News headlines about the coming tax season nightmare have been hard to miss. The IRS warned Americans to expect backups in processing returns and refund delays.
With the IRS in crisis, some taxpayers may conclude that this is the year to test the boundaries of what’s legal — or ethical — as they complete their federal returns. This can put financial advisers and paid tax preparers in an uncomfortable position.
Many advisers serve as fiduciaries, meaning that they commit to put the client’s interest first. If they’re bound to act in the client’s best interest at all times, then what are they supposed to do if a client insists on taking a highly aggressive or questionable tax strategy?
“If it’s transparently unethical, I will fire the client,” said Don Grant, a certified financial planner in Wichita, Kan. “I will not go against IRS rules.”
While Grant does not provide tax preparation services for clients, he might work with their accountant to address certain tax issues. If clients want to gamble by interpreting tax law in the most favorable terms to them, he will urge them to confer with their tax preparer to ensure they’re in the clear.
“There are some ambiguous rules,” he said. Involving an experienced and knowledgeable CPA helps his clients make an informed decision on how to proceed.
When considering tax shelters or certain reportable transactions, tax preparers have a duty to follow a “more likely than not” standard. That means they must have a reasonable belief that the position would more likely than not be sustained on its merits.
Even if they sift through the ambiguity and conclude that a particular reporting decision passes muster, the upshot can still sting. Just because an understaffed IRS is struggling with budgetary constraints and processing delays doesn’t guarantee cheaters will come out ahead.
“If you’re playing the audit lottery as a taxpayer, you’re asking for trouble,” said Mark Prendergast, a certified financial planner in Huntington Beach, Calif.
Prendergast, who’s also a CPA, used to provide tax prep in addition to financial planning for his clients. Today, he offers general guidance but isn’t involved in filling out tax forms. When clients mention a dubious tax reporting strategy, he might reply, “Here is the right way to do it.”
Ultimately, he says, it’s up to his clients to determine how they complete their returns — and whether they heed his advice.
A common area for fudging involves business expenses. Small business owners and the self-employed may apply a broad definition to what constitutes a deductible business expense.
Prendergast recalls a client who treated “almost everything as a business expense,” he says. Because this often involves judgment calls and gray areas, taxpayers may not blatantly break the law in their attempt to justify what they deem business expenses. So advisers might accept such behavior as long as it’s defensible.
“People are going to do what they’re going to do,” Prendergast said. “But if they’re going to cheat the government, they cheat me too.”
At the very least, he suggests that tax preparers educate filers about business expenses. If taxpayers intend to deduct meals and entertainment expenses, for example, their accountant should ask, “Do you understand what documentation is required for this?” and “Do you have all the receipts?”
Many advisers warn clients about the risks of push-the-envelope tax reporting, even with the IRS struggling to cope with mounting operational challenges.
“If we thought a client was being overly aggressive, we’d remind them of the financial and other ramifications,” said Doug Lynch, a certified financial planner in Dublin, Ohio. “You may pay back taxes and very high penalties. And you might face difficult legal issues with significant attorney and accountant fees. So we do our best to steer them away from an overly aggressive situation.”