State and local governments’ use of auditors paid on a contingent fee basis for taxpayer audits has drawn criticism because of the conflicts of interest such arrangements create. This article examines the state of the controversy and recent actions that states have taken to ban the practice. It concludes with advice for tax professionals on how to handle audits where the auditors have a direct financial incentive to collect the highest, rather than the correct, amount of taxes.
One current controversy in the tax arena is the use of contract auditors paid on a contingent fee basis to perform state and local taxpayer audits. Many states and localities are permitted to use contingent fee contract auditors to generate additional net tax revenue with little or no up-front cost. Though these arrangements may appeal to state and local budget committees, several states have enacted or proposed legislation prohibiting this practice, asserting that it creates a conflict of interest and that it is against public policy because contingent fee contract auditors are only compensated when audits result in additional taxes.
The National Conference of State Legislators (NCSL) defines a contingency fee as “any commission, percentage, brokerage, or other fee that is contingent upon a favorable legislative result” (see http://www.ncsl.org/research/ethics/50-state-chart-contingency-fees.aspx). The NCSL indicates that 43 states prohibit legislators from receiving contingent fee contributions because legislation should be prompted solely by the public good; the use of agreements in which compensation is contingent upon the enactment of specific legislation suggests a corrupt process that undermines public confidence in government. The NCSL also notes federal prohibition of contingent fees related to federal regulations governing the lobbying process for government contracts on the grounds that such contingent fees “induce someone to act on any basis other than the merits of the matter.” Based on this reasoning, the authors assert that states and localities retaining contingent fee contract auditors to audit taxpayers not only undermine the public confidence in state and local governments—they also induce the contract auditor to maximize the taxes assessed, regardless of “the merits of the matter” (i.e., whether the taxpayer is in compliance with the tax laws).
The American Bar Association’s website states that “a client pays contingent fees to a lawyer only if the lawyer handles a case successfully” (see bit.ly/1QCdw8i). Success—and the amount of compensation received by the lawyer—typically hangs on obtaining a financial award or settlement. Although this might be appropriate in medical malpractice cases and personal injury lawsuits, states may prohibit contingent fee arrangements when a conflict of interest is created that adversely affects a lawyer’s professional judgment, particularly if the lawyer is compensated by a third party with interests that differ from the client’s. For example, Rule 1.8 of the New York Rules of Professional Conduct provides the following:
Third-party payers frequently have interests that may differ from those of the client. A conflict of interest may exist if the lawyer will be involved in representing differing interests or if there is a significant risk that the lawyer’s own professional judgment on behalf of the client will be adversely affected by the lawyer’s own interest in the fee arrangement or by the lawyer’s responsibilities to the third-party payer (http://www.nysba.org/WorkArea/DownloadAsset.aspx?id=50671).
For example, a conflict of interest exists if a lawyer who is contracted and paid by the plaintiff represents the defendant. Clearly both parties have differing interests, and there is a significant risk that the lawyer’s professional judgment on behalf of the defendant will be adversely affected by his fee arrangement with the plaintiff. A more egregious conflict of interest would result if a judge or arbitrator were not only contracted by the plaintiff but also compensated under a contingent fee arrangement by the plaintiff, and therefore paid based on a percentage of the financial judgment awarded to the plaintiff against the defendant.
A similar conflict of interest would result if a taxpayer were subject to an audit by a contract auditor retained by a state or locality and compensated based on a percentage of any taxes assessed and collected as a result of the audit. The greater the amount of taxes collected from the taxpayer, the greater the “success” of the audit and the compensation for the contract auditor. This distorts the audit objective of determining a taxpayer’s voluntary compliance with the tax laws. The auditor, in order to remain independent and unbiased during the audit, should receive fair compensation regardless of whether additional taxes are assessed.
Moreover, audit-contingent fee arrangements have long been determined by U.S. auditing standards–setting bodies, such as the PCAOB, to impair auditor independence and damage auditor objectivity. Specifically, PCAOB Rule 3521 states:
A registered public accounting firm is not independent of its audit client if the firm, or any affiliate of the firm, during the audit and professional engagement period, provides any service or product to the audit client for a contingent fee or a commission, or receives from the audit client, directly or indirectly, a contingent fee or commission.
