Provide clarity and avoid scope creep with a carefully drafted engagement letter
This discussion focuses on how and why to use engagement letters and what they should cover. The primary purpose of using a letter to define a professional relationship is to ensure that the client and the practitioner agree upon the services that are to be provided. Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), Section 10.33, Best Practices for Tax Advisors, states that a practitioner should communicate clearly with the client regarding the terms of the engagement; a signed engagement letter provides clarity and prevents scope creep.
An engagement letter is also a valuable tool for cementing the relationship with a new client, particularly when there is a delay between accepting a new client and beginning services. Furthermore, defining the scope and agreeing upon the terms in writing clarifies the client’s expectations and builds trust by preventing the billing of services that were not anticipated by the client. It also removes any ambiguity regarding who the client is, especially when the practitioner is dealing with a representative of a business.
In addition, clarifying the services through an engagement letter acts as a primary defense against malpractice claims. Disagreements arise when clients believe you are handling their taxes but do not understand exactly what that might entail or encompass. A clearly defined engagement letter sets out the scope of services, defining what the practitioner has agreed to do, what the client has agreed to do, and what the practitioner will not be doing. Additionally, malpractice insurance premiums may be increased without the consistent use of engagement letters.
The importance of being specific
The benefits of engagement letters are often limited by vagueness and the omission of useful provisions. For instance, tax forms should be listed specifically, rather than using a general phrase like “all income tax returns” or “all state tax returns” and should patently exclude all returns and forms not listed. For instance, specifically mentioning and excluding any foreign reporting requirements such as the FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR), is prudent, considering the potential for significant penalties.
Tax planning and consulting should be excluded from engagements that are merely for tax return preparation and should ideally be dealt with under a separate engagement letter with clearly defined parameters. Clients can become upset when they discover that they have missed a tax-saving opportunity, regardless of whether they were paying for proactive tax advice. Clients’ expectations of CPAs generally include tax-saving advice, so being specific about tax services can prevent a client from looking to the firm to provide remuneration for a missed opportunity.
Useful provisions to include
Because firms may not have liability protection in the event of a data breach (although this optional coverage is recommended when available), an engagement letter can offer additional protection with a provision to disclaim liability from a data breach that occurs through no fault of the firm. Reasonable measures must be taken to ensure security of data, but language providing protection is helpful when reasonable measures fail.
Practitioners should also consider a conflict-of-interest waiver clause for related parties, divorcing couples, or multiple shareholders or partnership situations. These waivers can be a part of the engagement letter or executed in conjunction with the engagement letter.
The following points should also be included in the engagement letter:
- Alternative dispute resolution provisions;
- Venue in the event of a civil claim;
- A clause to limit liability to a percentage of fees, if allowed under applicable state law;
- Termination date for services (to trigger the statute of limitation);
- Date by which information must be provided by the client to complete the work on time;
- Language about filing extensions for tax returns;
- Statement of client asserting the completeness and accuracy of the data provided;
- Disclaimer that the firm is not verifying or auditing data;
- Provisions on data retention and who is responsible for providing supporting data in the event of a future audit;
- Disclaimer that the firm is not taking steps to discover fraudulent activity, although the firm may disclose any indications of fraud that are observed during the engagement.
Engagement letters should be reviewed and revised on a continual basis, at least annually, to incorporate changes in the tax law or other provisions as needed.
Challenges for small firms
While the benefits are clear, implementing engagement letters for all clients is undeniably challenging for smaller firms with limited resources. But there are practical steps that can lessen the impact and track the process better.
Firms preparing less complex tax returns may consider negative assurance engagement letters. Essentially, such a letter provided to clients lays out the terms and states that providing information to begin work constitutes acceptance of those terms. This type of engagement letter is not as good as one requiring a signature acknowledgment but may provide some protection.
In addition, electronic signatures can be used to streamline the process. The firm can send all engagement letters en masse at the beginning of the year for electronic signature or with organizers when sent. When data is received to begin tax preparation, a process must be in place to verify that the engagement letter was signed before routing or assigning the work. If no signature is received, the firm should notify the client that work cannot commence until the engagement letter has been signed and should consider returning the paperwork to the client with the engagement letter requesting a signature for work to commence.
Choosing whether to represent a client via POA or tax information authorization
The ability to access information from the IRS on behalf of a client is a necessary component of the practice of most CPA firms and other tax practitioners. The two avenues for this are Form 8821, Tax Information Authorization, and Form 2848, Power of Attorney and Declaration of Representative.
