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Larry Jacobson

Advising Clients in Uncertain Economic Times

Clients are cutting back on nonrevenue producing services, including tax compliance services. Tax advisors need to counsel these clients on the long-term costs of such a short-sighted approach.

November 13, 2008
by Larry Jacobson, CPA/JD

The signs of an economic downturn are all around us. A declining stock market, the credit crunch, the decline in real estate prices and softening consumer demand all have led us into the toughest economic times we have seen since at least the early 1980s. Many of our business clients are in a “hunker down” mode where they are delaying all essential spending (whether in the area of capital expenditures, hiring new employees, eliminating spending on nonessential travel, entertainment and professional development).

Those of us in the tax advisory business have begun to see similar attitudes to tax compliance areas that are either legally mandated or strongly advisable. Even in the best of economic times, clients are loathe to spend money on ensuring that their books and records meet the requirements of the Internal Revenue Code or state tax statutes. These clients view such expenditures as wasteful in that they are not revenue producing in nature. Now that the economic tide has turned decidedly negative, more clients are openly questioning the need to spend funds to document and protect tax positions on their tax returns.

Tax Compliance Costs

What are the different types of tax compliance costs? There are five distinct types of tax compliance costs. These are:

  1. Items that involve related party transactions, such as reasonable compensation, interest rate charged on loans between related parties, transfer pricing, etc.
  2. Generation and retention of records necessary to support the deductibility of items under different tax laws, such as documentation for travel expenses, documentation for justifying an item as a repair versus a capital expenditure, documentation relating to pension plans, etc.
  3. Documentation necessary to determine whether the client is subject to income or sales tax in various states due to nexus requirements.
  4. Myriad U.S. and foreign tax rules imposed on U.S. companies that, directly or through foreign subsidiaries, engage in international operations or on foreign companies that, directly or through U.S. subsidiaries, engage in business operations in the United States.
  5. Valuation studies that are required to support the fair market value of an asset for tax purposes.

With increasing frequency, clients (including those who are among the most ethical and law abiding) are coming to their tax advisors and asking what the consequences are if they delay tax compliance costs that are either legally mandated or strongly advisable in order to preserve a position taken on their tax returns. Some of these clients are facing a life or death situation in terms of keeping their businesses afloat and do not wish to spend an additional penny on nonrevenue producing matters.

Treasury Circular 230

The short answer to these clients is that Treasury Circular 230 (the “TC”) imposes clear guidelines on tax advisors who practice before the Internal Revenue Service. TC Section 10.21 requires a tax advisor who knows that a client has not complied with the revenue laws of the United States to advise the client promptly of the fact of such noncompliance and advise the client of the consequences under the Internal Revenue Code and Regulations of such noncompliance. TC Section 10.22 requires a tax advisor to exercise due diligence in preparing tax returns. TC Section 10.34(c) requires an advisor to inform a client regarding potential penalties under the Code with respect to matters taken on tax returns. Finally, TC Section 10.37 bars a tax advisor from giving written tax advice based on the probability of a tax audit or unreasonable factual or legal assumptions. Failure to follow the TC rules can result in penalties imposed on the tax advisor, including in extreme cases, disbarment from practicing before the Internal Revenue Service.

In addition to the requirements of the TC, the rules applicable under various state bar and CPA laws, rules and regulations impose additional ethical requirements on attorneys and CPAs who render tax advice.

Advising Clients

Given the pressure to retain clients during tough economic times, it can be easy for tax advisors to capitulate to client demands and turn a blind eye to a client’s failure to follow legally-mandated tax compliance requirements, let alone those tax compliance requirements that, while not legally required, are necessary to defend reasonable positions taken on tax returns. In such a situation, the tax advisor must give clear and objective written advice to the client regarding all tax compliance requirements, whether legally mandated or otherwise necessary to avoid potential tax penalties. A skeptical client needs to know the legal and financial consequences of the failure to follow tax laws and regulations. As a professional, the tax advisor cannot let the audit lottery or short-term personal economic considerations impact his or her professional independence and the quality of advice given. The advisor’s reputation will follow long after economic times turn better.

If the client follows the advisor’s advice, then nothing further needs to done. However, if the client fails to follow the advisor’s advice, the advisor is placed in a difficult position. On the one hand, the TC and relevant bar/CPA ethics rules do not require the advisor to “turn in” the client to the Internal Revenue Service or state tax authorities. Nevertheless, continued representation of such a client, including rendering of tax advice or signing tax returns, might place the advisor at risk of an Internal Revenue Service investigation if it discovers that the client failed to keep adequate books and records and the advisor signed a tax return even in the face of a clear inadequacy of record keeping.

As tough as it is to recommend, failure of a client to follow and pay for the creation of adequate records to support a reasonable tax return is a sign that this is a client that is not worth continuing to represent. If a client’s financial problems cause the client to cut corners with respect to mandates of the tax law, the strong likelihood is that the client either will not survive financially or its propensity to cut corners will come back to cause the client serious harm in one way or another. Moreover, it is not worth a tax advisor risking reputation over a knowingly noncompliant client.

Conclusion

Part of being a professional advisor is having candid conversations with clients, both in good times and bad. Tax advisors should strongly urge their economically strapped clients not to cut corners in creating the documentation necessary to prepare a proper tax return. We should also have the courage of knowing what our response should be if a client fails to heed our advice.

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Larry Jacobson, an attorney and CPA, is a senior partner in the Chicago office of the law firm of Schiff Hardin LLP. He holds a BA from Washington University, an MBA from the University of Chicago, an MSOD from the University of Pennsylvania and a JD from the Georgetown University Law Center.