At this panel, the group discussed how to deal with a lack of sufficient information from a client, including how to obtain or deduce that information and the regulatory standards on such matters.
Filling the Gaps
Geiger began the panel by asking the general question: What is a tax preparer supposed to do when a client with a cash business hasn’t kept the necessary receipts and documentation regarding sales? She turned to Brackney, who laid out some information from the IRS’s Audit Techniques Guide for Cash Intensive Businesses.
Ideally, Brackney said, “you should be working with [cash businesses] to educate them about how to keep their books and records in a businesslike way, so that every year it’s not some big guess as to what their actual income is.” When a new client comes to the CPA with inadequate records, however, some digging will be required. Bank records, invoices, and past returns may help with cross-checking computations of income; expenses not matching reported income is one possible red flag.
Hill remarked on the perception gap between clients and practitioners regarding the difficulty of preparing returns and the wealth of information needed. Pagano noted the unlikelihood of any cash business not involving some type of skimming. The bottom line, he said, is to look for reasonability and consistency in the gross profit figures; if things don’t add up, a CPA should inquire further. Even though there is no obligation to audit the return, it’s still appropriate to apply a reasonableness standard and compare margins and expenses to industry sources in these cases.
Pagano noted the unlikelihood of any cash business not involving some type of skimming. The bottom line, he said, is to look for reasonability and consistency in the gross profit figures.
Brackney brought up a question that many practitioners might not want to ask clients: ”Do you have two sets of books?” If income is not being fully reported, she said, there will be two sets, because “they have to know whether their business is profitable.” Geiger pointed out that it is also important to know which people know about the two sets of books, as such persons are potential whistleblowers. She mentioned a case she worked on where, after she had conducted a bank deposit analysis alongside an IRS agent and resolved the case with all income reported and penalties paid, the agent confided in her that there was a whistleblower, and had Geiger not been forthcoming and cooperative in her work, the case would have gone quite differently.
Hill brought up the lack of accountant-client privilege. The panel agreed that, outside of the limited privilege provided by Internal Revenue Code (IRC) section 7525, there is no protected confidentiality for these sorts of conversations. For this reason, Hill said, she would be reluctant to ask questions about multiple sets of books, saying such a case may leave the preparer no choice but to “fire the client.” Geiger and Brackney both cited cases of such recordkeeping that eventually landed clients in hot water, one where a whistleblower posed as a prospective buyer to gain access to the “real” books. Pagano also noted that cash businesses often misreport cash payroll and employment tax as well.
Turning to poor recordkeeping rather than actual fraud, Brackney recommended several methods for analysis, such as industry ratios, year-to-year comparative analysis, and inventory analysis. Hill said that her company uses software with an analysis section that can show the proportion of Schedule C income deductions taken compared to industry norms. She also recommended the website BizStats.com for such comparative analysis, noting that the information gained is usually not intended for the business owner, but for the practitioner to gain a sense of what issues to discuss with the client.
Pagano added that comparing costs of goods sold to beginning and ending inventory can be a helpful measure of real gross profits. “More likely than not,” he said, “[the fraud is] on the cash payroll side, and there you run into not only an income tax issue but clearly an employment tax issue and perhaps even a criminal referral.”
Whether to Continue the Relationship
Geiger then segued into the applicable professional standards, in particular the AICPA’s Statement of Standards for Tax Services (SSTS) 3, Certain Procedural Aspects of Preparing Returns. Hill noted that enrolled agents are covered by Circular 230, as are small firms that are not members of the AICPA. “You don’t know what your client chooses not to share with you,” Hill said. “You need to have something in your possession that shows where those numbers came from. And if you get into a reconstruction, then you need the tools to help you reconstruct.”
Hill then shared a case where an enrolled agent was doing the business’s books and reconciling the bank statements, but the IRS was still pressing the issue. Unbeknownst to him, the business owner’s wife was depositing checks in a second account. An analysis of industry norms would have revealed that the business’s margins were out of line. Ultimately, Hill said, “none of us in this room would have the kind of practices we have today if we didn’t begin from the assumption that our clients come to us with a desire to help us help them comply with the law.” That position of trust is vital, even if it occasionally borders on naiveté.
