the error is attributable to the tax practitioner's own advice.

Background of the Rule What Does the AICPA Generally Require?

The most comprehensive set of standards guiding the actions of tax practitioners who identify an error in a client's previously filed return is enunciated in the AICPA Statement on Standards for Tax Services (SSTS) No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings. This standard specifically applies to tax practitioners who are members of the AICPA, most of whom are CPAs. Nevertheless, the standards have much broader applicability, both in their persuasive authority and their power to create industry norms, which directly or indirectly establish the general parameters within which tax practitioners operate.

Specifically, SSTS No. 6 states in relevant part:

A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer's failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken. (1) The explanation of SSTS No. 6 contemplates that an error in a previously filed return will be discovered by a tax practitioner "[w]hile performing services for a taxpayer." (2) Nevertheless, the standard applies "whether or not the member prepared or signed the return that contains the error." (3) Thus, the scope of SSTS No. 6 is relatively broad. (4)

The standard's coverage, however, is somewhat narrowed by the stipulation that "an error does not include an item that has an insignificant effect on the taxpayer's tax liability." (5) SSTS No. 6 grants a fair amount of leeway in this context, explaining, "Whether an error has no more than an insignificant effect on the taxpayer's tax liability is left to the professional judgment of the member based on all the facts and circumstances known to the member." (6)

What Does Circular 230 Generally Require?

The Treasury Department on behalf of the IRS in Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), likewise has articulated standards governing situations in which tax practitioners discover an error in the previously filed tax return of a client. These standards, which are set forth in Circular 230, Section 10.21, are directly applicable to virtually all tax practitioners with respect to federal tax practice. This is the case because Circular 230 generally governs the activities of all professionals practicing before the IRS, with "practice" currently defined so broadly as to encompass not only the representation of clients in front of the IRS but also the preparation of clients' tax returns for submission to the IRS. (7)

While SSTS No. 6 is by no means verbose, Circular 230, Section 10.21, provides such a terse directive with respect to the discovery of an error in the previously filed return of a client as to make SSTS No. 6 appear encyclopedic by comparison. Section 10.21 states in its entirety:

A practitioner who, having been retained by a client with respect to a matter administered by the Internal Revenue Service, knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return, document, affidavit, or other paper which the client submitted or executed under the revenue laws of the United States, must advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission. The guidelines of Circular 230, Section 10.21, are direct and straightforward, leaving little latitude for doubt or interpretation. Nevertheless, room for substantial uncertainty remains at the margins, which is precisely where the questions that try practitioners' souls--and livelihoods--typically are presented.

Differences in Approach Between SSTS No. 6 and Circular 230

Certainly, the basic terms of SSTS No. 6 and Circular 230, Section 10.21, are similar and the principle behind them is the same. Both provisions generally desire and direct that a tax practitioner, once aware of an error in the previously filed tax return of a client, promptly inform the client of that error.

However, from this common starting point, the provisions then follow somewhat different paths. As mentioned above, SSTS No. 6 establishes a materiality threshold in identifying an error and leaves the definition of "material" to the discretion of the tax practitioner. By contrast, no such de minimis provision exists under Circular 230, which by its literal terms demands that upon discovering a $5 error on the return of a multibillion-dollar corporate client, the tax practitioner must immediately disclose it, even if the client likely would have little interest in the disclosure. Circular 230 grants the tax practitioner no discretion in this context.

Interestingly, however, Circular 230, Section 10.21, adopts a somewhat lighter tone regarding the extent of the follow-up advice that tax practitioners must provide in connection with the disclosure of the erroneous position. It simply directs that "[t]he practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission."

On the other hand, SSTS No. 6 not only mandates that the tax practitioner inform the client regarding the consequences of the error but also that the practitioner recommend the corrective measures to be undertaken. (8) Moreover, if the client declines to adopt the corrective measures recommended by the practitioner, SSTS No. 6 suggests that the practitioner contemplate disassociation from the client:

If a member is requested to prepare the current year's return and the taxpayer has not taken the appropriate action to correct an error in a prior year's return, the member should consider whether to withdraw from preparing the return and whether to continue a professional or employment relationship with the taxpayer. (9) Accordingly, given the de minimis rule of SSTS No. 6, its provisions will apply somewhat less universally than those of Circular 230, Section 10.21. Nevertheless, where they both come into play (which will be most of the time in the federal tax practice of an AICPA member), SSTS No. 6 may well require more of the tax practitioner than its Circular 230 counterpart.

Definitional Distinctions Between the Two Standards

SSTS No. 6 provides that the term "error" includes a position taken on a prior year's return that no longer meets the accuracy standards "due to legislation, judicial decisions, or administrative pronouncements having retroactive effect." (10) In contrast, Circular 230, Section 10.21, does not provide a definition of "error" or "omission," and its text is silent on whether awareness of a retroactive change in the law affecting a client triggers any professional responsibility on the part of a practitioner.

In addition...