Top 10 Tax Claims
Tax law is extremely complex and despite debate in Congress about fundamentally restructuring the Internal Revenue Code, it has not gotten simpler. The ongoing enactment of new laws, such as the 1997 Taxpayer Relief Act, continues to frustrate taxpayers and CPAs and makes it especially difficult for small and midsize accounting firms--which have fewer resources than large firms--to keep pace with the changes. The IRS and the Tax Court also are more inclined now than in the past to expect practitioners to verify client data before filing returns. The added pressure has led to more frequent and more severe malpractice claims arising from tax planning and preparation. Audit-related suits get media coverage, but most tax-related lawsuits are settled behind closed doors--shielding CPAs from the unfortunate yet educational experiences of their peers. We have culled the 10 most common areas of malpractice litigation from claims covering more than a decade. When combined with CPAs' knowledge of recent tax code changes and awareness of the potential economic impact of large surges and dips in the stock market, this list can steer CPAs away from engagements that pose high risk. THEN AND NOW Based on the claims files of three large U.S. insurance carriers, tax shelter claims were the most common malpractice claims among small and midsize CPA firms between 1980 and 1986, prior to the 1986 Taxpayer Relief Act. A review of claims filed between 1986 and 1993 at another U.S. insurance carrier revealed that estate-tax claims ranked highest in the number of tax-related malpractice suits. We compared the data sets to select the most common ill-fated engagements. We also considered recent tax law changes that could have a future impact on CPA firms. 1 ESTATE TAX In our sample, estate-tax claims were 11.7% of claims filed between 1986 and 1993. The average dollar settlement was $30,043. The most common cause for such claims was the failure to make the qualified terminable interest property (QTIP) election, or making the election when the taxpayer should not have done so. Late estate tax return filing was another major cause for claim. The claims files frequently showed that an attorney had played a large role in a return's being filed late; often, however, the CPA didn't have the documentation to prove this. CPAs should protect themselves by sending return-receipt letters, setting up fax machines to print out confirmations and retaining confirmations that e-mail has been sent. Estate-tax engagements will continue to be a high-risk area for tax litigation, given stock market results over the past several years and substantial appreciation in real estate in certain parts of the country. The 1997 act's new $1 million unified credit exemption should help mitigate the problem, but it will not be fully phased in until 2006. 2 PARTNERSHIP RETURNS The partnership tax return was the second most common cause for malpractice claims, but ranked ninth in settlement size. In one claim, a CPA failed to make an IRC section 754 election on behalf of a partner. A review of that claim showed that not only should a section 754 adjustment in basis have been made, but partnership assets also should have been distributed directly to the partners, instead of the direct sale of partnership interests that took place. These errors cost the firm's insurance carrier $155,000. It is important to remember that partnership asset-distribution rules are complex. CPAs need to do a great deal of analysis before making distribution decisions. Consider the interests of all partners, limited as well as general. In court, CPAs often cannot even produce a copy of the partnership agreement--a document client files should always contain. 3 STATE TAX While state tax return issues ranked third in number of claims, the mean settlement was a relatively low $10,458. A common problem was the failure to make appropriate state elections, especially when they differed from the federal election. …