An insider’s look at avoiding ethical violations

Ethical dilemmas can occur at any time during the career of a tax practitioner. Sometimes, the practitioner doesn’t even know they did anything wrong. As a former IRS Office of Professional Responsibility attorney, cases just like that would come across my desk.

A vast majority of these cases came from simple misunderstandings of ethical responsibilities — practitioners were not aware they were violating Circular 230 or the practitioner just had a bad day and made a one-time mistake. Review these stories and learn a little more about how easy ethical violations can happen if you aren’t paying close attention. (Note: details have been changed to protect the privacy of those involved).

When an engagement letter becomes an opportunity for tax evasion.

One case that comes to mind involves a practitioner who performed a lot of tax controversy work as a solo practitioner. While he maintained a best practice of using engagement letters, a major issue occurred in each of his engagement letters when representing clients to resolve corporate tax debt. He used a standard engagement letter he found somewhere online that disclosed a tax debt action plan. This action plan stated that he would help close the client’s corporation, re-open a new corporation for the client and request the IRS close the case on the old corporation as “Currently-Not-Collectible – Defunct Corporation.”

This is known as creating alter-egos and can be seen as a tax evasion technique.

This case was originally referred to the OPR from IRS collections. After OPR requested additional engagement letters under Circular 230 section 10.20, it appeared he was using similar language in most of his engagement letters for this type of representation.

The practitioner didn’t understand what he put in his engagement letters. After discussion with the practitioner, we found he didn’t actually utilize that action plan in most situations. While it was a best practice by the practitioner to utilize engagement letters, the better practice is to not only use them, but read them and have an understanding of what they disclose before providing them to a client.

The AICPA Tax Section has a variety of engagement letters to help guide you. And for more on how engagement letters can land you in hot water, check out this blog post about when engagement letters help, and when they can hurt.

When lack of due diligence lands you in hot water.

Each year a CPA prepared the tax returns for a Schedule C construction business that was the only reportable income on the client’s Form 1040. And each year, the business would run $100,000 or so of losses with a minimal amount from non-cash expenditures.

The practitioner would only report the 1099-MISCs the client received as gross receipts. For the year that came under IRS scrutiny, the tax preparer reported only about $50,000 of gross receipts from the 1099-MISCs. Upon audit, the actual gross receipts were closer to $200,000.

Unfortunately, the practitioner did not perform due diligence by questioning the gross receipt totals, despite there not appearing to be a source of funds to support the large losses each year. The business could sustain these losses for several reasons — such as the client receiving a large inheritance or gift — but the practitioner never questioned the client on funding sources for these large cash losses.

When credit card receipts don’t tell the whole story.

A similar situation deals with Form 1099-K, which only captures credit card receipts and not any cash receipts. Practitioners often fail to look at the 1099-K reported amount, and instead consider the industry and make an analysis of whether the gross receipts cash to credit card ratio makes sense.

For example, a fast food restaurant received a 1099-K for $99,000. On the fast food restaurants return, they report gross receipts of $100,000. This means, the restaurant received $1,000 in cash, or alternatively, one percent of sales were in cash. This percent appears low for the industry, so the practitioner should question the client about gross receipts and the low cash to credit ratio, then document his conclusions.

“Practitioners cannot ignore facts that don’t make sense.” This is usually known as willful ignorance. One of the best examples of ignoring facts deals with hobby losses. Practitioners will frequently prepare tax returns for multiple years where a sole proprietorship or other entity will generate a loss year after year. The practitioner often fails to review the past several years of tax returns to see if losses were generated in prior years. While it is fine to prepare a tax return with an entity that has had losses for several years, it’s the practitioner’s responsibility to use due diligence and consider the activity under the hobby loss rules and document their conclusion.

To help with these situations, practitioners should lookout for what the IRS refers to as “LUQs:” Large, Unusual or Questionable items, on tax returns. Anything that appears to be a LUQ on a tax return would require documentation on the position the practitioner uses.

Where to go to learn more

While practitioners can make ethical mistakes without even realizing it, there are common sense measures they can take to reduce the chances of making them. Review these AICPA resources to help stay on top of IRS procedures and rules, communicate with the IRS and resolve IRS account issues.

Nick Preusch, CPA, JD, LLM, tax manager, PBMares, LLP. Nick is a member of the AICPA Tax Practice Responsibilities Committee.

An insider’s look at avoiding ethical violations

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