Most accountants perform at least some tax work, so it’s not surprising that the majority of professional liability claims against accountants are in the tax arena.
“The higher-dollar claims against accountants are in the financial statement area, but the opportunity for tax claims is greater,” said Ron Parisi, of Orchard Accounting and a former insurance company executive. “But there are a lot of ‘black and white’ errors. The consequences and penalties can be calculated almost immediately, as opposed to the true value of damages on fraud and audit. The legal concept of ‘proximate cause’ can link damages with the breach easier on tax than in audit cases.”
Parisi cautions that due to Internal Revenue Service resource constraints, tax matters are taking longer to resolve. “This is driving up costs and expenses, and consequently CPAs should be cognizant of their deductible and the limits on their professional liability policy,” he said.
“Once a mistake comes to light, try to amend the return,” he said. “Work with the IRS to abate penalties or restructure a transaction. [Private letter rulings] are very expensive and take a long time. The resolution of tax issues takes longer and drives up the cost.”
The IRS is taking a closer look at nonprofits, Parisi noted. “Their Form 990s usually have a different deadline [the 15th day of the fifth month after the organization’s accounting period ends]. Practitioners often miss these.”
LATE, AND LIABLE
The most common mistake accountants make giving rise to liability is simply late filing, observed Bill Thompson, president of CPA Mutual. “Late filing is especially prevalent in the estate area,” he said. “For whatever reason, CPAs don’t file the estate return on time, and the penalties are pretty large. “Then there are CPAs that tend to dabble in some areas they’re not familiar with, such as Code Section 1031 [‘like-kind’] exchanges. They just don’t handle it correctly because they haven’t done it before.”
Allowing time to run out on a year in which there was a return error is also a common mistake, according to Thompson. “We have a situation where the CPA could have prepared the return incorrectly and they let the deadline pass for refiling the return. When the statute of limitations expires, the IRS considers it a closed year, which would prohibit the CPA from refiling the tax return correctly and getting a refund for overpaid taxes.”
“These mistakes — late filing and allowing the statute of limitations to expire on a prior year in which there were errors — can be avoided pretty easily,” advised Thompson.
“Far too often, our loss prevention specialists receive calls close to a filing deadline asking for help to disengage from a client who has put them at risk by failing to provide the necessary information for a return to be prepared on time,” said Randy Werner, loss prevention executive at Camico. “The client’s failure may even include failing to provide the information to complete a year’s worth of bookkeeping which will then be used to prepare returns. If a client has previously exhibited behavior that indicates they will not have their information to the CPA in a timely manner or have not paid on an outstanding account balance, we recommend that the CPA either enforce their stop-work clause in their engagement or write what I call a ‘drop-dead’ letter, which is a pre-disengagement letter indicating the problem the client needs to resolve, such as payment, providing information, or merely contacting the firm for a further consultation. The letter should include a drop-dead date by which the client must comply or the CPA will disengage. However, this must be done well before the due date to allow the client sufficient time to obtain the services of another tax preparer and thereby reduce the risk of a claim against the CPA. This is good defensive documentation in the event of an actual claim.”
“CPAs are often buried in their work during the tax season and often don’t recognize or acknowledge a potential claim as it is developing,” she said. “This has been an ongoing issue for CPAs and is particularly devastating when the damages claimed are significant and the CPA is denied professional liability coverage because of late reporting.”
“CPAs need to pay more attention to potential issues and report to their carriers as soon as they think there may be a problem with their services,” she said. “We are now offering ‘continuity of coverage’ which permits much later reporting by a CPA who has consistently renewed with us even if that CPA knew of a potential claim but did not report it until the client makes an actual claim months or even years later.”
HOT SPOTS
“The primary reason tax is the most frequent claim is that there is more tax work being performed by CPAs across the country than any other type of service,” said John Raspante, senior vice president and director of risk management for NAPLIA. “We represent many carriers, and they all report between 55 to 60 percent of claim activity against accountants arise out of tax engagements,” he said.
“There are more audits now, and there is a direct relation between audits and claims,” he said. “When audits are quiet, claims are quiet. When audits go up, there’s an upward trend in claims, because the client thinks it’s the accountant’s responsibility.”
For example, Raspante observed, a preparer might list the taxpayer as a real estate professional on the return, but the IRS successfully contends that the taxpayer is not a real estate professional. “When allowable real estate losses are now unallowable, the client’s reaction is to hold the accountant responsible for advising him on the matter.”
“And of course, the Tax Code is very complex and it’s not getting any easier,” he noted. “With that comes the challenge of being a tax preparer.”
