Failure to advise clients (or providing improper advice) is the most frequent cause of claims in the AICPA Professional Liability Insurance Program. Often, these disputes are a result of scope-of-service disagreements between firms and their clients. Engagement letters are the first and most critical line of defense against scope-of-service claims, helping to prevent claims by establishing clear responsibilities and managing client expectations as well as defending against claims by defining the scope of services and establishing limitations on the services to be provided to a client. Using engagement letters is also associated with reducing the severity, i.e., the dollar amount, of claims (see "Professional Liability Spotlight: Setting Expectations," JofA, Oct. 2017, tinyurl.com/ybybahpx; see also "Professional Liability Spotlight: Overcoming Obstacles to Engagement Letter Use," on page 14). Unfortunately, small firms and sole practitioners are the least likely to regularly use engagement letters.
While firms may be reluctant to send multiple-page engagement letters to clients (the sample AICPA letter for individual clients is eight pages, with an additional eight-page addendum of terms and documents) and may have difficulty getting clients to sign and return the letters, best practice standards in Section 10.33 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), require "[c]ommunicating clearly with the client regarding the terms of the engagement."
LIMITING SCOPE OF SERVICES
Engagement letters should be used to limit the scope of services by specifying the returns and other services for which the firm is responsible. It is just as important to specify the services for which the firm is not responsible. For example, a firm may want to include language regarding whether bookkeeping services required to prepare a tax return are included in the engagement, or whether the firm will prepare partner or shareholder basis schedules as part of an engagement. Firms should generally exclude from a compliance engagement any tax consulting and tax planning, as well as correspondence with taxing authorities, and use separate letters for those services if a client requests them.
Care should be taken to specify the client taxpayer or taxpayers to which the engagement services are being provided, particularly if an individual taxpayer has an ownership interest in business entities or trusts. Separate...