In today’s post, Megan L. Brackney.turns to the challenging issues that practitioners must confront when faced with a client or potential client’s failure to file foreign information returns. Les
Ethical Standards Related to a Client’s Non-Compliance With Foreign Information Reporting
In yesterday’s post, I discussed some common penalties for failing to file foreign information returns and the practical and legal challenges associated with establishing that a client is entitled to relief from those penalties. Today we focus on how this penalty regime raises difficult ethical issues for practitioners who want to zealously represent their clients but also want to practice in a way that is consistent with their responsibilities and duties.
Circular 230 governs attorneys, CPA’s, enrolled agents, and others who practice before the IRS. On the subject of a taxpayer’s error or omission, Circular 230, Section 10.21 states as follows:
A practitioner who . . . knows that the client has not complied with the revenue laws of the United States or has made an error in or omission from any return . . . must advise the client promptly of the fact of such noncompliance, error, or omission.”
This section goes on to say that “the practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.” It does not, however, require the practitioner to advise the client to self-correct.
The Statements on Standards for Tax Services (“SSTS”),SSTS No. 6 contains a slightly different iteration of the duties concerning knowledge of a client’s error or omission:
A member should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken.
In SSTS No. 6(13) (Explanation). the AICPA explains, however, that the SSTS do not require CPAs to advise clients to amend if “an error has no more than an insignificant effect on the taxpayer’s tax liability,” a question which “is left to the professional judgment of the member based on all the facts and circumstances known to the member.”
On the taxpayer’s side, it is generally understood that taxpayers do not have an obligation to file amended returns. As stated in Badaracco v. Comm’r, 464 U.S. 386, 393 (1984), “[t]he Internal Revenue Code does not explicitly provide either for a taxpayer’s filing, or for the Commissioner’s acceptance, of an amended return; instead, an amended return is a creature of administrative origin and grace.”)
It is also generally understood that a tax practitioner cannot advise a client not to file a return that is currently due. There is no guidance on whether the same is true for a delinquent return once the filing deadline has passed. Do tax practitioners have an unending obligation to recommend that their clients file delinquent returns?
The IRS’s policy is to solicit unfiled income tax returns for the prior six years. See IRS Policy Statement 5-133, Delinquent returns—enforcement of filing requirements (IRM 126.96.36.199.18 (08-04-2006) ( “Normally, application of the above criteria will result in enforcement of delinquency procedures for not more than six (6) years. Enforcement beyond such period will not be undertaken without prior managerial approval.”). This indicates that there may be some period of time after which we would not view a practitioner’s advice not to file a tax return as unethical but this is by no means a clear standard (Last season’s Form 1040? Ten years ago?).
Another aspect of the practitioner’s ethical duties is the prohibition on basing advice on the likelihood of audit. For purposes of advising a client on a return position, it is clear that the tax practitioner cannot consider the likelihood of audit but must instead determine whether the position is objectively reasonable.I.R.C. § 6694(a)(2); Circular 230 10.34; SSTS No. 1(4), (5). Circular 230, Section 10.37(a)(2) states that “the Practitioner must not, in evaluating a Federal tax matter, take into account the possibility that a tax return will not be audited or that a matter will not be raised on audit.”See also Regulations Governing Practice Before the Internal Revenue Service, 79 FR 33685-01 (“Treasury and the IRS agree that audit risk should not be considered by practitioners in the course of advising a client on a Federal tax matter, regardless of the form in which the advice is given.” ).
Does this rule apply when advising on whether to correct a past failure to file?
What Advice Can We Give?
fter considering the above ethical standards, if we return to the example of the college student, we know it is highly likely that if she files the Form 3520, the IRS will impose the maximum penalty. If she does not self-correct, given the low audit rates and the fact that her non-compliance was several years ago, there is a very strong chance that the IRS will never audit this tax year. Are we doing this client a disservice by not providing her with this information when as she decides whether or not to file the Form 3520 now? Do the ethical standards for tax practitioners actually require me to lead my client into financial ruin in order to correct a five-year old mistake that caused no actual harm?
It is not clear how the ethical rules apply in this context. Is a taxpayer who previously filed an income return but failed to file a foreign information return more like a taxpayer filing an amended return or filing a delinquent return? Certain foreign information returns, like Forms 5471 and 8938, are attached to the income tax return. And, the IRS has instructed that when taxpayers file these returns late, they be accompanied with a Form 1040X, even if there are no changes to the income tax return.
One could argue that a practitioner does not have an ethical duty to advise clients to file delinquent Forms 5471 and 8938 and other foreign information returns filed with the income tax returns because that would be the equivalent of filing an amended return.
But what about Form 3520? As the instructions provide, Form 3520 is not filed with the income tax return, but separately filed with the IRS Service Center in Ogden, Utah. Is filing a Form 3520 more like filing a delinquent income tax return?
I have difficult time believing that there should be different ethical rules for forms attached to the income tax return, such as Form 8938, and a free-standing form like the Form 3520. That is slicing it a bit too thin. And many practitioners would say that for a delinquent return, after the filing deadline has passed, the situation is similar to that of an amended return, and they are not obligated to recommend that the client self-correct. I think that this is a reasonable interpretation of the ethical rules, and that the Circular 230 practitioner is not required to recommend self-correction but should fully advise the client on the potential penalties, and the CPA should recommend self-correction if the failure to file a particular foreign information return is material.
What about the likelihood that a taxpayer will be audited in the future, after the non-compliance has already occurred? Is it unethical for a practitioner to advise the client in our example ho failed to file the Form 3520 five years ago that there is almost no chance that the IRS will audit this issue? The statute of limitations for assessment does not close until the taxpayer files all required foreign information returns. I.R.C. § 6501(c)(8). The same is true for income tax returns, for which the statute of limitations does not begin to run until the return is filed, but nonetheless the standard advice for long-term non-filers is to just file returns for the preceding six years.
As to discussing the likelihood of audits, this information is publicly available,and we should be able to discuss it if a client asks. However, I would still not base my advice on the likelihood of audit, as even with the currently low rates, I cannot accurately predict whether a particular client will be audited. However, we can advise our clients on the potential outcomes if they are audited so that they can weight the cost of voluntarily compliance versus waiting to be contacted by the IRS.
I believe practitioners should be able to use their professional judgment to advise clients while still upholding their ethical obligations to the IRS and the tax system. On the other side, the IRS should re-think its enforcement of these penalties in order to encourage, rather than punish, voluntary compliance, and, as the IRM provides, live up to its own obligations to ensure that penalties “encourage noncompliant taxpayers to comply,” and are “objectively proportioned to the offense.” I genuinely want to encourage tax compliance, but it is challenging when it is so harshly penalized. The IRS could help tax practitioners, as well as taxpayers, by providing some reasonable options for correcting past failures to file foreign information returns.