Pagano returned to the standards, saying that the operative word in SSTS 3 is “reasonable”; that is, what any CPA would have done in a similar situation. If another accountant would have inquired about a certain issue, but the accountant at issue did not, then the standard has been violated. He said that this language is in Circular 230 as well.
Brackney asked what the professional obligation is to keep or terminate the relationship with such a client: where does one draw the line? Hill’s first answer was that “a client who makes my stomach hurt isn’t a good match for me.” She elaborated that if the client had an unusual circumstance that caused the lack of records, she considers that more of a “teachable” situation, whereas annual faults with Schedule A or C deductions, especially charitable contributions, are more of a red flag.
Geiger pressed the issue, asking about repeated Schedule C business losses and how many years a practitioner can see them before deciding whether a venture is a hobby rather than a viable business. Pagano said that this is part of due diligence, and ultimately, if such losses continue, a professional must ask how the losses are being funded. Worse yet, he said, “you could have a potential problem for aiding and abetting in the preparation of a false return.” He noted that CPAs possess “an obligation that goes beyond simply satisfying the client.” Hill added that a Cash T analysis is an easy way to point out these sorts of problems. “It’s up to us to raise that flag when we see it happening and not let it go on from year to year,” she said.
Using Estimates
Brackney returned to the issue of estimating incomplete information so that a return can be filed on time. Pagano gave an example of a Chapter 7 trustee who does not have all the information necessary to do a full accounting of a nonprofit entity. In that case, he suggested using a Form 8275 to disclose and explain the gaps in the information and detail which information has been provided by the trustee. Hill added that in such cases, it is important to carefully follow the instructions for Form 8275, and also that the form is useful for explaining the numbers on attached schedules that the practitioner cannot validate.
Hill then discussed the AICPA’s SSTS 4, Use of Estimates. She said that while the statement allows the use of estimates, it does not allow the return preparer to be the one creating the estimates. “The taxpayer has to have a reasonable basis for information upon which you form the estimate,” she said. “The whole thought of making up a number for a client, that’s just a time bomb.” Brackney also cited Revenue Procedure 2016-13, which defines adequate disclosure. “The two functions it serves,” Brackney said, “are to protect the taxpayer against accuracy penalties if the IRS does disagree with the amounts stated on the return later and protect the return preparer from penalties under [IRC section] 6694, regardless of whether the taxpayer actually includes this Form 8275 in its filing.”
“It’s up to us to raise that flag when we see it happening and not let [losses] go on from year to year,” Hill said.
Brackney then asked the audience how many of them had filed a Form 8275 on any return; approximately 20% raised their hands. Of those, none reported being audited on that return. Brackney said that this result is consistent with when she speaks on this topic.
An audience member asked about having a client sign and initial certain items on a Schedule C and then keeping a copy in his file. Brackney thought this could be useful, but did not obviate the responsibility to act on suspect information. “It’s not a silver bullet,” she said. Pagano agreed, saying, “that’s nice, but to me, especially being a former agent, it’s irrelevant.” Hill added that an agent conducting an audit will still ask where the numbers came from, and Geiger said that one’s duty is always to inform the client about the error once it is discovered and ensure that it is corrected.
Another audience member asked about correcting an accounting method that requires the IRS’s consent to change—that is, once the deadline for doing so for the current year has passed. Brackney answered that, while the situation is not ideal, her advice would be to seek the consent: “It’s kind of assumed that you’re going to continue with the old method until you get consent to change it, and that no one is going to criticize you about that.” She also suggested filing a Form 8275 to disclose the method and then seeking consent to change it.
Illegal Source Income
Pagano mentioned a case where a check-cashing business was found to be laundering money. That prompted Brackney to say that “the right advice isn’t to not report that income or to not file a return, it’s to call your friendly tax controversy attorney about how to file a Fifth Amendment return—which is outside the scope of this panel.”
As another example, Hill brought up the fact that a number of states have legalized the growing and sale of marijuana, which is still illegal under federal law and thus considered illegal source income. “It’s an industry that really needs competent people to prepare the returns,” she said, “and preparers are in a Catch-22 in terms of what they do.”
The comments below represent the speakers’ own views and do not necessarily represent those of their partners, affiliates, or employers, nor do they represent official policy of the government or any government agency.
