CPA Responses to Gray Areas in the Tax Codes
May 02, 2007
Scott Phillips
The topic for this paper, as the title suggests, concerns gray areas in the tax codes. In preparing for this topic, I spoke to three practicing CPAs. Each has over 10 years of experience and has prepared countless personal and business tax returns. Over the course of their practice, each practitioner has encountered situations where the tax laws were unclear. Each person has likewise developed their own ways of assessing how to handle the situation.
Before continuing on, I must stress that this essay deals with tax situations that arise for which the rules are ambiguous or non-existent. Some areas are more undefined than others, and thus are open to more interpretation. As such it is up the CPA to determine how much exploitation of the gray area is acceptable. These ethical considerations DO NOT apply to situations involving outright fraud or to situations where the law is clear and the tax preparer chooses to ignore it. Each CPA interviewed here adamantly stressed that undefined gray areas are NOT equivalent to fraud, and that advising clients to claim deductions that they don’t qualify for is a violation of law as well as ethics.
“Real World” Gray Areas
Gray areas in the tax code appear because technology and society move faster than government. Questions routinely arise concerning areas such as “the deductibility of rental income” as well as how independent contractors deduct mileage. These questions are settled usually through one of three methods [Wikipedia: Administrative Law]: 1) IRS rulemaking procedures (guidance, administrative rulings, etc), 2) Court rulings (administrative tax court and civil court), and 3) Legislative action. Naturally the more income one has and the more economic activity a person creates, the more likely they are to run into unsettled questions.
CPA Tax Responsibilities
Personal and business tax returns make up a large portion of a private CPA’s core business. The practitioner must sort through a myriad of regulations, administrative courts, and various agency rulings. It can at times seem very similar to practicing law (and in many states, it is treated as a legitimate practice of law without a license). The agencies that govern tax returns include (among others) The IRS, administrative tax courts, various state-level taxing authorities, and American Institute of Certified Public Accountants (AICPA).
Some the problems come into play beginning with the AICPA’s core value statements. The AICPA’s core tenet is that the CPA is an advocate for his client [AICPA Website]. As such, the CPA’s duty “is to arrive at the legal minimum tax possible in accordance with all professional and legal standards.” [RIGOS Loss Prevention Manual] Furthermore, AICPA says that the CPA must “have a good-faith belief that a controversial tax position will be sustained if questioned under audit.” So the CPA must work not just as an advisor, but as an advocate of the client that is trying to secure the lowest amount of tax owed possible. But at the time statement the CPA has a code to uphold concerning “questionable” deductions. It is easy to see how it these two core tenets could be in conflict very quickly.
Interestingly, the CPA is under no legal or professional obligation to verify the validity of a client’s claims. For example, the law says that if an independent contractor wishes to take a deduction for miles driven, then he must keep records. The law is specific as to what records would be required to support the claim. Yet in situations where the law requires documentation for a deduction, the CPA is not required to review these records or even to confirm that they even exist. Rather the AICPA guidelines require only that the CPA “should make appropriate inquiries to determine to his or her satisfaction whether such conditions have been met.” It is conceivable that a standard such as this could tempt some to engage in unethical behavior.
Client Tax Responsibilities
While the CPA has various ethical and legal responsibilities, the client does not get off completely free of consequence. The client has a responsibility to be as thorough and forthright as possible with the accountant when preparing documents. This could cause great conflict in the minds of many considering the fact that taxes are not seen as particularly pleasant. The temptation is certainly there to attempt to “minimize” the amount of taxes owed to the government.
At the end of the day the tax payer is responsible for all information presented on their tax form, regardless of who prepared it. For the client, this means that the CPA’s error becomes your error. If the IRS conducts an audit, stating that the error isn’t your fault because someone else filled out your return is not a valid defense. At the end of the day the tax payer shoulders the burden for the results of that return. Thus besides having an ethical duty to honestly pay their taxes, the prospect of being the only one “on the hook” for the consequences of an incorrect return places a high legal burden on the individual as well.
CPA Responses to Gray Areas
A brief review of guidelines from the relevant organizations reveals that in many cases there is no clear cut way to evaluate a lot of these cases. AICPA guidelines are vague and tend to avoid specific circumstances whereas IRS guidelines and rulings are usually quite the opposite. Generally speaking AICPA rules are less inclusive and set a lower standard than IRS rules [ Rigos ]. In cases where potential conflicts occur, CPAs are relegated to using their own judgment.