Issues with the FBAR, or Foreign Bank and Financial Accounts report, are still prevalent, according to Raspante. “The IRS hasn’t let go of the issue,” he said. “CPAs have a great deal of exposure to risk in this area, and they’re getting more of the blame for clients not complying with FBAR reporting. This area is growing both in frequency and severity of claims.”
Naturally, insurers would much rather avoid lawsuits than successfully defend them, observed Frederick Fisher, president of Fisher Consulting Group Inc., which specializes in professional risk management. “There are basically two models. The first is to strictly do taxes based on what the preparer has been provided by way of documentation. The second is to give advice and offer tax planning. That’s the better model, but it also gives rise to more claims arising out of the services provided.”
“Plaintiffs rarely if ever get tax owed as part of damages, because tax is a debt,” he said. “The damages arising out of lawsuits against tax preparers are normally confined to fines, penalties and interest.”
“There are dangers that lurk in policies on the street. They’re not standardized, and they’re loaded with ‘gotchas,’” he said. “What you think is covered may not be. The key to protect yourself is to be well-documented.”
“Document everything,” agreed Gary Shendell, CPA, Esq., a partner at Shendell & Pollock. “The six most common words plaintiffs suing their CPA/tax preparer say during their deposition are, ‘My accountant never told me that!’ Usually followed by, ‘Had I known that, I would have acted completely differently!’”
When CPAs become mired in the preparation of taxes and meeting deadlines, other important parts of their practice may suffer, Camico’s Werner observed. “In particular, it is good risk management for CPAs to document significant interactions with their clients contemporaneously no matter now busy the CPA is with their practice,” she said. “Those important telephone calls should be documented as contemporaneously as possible and then placed in the client’s file.”
TOO TRUSTED?
“The most challenging claims to defend against CPAs acting in a tax preparation role involve assertions that the tax preparer was aware of information from the client but took an inconsistent or aggressive position on their return, often contrary to the client’s explicit verbal instructions,” Shendell said. “If a preparer’s file does not contain copies of the information originally provided, plus letters documenting key communications regarding significant decisions or instructions, it is difficult to defend these claims. If a preparer cannot substantiate what information was received by the client, then it will be an issue for the jury to decide.”
“Keep the ball in the client’s court,” he advised. “Claims regarding failing to file a return or to file a return on time typically devolve into finger pointing over who is at fault. Sadly, once a return is filed late, any reason that the CPA provides comes across as self-serving. Plaintiffs’ counsel frequently point to the CPA’s Web site advertising that the CPA is a ‘trusted advisor’ and then turn to the jury to ask why a trusted adviser would not follow up with their loyal client in writing to tell them they had to act in order to avoid filing late and incurring penalties. If your client has not provided you with sufficient information to prepare their return or is non-responsive to requests for additional information, make sure you advise them in writing that their return cannot be timely prepared without further action on their part.”
“We always advise our CPA tax preparer clients to have a detailed engagement letter and place a deadline on their clients to return the necessary information to prepare their returns. If you send an engagement letter and tax planner to your client and they fail to return it, have you impliedly agreed to file their extension? One CPA’s client thought so. When the IRS penalized him for failure to timely file his return, he threatened a civil and professional responsibility complaint against his CPA. He argued that because he had been a multi-year client who always filed an extension and never previously signed an engagement letter, he and his CPA had an implied contract to file the extension. The litigation that ensued could have been avoided if the engagement letter had clearly stated that no activity on the client’s file would be undertaken by the accounting firm unless, and until, the signed retainer was returned.”
Ricard Jorgensen, president and chief underwriting officer at Jorgensen & Co., a professional liability and risk management consulting firm, agreed: “The key issue is to secure an engagement letter or some form of signed acknowledgement regarding the scope of services. Otherwise, CPAs leave themselves open to allegation for risks beyond the scope of a relatively conventional tax assignment. We have seen tax preparers pulled into defalcation claims because the CPA failed to clarify the scope of the assignment. Even where the scope of services is obvious, stating in writing what you are not going to do can avoid a lot of grief in the long run.”
“Of course, the evolving cyber-exposure and theft of your clients’ data, resulting in the filing of a bogus tax return, is an increasing problem,” Jorgensen cautioned. “Take nothing on face value — treat all client instruction e-mails with suspicion until physically verified. Don’t open that e-mail offering you a free cruise to the Bahamas, and conduct background checks on all new hires. Many thefts of client data are ‘inside jobs,’ according to the FBI. It’s a cyber jungle out there!”