There are three key differences between these two avenues. Form 2848 can be used only by someone with authority to practice before the IRS, such as an attorney, CPA, enrolled agent, enrolled actuary, or enrolled retirement plan agent; it also grants power of attorney (POA) to represent the client before the IRS. Representation before the IRS encompasses advocating for the client and providing information on behalf of the client.
Form 8821 only allows the appointee to receive information, but the appointee does not need any authority to practice before the IRS or even need to be an individual; businesses and entities can be appointed via the Form 8821. Form 8821 may be a viable option if a practitioner is merely collecting data to file a return or, where the firm is the appointee, to allow unlicensed staff to request transcripts from the IRS. It also may be useful to accept a limited authorization under a Form 8821 during the process of determining whether to accept someone as a client. It allows the practitioner to receive information but makes clear to the IRS representative and to the client that the practitioner has not accepted the authority and responsibility to advocate on the client’s behalf.
The final key difference is that a Form 8821 automatically expires after seven years, while a Form 2848 must be revoked. With the termination of a POA, the practitioner can no longer represent the taxpayer for that tax period.To revoke a Form 2848, the practitioner should write “REVOKE” across the top of the Form 2848 that is being revoked and sign and date below the notation. The revocation should be filed with the Centralized Authorization File (CAF) unit in the same manner as the original POA. If the original Form 2848 is not available, a signed and dated letter from the practitioner stating the intention to revoke the POA for the applicable tax matters and periods, the name and address of each recognized representative whose authority is revoked, the taxpayer’s name, the taxpayer’s address, and the taxpayer identification number can be submitted to the CAF unit. If all authority under the POA is being revoked, “revoke all years/periods” can be written instead of listing the specific matters and years/periods.
With the revocation, both the client and the firm should be clear that the firm is no longer responsible for tracking new notices as they arise. It may be prudent to issue a termination of the engagement letter at the time of the POA revocation. The clear communication of the letter articulates the mutual understanding while also working within the relationship to remind the client that the practitioner will be available to help on other issues later.
If Form 2848 is used, the firm should track all POAs for all practitioners in the firm and have a system in place for revoking them when the project terminates or when the client is no longer a client. This avoids confusion about who is responsible for replying to further notices for the covered subject or period.
If there is uncertainty regarding what POAs a firm has outstanding, a Freedom of Information Act (FOIA) request can be filed. The request must state that it is being made under the Freedom of Information Act, identify the records that are being sought, identify the name and address of the requester, provide a copy of a valid photo identification of the requestor that includes a signature, and make a firm commitment to pay any applicable fees. The requestor can state the maximum fee he or she is willing to pay. Generally, there will be no fee for individuals seeking records for their own use unless the request is for more than 100 pages or the search takes more than two hours. If the applicable fees will exceed the maximum fee stated, the IRS will contact the requestor and ask the requestor whether he or she would like to withdraw or modify the request before proceeding.
The IRS recently implemented an online authorization process through the Tax Pro Account service to simplify the process and allow instant access for the practitioner. A tax practitioner can submit a POA authorization (if the practitioner meets the POA requirements) or a Tax Information Authorization request to the taxpayer’s individual IRS online account. The practitioner chooses the appropriate authorization type when requesting it.
To request an authorization online, representatives log in to their Tax Pro Account on irs.gov and request an authorization from the taxpayer. The representatives will need all of the data traditionally required on a Form 8821 or Form 2848; the data entered must match previously filed returns exactly. After submitting the form, the practitioner should notify the taxpayer that the request is waiting for authorization. The taxpayer must log in to his or her individual IRS account to review and sign the authorization request; if any data is incorrect, the request will not appear for the taxpayer, and the practitioner will need to resubmit the request with the correct data.
Authority via a Tax Pro Account can only be granted for the years 2000 through the current year plus three calendar years forward from the date of the request and is limited to the following matters:
- Form 1040, U.S. Individual Income Tax Return, income tax;
- Split spousal assessment or innocent spouse relief;
- Shared-responsibility payment, including split spousal assessment; and
- Civil penalties.
Unlike with a paper filing, only two representatives can receive copies of a taxpayer’s IRS notices and communications, and the online process automatically revokes any other authorization granted for that period, tax matter, or authorization type. If multiple representatives are requesting authority, the taxpayer must authorize them on the same day. Once the taxpayer has accepted the request in his or her online account, the representative has immediate access to the records.
Extensions provide several timely benefits
Extensions provide a valuable release valve for the tax preparer in two primary ways: They spread out the tax filing over a longer period, and they allow time for the necessary data to arrive for the return to be accurately prepared.