In the case of a public company financial audit, the payer—and one “client”—of the audit firm is the public company, which has an interest in receiving an unqualified (clean) opinion on its financial statements. Another “client” of the auditor is the investing public (e.g., shareholders, creditors), which relies on the auditor’s opinion to obtain reasonable assurance on the fair presentation of the public company’s financial reports. A contingent fee arrangement under which the auditor would only receive compensation for issuing a clean audit opinion clearly would impair the auditor’s independence at the expense of the investing public.
IRS Tax Audit Guidelines
The IRS’s Tax Audit Guidelines include the following under its Statement of Principles:
The function of the Internal Revenue Service is to administer the Internal Revenue Code. It is the duty of the Service to correctly apply the laws enacted by Congress; to determine the true meaning of various Code provisions in light of Congressional purpose in enacting them; and to perform this work in a fair and impartial manner, with neither a government nor a taxpayer point of view (http://www.irs.gov/irm/part4/irm_04-035-001.html).
The IRS also states that it accomplishes its mission by “measuring the degree of voluntary compliance as reflected on filed returns” and by “conducting on a timely basis quality audits of each selected tax return to determine the correct tax liability.” Finally, the IRS asserts that “the purpose of auditing a tax return is to determine the taxpayer’s correct liability—no more or no less.”
The above guidelines are inconsistent with state and local use of contingent fee contract auditors to perform taxpayer audits. It is difficult to believe that a contract auditor, compensated only if and to the extent that additional taxpayer taxes are assessed and collected, could conduct an audit “in a fair and impartial manner, with neither a government nor a taxpayer point of view.” Indeed, such an auditor would receive no compensation for “measuring the degree of voluntary compliance” and “determining the correct tax liability.” A contract auditor would likewise receive no compensation for successfully determining the taxpayer’s correct liability if the taxpayer properly reported the tax liability on her tax return.
In addition, IRS Circular 230 prohibits a practitioner from charging contingent fees for services rendered in connection with matters before the IRS, except for services related to 1) an IRS examination of or challenge to an original or amended tax return, 2) a claim for credit of IRS statutory interest or penalties, and 3) any judicial proceeding arising under the Internal Revenue Code (see http://www.irs.gov/pub/irs-utl/Revised_Circular_230_6_-_2014.pdf). Similarly, the contingent fee rule under the AICPA Code of Professional Conduct (“Code”) states that a member in public practice is prohibited from receiving contingent fees for professional services related to 1) an audit or review of a financial statement and 2) the preparation of an original or amended tax return or claim for a tax refund (see http://bit.ly/1GI8QLs).
The Code also provides examples of when a contingent fee is permitted, such as in certain cases where the taxpayer may be requesting a refund of tax (and any interest or penalties charged) based on a previously filed return. For example, companies may engage a contract auditor to conduct a reverse sales and use tax audit review, in order to determine whether a refund is due for any overpaid sales and use tax in a prior period. In essence, the taxpayer and the contract auditor are determining whether the taxpayer overpaid sales and use taxes. This is much different from the taxing authority engaging a contract auditor to conduct an examination of a currently filed return.
Opposition from Professional Organizations
On August 15, 2011, the Tax Executives Institute Inc. (TEI), a worldwide in-house association of tax professionals with nearly 7,000 members, issued its “Policy Statement on Contingent Fee Audit Arrangements,” in which it urged states and localities to renounce the use of contingent fee auditors for all taxpayer audits (bit.ly/1TZX6J7). On May 14, 2013, the AICPA also issued a statement on contingent fee audit arrangements, in which it likewise called for state CPA societies to advocate for the prohibition of such arrangements (see bit.ly/1TmT9y3). Both the TEI and the AICPA recognize the short-term financial incentive to retain contingent fee contract auditors for taxpayer audits; however, they also present several compelling arguments against the practice (summarized in Exhibit 1):
- A compliance tax audit objective should be to verify whether the taxpayer reported and paid the correct amount of taxes, not to assess the maximum amount of taxes possible. As noted earlier, this objective is advocated by the IRS, which relates the quality of tax audits to the timely determination of whether the returns reported the correct tax liability.
- Contract auditors’ financial incentive to aggressively seek additional tax assessments and quickly close audits may cost governments and taxpayers. Contract auditors not only aim to maximize taxpayer assessments, but also to quickly complete the audit. This approach may lead the taxpayer to appeal taxes assessed and engage professional—and expensive—tax practitioners or attorneys, while also burdening governmental tax administrators and the courts.