The accountants interviewed for this assignment were: Steele Jones and Gonzalo Salas, both of Jones and Company. The third CPA works for a “big four” and is currently based out of Houston. Due to a corporate policy that requires management approval before answering questions about business practices, she asked that her name not be used. For purposes of this report, she will be referred to as Amanda.
The discussion with each CPA centered around two core questions: 1) How close to a gray area are you willing to go? and 2) How do treat a client / situation if you feel it crosses the line?
The answers to question 1 were more varied than I was expecting. Gonzalo seemed to take more of a “hired gun” approach. While stressing that he wouldn’t do anything blatantly illegal (like claim an earned income tax credit for someone who shouldn’t receive it), he said that each client has their own comfort level. Some clients are so scared of being audited, that they wouldn’t even THINK about doing something that wasn’t absolutely defined. Others were willing to push it considerably farther. He also pointed out that gray areas in the tax law aren’t necessarily a bad thing. Rather they tend to be areas that no one has laid down rules for yet. He has also had clients who have gone both ways: Sometimes the ruling was against them and they ended up owing more. Other times the ruling went for them and the deduction was upheld. When asked what he uses to determine how gray is too gray, he responded “you just know. Sometimes things just don’t add up and end up looking way too shady.
Steele Jones takes a more measured approach towards question 1. He uses the “realistic possibility of success” standard. This standard has generally been interpreted to mean that a position has at least a 33 percent chance of winning on the merits (assuming it is detected) [Colloquium on Tax Policy and Public Finance]. Now how he evaluates the question before him and arrives at that 33 percent number can be rather subjective. Here too, Steele takes a more quantitative approach: “By looking at the past case rulings and looking for similar precedent and situations, you can usually guess which way the IRS is going to rule.” Like Gonzalo he also pointed out that the client has the ultimate say over how much they are willing to wade into the gray area.
Amanda’s answers were a little surprising to me. Given all the recent history concerning the big four accounting firms, I would have thought for sure that they would be very high on keeping returns as clean as possible. But she is still feeling some big pressure by her senior partners to make the tax returns “look right.” That certainly isn’t to say that they are telling her to commit fraud, but it is safe to say that the larger corporate clients willing to wade farther into the gray areas. Not surprisingly she said smaller corporate and LLC clients show considerably less tolerance for ambiguity and risk, and that from her experience they are also the ones that tend to get audited more.
She would not hazard a guess as to why that was (although this author postulates that it is because the smaller corporations are easier pickings seen as how the larger corporations have an army of tax lawyers on speed dial ready to fight any audit).
With question two, the responses were mostly similar. When faced with a situation that they feel is over the line, all three intimated that they would take action by notifying the necessary parties. Steele and Gonzalo have actually had situations where they had to confront an executive or business owner over what they felt were unjustified tax and financial transactions. In Steele’s case, time and experience has taught him that it is usually better to try and avoid an outright fight with the client. Instead he has had more success by re-classifying the transaction based on how it should be, and then leaving it up to the owner to challenge the change. Most of the time the owner will let it go. However occasionally there are those who “have no shame” and will try to argue that the $100,000 for two matching Mercedes convertibles constitute a legit business expense. In Steele’s words, “That’s not to say that it wasn’t legit, but he had a high burden of proof to convince me otherwise.” All three indicated that there had been instances in their careers where they outright refused to participate when they felt that the presentation was fraudulent. While it would be nice to think that in these instances justice was done, Gonzalo was quick to point out that it is always possible to find another CPA who WILL allow the dual convertibles.
Conclusion
Taxes are that rare creation where it is possible to come up with two different answers, and still have each one be “right.” As long society keeps changing and new inventions are created, there will be gray areas. And as long as payments continue to be due on April 15th, people will look for ways to parlay the unknown and unsettled to cold hard profit and a lower tax bill. The models used to make “ethical” decisions in this case vary from person to person. All three accountants interviewed look at the same set of regulations and agree to abide by the same code of personal conduct. Each interprets those rules differently, and each believes that they are acting in an ethical way. And much like a Federal Tax return there may not be a “right” answer, but we sure do know a “wrong” one when we see it.
Bibliography
AICPA Code of Professional Conduct. Copyright 2007.
http://www.aicpa.org/about/code/index.html
Colloquium on Tax Policy and Public Finance. Presented Spring 2007.
http://www.law.nyu.edu/colloquia/taxpolicy/papers/07/KLogueSp07.pdf
Rigos Professional Education Programs. Copyright 2007. http://www.rigos.net/Loss_Control/LC_Tax.shtml
Wikipedia Entry on Administrative Law. 2007 http://en.wikipedia.org/wiki/Administrative_law.