Increased complexity and additional reporting requirements have resulted in Schedules K-1 and corrected information returns being sent out shortly before or even after the filing deadline. However, clients often want their returns to be filed “on time,” while failing to understand that, with an extension, the return is still on time if it is filed by the extended due date. The taxes must be paid by the due date, but unless there is a compelling need for the return to be filed by the original due date, the practitioner should advise the client to wait so that a more complex return can be done when professionals are less fatigued and not under a pressing deadline. It is worth considering charging a higher rate for those who insist on filing by the original due date, to compensate for the additional burden and risk of error.
An extension allows additional time for retroactive tax law changes to be incorporated into tax preparation software. The IRS did not require amended returns to be filed for returns filed prior to the tax law changes for tax year 2020 but instead adjusted taxpayers’ returns; the resulting notices of the adjustments sent to taxpayers by the IRS raised concerns that the practitioner had erred. Thus, because these returns were not extended, additional time was required for client inquiries and explanations for returns. Moreover, because not all states pass legislation to conform to the federal tax law by the due date of the return, retroactive changes at the state level also generate notices to adjust the state tax return, again wasting the time of taxpayers and practitioners.
The opportunity for filing a superseding return is an often-overlooked benefit of filing an extension. A superseding return acts as the original filed return and allows for elections that are required to be filed with the original return if they are considered timely filed by its extended due date. Even if the return is filed by the original due date, an extension allows for the possibility of filing a superseding return and acts as a safety net for any missed elections if they are caught before the extended due date. However, superseding returns do not allow a change from married filing jointly to married filing separately or changes to other irrevocable elections.
When return due dates are legislatively postponed, such as occurred during the filing seasons for tax years 2019 and 2020, the period for claiming a refund may be shortened if the return is filed after the original due date but before the postponed due date. Under Secs. 6511(a) and (b)(2) and Regs. Secs. 301.6511(a)-1(a) and 301.6511(b)-1(b), a refund claim can be made for three years from the date of filing, with the amount of the claim limited to the taxes paid or considered paid within a lookback period of three years plus any extension period. If no extension was filed, taxes are considered paid on April 15, even if the return was timely filed on May 15. The three-year lookback period stops at the date filed unless a valid extension was filed to bring it back to the original due date of the return.
When due dates are postponed, filing extensions as of the original due date of the returns serves a practical purpose for smaller firms; by following the firm’s normal procedures, there is less likelihood of making mistakes or missing necessary extensions.
There are potential pitfalls to be wary of when filing extensions. Some elections, such as the mark-to-market election for traders, must be made by the due date of the return without taking into account any extensions. If extensions are filed without a full review of the taxpayer’s documents, the need or benefit of such an election may be missed before the due date.
An additional area of potential liability is in failing to properly advise the taxpayers or document having advised them that the extension does not extend the time to pay. Taxpayers must still provide the necessary data to enable the correct tax liability to be calculated and paid by the original due date. To qualify for an extension, the taxpayer must properly estimate the tax liability using the information available, enter the total tax liability, and file the extension by the return’s due date. A failure to calculate the tax may result in a rejection of the extension and additional penalties.
Preparers subject to Treasury Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10), must follow the due diligence guidelines for preparing and filing extensions found in Sections 10.22, Diligence as to Accuracy,and 10.36, Procedures to Ensure Compliance, of Circular 230 or face potential penalties and liabilities.An example of a potential area for concern is when a taxpayer has an accepted offer in compromise or an installment agreement, or is subject to a pertinent court order; failing to file or failing to pay the full amount of tax due could terminate the existing agreement or violate the terms of the order. It is advisable to document the authorization to file the extension and the calculation of the tax due. Smaller firms may have a difficult time tracking the information for due diligence compliance and may not be able to bill the clients for the additional expense and the additional time in the file.
An extension may lessen the urgency felt by taxpayers to compile their financial data; in the event of an increase in taxable income, the delay in organization of the data creates the possibility of cash flow difficulties for business owners. A taxpayer with a surprise tax payment due for the prior year may also have to make a large fourth-quarter estimated payment for the current year if the three quarterly estimated payments for the current year that are due prior to the extended due date of the return were underestimated using old data. The additional penalties and interest on the underpayment of estimates and the late payments of taxes may cause the client to feel the preparer is at fault regardless of when the information is provided to the preparer.
A final point to consider is that the statute of limitation for errors is three years from the date of filing; the clock starts on April 15 if the return is filed on or before that date. A later filed return pushes the time for the IRS to change the return out to three years from the date of filing. However, the taxpayer can file both an extension and a return by the due date of the return and retain some of the benefits of filing the extension.