- Taxpayer audits should report all appropriate tax adjustments, regardless of whether they cost or benefit the taxpayer; however, contract auditors may only pay attention to any adjustments that result in an increase in taxpayer liability.
- Since all classes of taxpayers must comply with the tax laws, all classes of taxpayers should be subject to potential audit review. The financial interest of the contingent fee contract auditor, however, will likely result in an exclusive audit focus on high-income taxpayers, with other taxpayer classes not subject to any substantive compliance review.
- Contract auditors may not have the same data privacy standards as governmental auditors. Sharing confidential taxpayer data with contract auditors presents a risk of unauthorized use (e.g., fraud, identity theft) for monetary gain.
- Potential conflicts of interest or the appearance of impropriety may result when for-profit auditors select and audit taxpayers who may be their potential competitors. TEI states that the contract auditor’s “business relationships could influence the contract auditor’s decision to audit and assess one company over another. Indeed, the risk exists that a contract auditor may use its auditor status to confer a competitive advantage to an affiliate in a business competing with an audited company.”
TEI and AICPA Reasons for Opposing States’ and Localities’ Use of Contingent Fee Auditors
The IRS asserts that “the purpose of auditing a tax return is to determine the taxpayer’s correct liability—no more or no less.”
Exhibit 2 provides selected state and court references addressing conflict of interest concerns in using contingent fee auditors. Each reference concludes that such arrangements threaten the fairness and impartiality of the tax audit process.
Selected State and Court References Addressing Conflict of Interest Concerns of Using Contingent Fee Auditors
Jurisdictions Banning Contingent Fee Arrangements
Several states have taken the lead in either banning a municipality’s use of contract auditors to perform tax audits or in disallowing service contracts entered into under contingent fee arrangements. For example, in July 2012, North Carolina enacted legislation prohibiting the state department of revenue, local governments, and the state treasurer from using third-party contractors paid on a contingent fee basis for audit and assessment purposes. In June 2015, the ban was made permanent.
In April 2011, Arizona enacted legislation that restricts municipalities from outsourcing tax auditing functions to private companies under contingent fee arrangements. Pennsylvania and South Carolina have also enacted legislation that generally prohibits the use of thirdparty auditors paid on a contingency basis in field audits. In Georgia, the Georgia Supreme Court invalidated on public policy grounds a contingency fee arrangement where a contract auditor received a contingent fee collected following its audit of property tax returns [Sears, Roebuck and Co. v. Parsons, 260 Ga. 824 (1991)]. Finally, Louisiana has enacted legislation that permits the use of contingent fee arrangements, but the contract auditor must disclose to the taxpayer the terms of such arrangement, and the auditor may not retain any documents or taxpayer records beyond the conclusion of the audit.
Proactive Steps for Companies and Practitioners
Companies that may be subject to a state or local tax audit conducted by a contingent fee contract auditor can take steps to prepare for such an audit and to advocate against states’ and localities’ use of such auditors. CPAs can become active members in the TEI, the AICPA, and other professional organizations to stay informed of relevant court cases and policies and statements issued. In addition, companies might consider supporting the AICPA initiative encouraging state CPA societies to advocate the prohibition of contingent fee audit arrangements. A possible solution to localities’ claims of insufficient funds to conduct their own audits is the shared use of state auditors to perform local audits based on pooled funding arrangements.
If CPAs have clients subject to a state or local tax audit performed by a contract auditor, they should discuss the concerns raised by the TEI and the AICPA (as outlined in Exhibit 1) with the contract auditor. For example, they should inquire whether the auditor is under contract with the state or locality and, if so, whether the contract is a contingent fee arrangement. Respectively exercising this right to know will inform the contract auditor of the company’s legitimate concerns and might help to minimize them. CPAs should also discuss their concerns with the state or local government that engaged the contract auditor and make certain that the auditor’s engagement is in accordance with state law governing the employment of outside contractors. Insisting that the state or local government agree in writing to accept responsibility for any breach of confidentiality on the part of the contract auditor is recommended.
Finally, CPAs should request that the contract auditor communicate any audit adjustments that benefit the client and be aware of any possible conflict of interests between the contract auditor and the client or a competitor. If necessary, legal counsel should be consulted for appropriate follow-up actions.