More than half of all professional liability claims against accountants are tax-related, according to insurance industry executives. As accountants plunge ahead into their busy season, they should take note of their increasing exposure.Although audit malpractice claims are the highest in terms of severity, the most frequent claims are those for tax services, said Joe Wolfe, assistant vice president for risk control at CNA, in an interview last fall. CNA is the underwriter for the American Institute of CPAs' professional liability insurance program.
"Tax work still has the highest frequency of claims," agreed Tom Herendeen, vice president of the specialty lines division of Philadelphia Indemnity Insurance.
Ron Klein, vice president of claims for Redwood City, Calif.-based Camico Mutual Insurance Co., noted that the technical nature of the tax issues and the financial complexity of business clients can create heightened risk exposures for CPAs who provide tax advice and services.
"In this environment, the tax professional must be sure of his or her competency and ability to render the best advice possible for the client," he said. "In addition, there are a number of fundamental steps the CPA can take to mitigate the risks associated with tax work."
A recent claims study conducted by Camico found that well over half of all claims reported by Camico-insured CPAs come from tax engagements.
The study included the claims experience of the insurer's nearly 7,000 policyholder firms in 44 states, focusing on the major causes and types of claims incurred by CPAs nationally. Tax was not only the most frequent claim, it generated the largest total of claims dollars.
"If you look at the average size of the individual claim, audit is the highest, but overall, tax claims total more than audit because there are so many more of them," explained Klein. "Traditionally, insurers have looked at tax as a monolithic group and the truth is it's not. For example, estate work generates a much different type of claim than standard income tax work, and reaches a much higher severity level. The average tax claim is about $70,000, while our audit claims average out over $300,000."
In good economic times, tax claims tend to be higher, Klein noted. "After the bubble burst, it generated a lot of financial statement and investment claims, so it made the tax portion shrink by comparison. For example, fraud tends to be uncovered after the economic bubble bursts, and fraud claims are very often financial statement claims rather than tax claims."
It is brain surgery
"The technical nature of this area of taxation places most of the burden for decision-making on the CPA," he said. "There is usually a limit to how much the CPA can ask the client to decide in technical tax issues. It's much like a patient seeing a doctor about a serious, complex medical condition; the problem and treatment are so critical that the patient will ultimately go with the treatment the doctor recommends."
"In the realm of income taxation, the CPA's job is to advise and warn the client about alternatives and their possible benefits and risks," Klein added. "Once the choice of alternatives is made, document why the choice was made and the client's involvement."
The CPA may also get a second opinion from another tax specialist, much like a doctor getting a second opinion from another specialist, Klein advised. "Large firms have the expertise within the firm for this. The small or solo practitioner should consider getting a second opinion from someone 20 or 30 miles away, so they're not competitors," he said.
Klein said that careful screening of the firm's clients and engagements will help to avoid engagement creep, where the scope of the engagement extends beyond the CPA firm's competence.
"All clients and engagements should be re-evaluated on a regular basis, at least annually, to ensure the firm is capable of performing the services required by the engagement, and is performing the services frequently enough to become proficient at them," he said.
Moreover, some clients need to be identified as more risky than others, according to Klein. He suggested that risky clients be identified by running credit checks, examining previous financial statements, examining the client's prior accounting firm's management letters, and interviewing the client, the client's key personnel, bankers, legal counsel, prior accountants and auditors.
S corporations and estate work are particularly risk-prone, according to Klein.
"Clients who make choices about S corporation elections do so primarily for tax benefits," he said. "When they do, they make assumptions about the future which may or may not come true. When events make their choice less beneficial than originally thought, the CPA is exposed to liability."
CPAs can also be exposed to liability from not consulting with clients regarding S elections, Klein said. "For example, a consultation should occur when a closely held C corporation has substantially appreciated assets."
In helping clients decide about corporate disposition, CPAs should provide the client with a full consultation of all negative and positive tax ramifications involved. The tax advisor should also document the consultation in an informed consent letter, and provide places where the client can acknowledge that they have read and understood the letter, and which provide the client an opportunity to affirmatively indicate that they either do or do not want an S corporation election, Klein advised.
"Informed consent is always important, but it is even more so in this situation because of its technical nature and the limited ability of the client to discern the pros and cons," he said. "Documentation will prevent the client from later asserting that your firm is responsible for unexpected events and for less than optimal results."
Likewise, informed consent letters are important in estate work, since memory of the CPA's advice and the client's decisions fade over time. The letter should outline the positive and negative consequences of all options.
In addition, tax professionals must be certain of their competency in this area, and should document both the reliance upon the attorneys drafting the estate plan and which professionals are responsible for each aspect of the plan, said Klein.
"When a client dies, the CPA may be dealing with unhappy, potentially litigious beneficiaries," he observed. "We know there will be no deposition from the deceased client, so the documentation from the original planning and decision-making process becomes the CPA's primary line of defense."
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