Tax Return Preparation and Its Implications
Jay A. Soled
2005 - The trend of outsourcing preparation of income tax
returns overseas, particularly to India, began about five
years ago and shows no signs of abating. Its popularity has
grown as tax practitioners have come to appreciate its advantages.
reason for this growing trend is threefold. First, there
is an economic basis. Outsourced tax returns can be prepared
in an cost-efficient manner by a highly skilled workforce.
Moreover, outsourcing obviates the need for U.S. accounting
firms to hire temporary staff during the busy tax season
months of February, March, and April, and pay concomitant
expenses (e.g., health-care costs and unemployment insurance).
Although U.S. accounting firms’ experiences have varied,
many have enjoyed tremendous labor-cost savings, often 50%
or more per return.
second reason is the practical efficiency associated with
using an overseas workforce coupled with the advent of secure
websites that enable information to be transferred across
the globe in seconds. Because of time-zone differences,
U.S. accounting firms often can delegate work to overseas
accountants before they leave work at night and find the
work done when they return in the morning, effectively creating
accounting firms want to maintain their competitive edge.
They fear that if competitors use outsourcing and they do
not, they may ultimately price themselves out of the marketplace.
is not an unalloyed blessing. U.S. accounting firms should
consider several issues if they have already jumped on the
outsourcing bandwagon or are considering doing so.
income tax return preparation work can be done in several
ways. Some accounting firms retain the services of unrelated
third parties; other firms hire overseas staff, which often
involves the same concerns (e.g., maintenance of confidentiality).
the mode of outsourcing is chosen, a firm must define the
scope of the responsibilities it wishes to delegate. Does
the accounting firm want to limit the outsourced labor force’s
responsibilities to menial tasks such as keypunching entries?
Alternatively, does the accounting firm want to broaden
the outsourced labor force’s responsibilities to include
substantive analysis? This critical decision may have civil
tax penalty implications (discussed below).
from defining the scope of outsourcing responsibilities,
an outsourcer must decide how to transmit information. Overnight
mail is one possibility, but it is cumbersome and often
impractical because of the associated expense and time involved.
Accounting firms usually scan taxpayers’ relevant
information into a portable document format (PDF) file and
then e-mail the PDF to the staff of the outsourcing entity.
Handling this process electronically solves both the delivery
cost and the timing issues. When the outsourced staff completes
its task, it e-mails back the output.
the processed income tax returns are received from the outsourcing
entity, most firms conduct a thorough review of their accuracy.
Absent that review process or some other procedure to ensure
accuracy, a firm risks the imposition of civil tax-return-preparer
penalties or, worse, suspension from practice.
of Tax Return Preparer Penalties
IRS has occasionally offered guidance on the implications
of using third parties in the tax return preparation process.
For example, Revenue Ruling 85-187 describes a fact pattern
where a practitioner completes a worksheet, and the third
party, using this worksheet, prepares a tax return. At no
time does the third party come into direct contact with
revenue ruling raises two questions:
Will the entity that furnishes the computerized tax return
preparation service be classified as an income tax preparer
under IRC section 7701(a)(36)?
If so, what are the implications of an entity being classified
revenue ruling points out that more than one person or entity
can be properly categorized as a preparer. According to
the revenue ruling, the practitioner is clearly a tax preparer,
because she has the primary responsibility for the overall
substantive accuracy of the return. The practitioner therefore
is responsible for signing the tax return, furnishing identifying
numbers, providing a copy of the return to the taxpayer,
and retaining a copy of the return on file
unexpectedly, Revenue Ruling 85-187 takes the position that
the third-party entity to which taxpayers’ information
was outsourced also fits the IRC definition of an income
tax return preparer. This is because the outsourcing entity
is in the business of preparing income tax returns for compensation,
and the scope of its work extends beyond mere typing, reproducing,
or other mechanical assistance. (Because the outsourcing
entity in question did not have the “primary responsibility
for the overall substantive accuracy of the return,”
however, it was held not to be responsible for ancillary
obligations associated with preparer status, such as signing
a result, the practitioner and the outsourcing entity face
the possibility that IRC sections 6694(a) and 6694(b) penalties
may apply if—
any part of an understatement of liability with respect
to a return or claim for refund is due to taking a position
that has no realistic possibility of being sustained on
its merits, or
the understatement is due to a willful attempt to understate
amounts of the penalties are $250 and $1,000, respectively.
Given the similarities between the fact pattern set forth
in Revenue Ruling 85-187 and overseas outsourcing, the IRS
position is clear: Notwithstanding that they use the services
of a third-party provider, U.S. accounting firms, for purposes
of the IRC, maintain their classification as income tax
return preparers. As such, they have the responsibility
to check the quality and accuracy of outsourced income tax
returns. If they are derelict in their duties, they may
be subject to civil tax penalties. In egregious situations,
the IRS can seek to enjoin their practice or, under Circular
230 (as revised under the American Jobs Creation Act of
2004), the Treasury Department may censure or impose monetary
penalties. If necessary, the preparer can be suspended from
practicing before the IRS, and the professional organizations
to which individuals belong can rescind their professional
IRS would also classify the overseas outsourcing entity
as an income tax preparer and, as such, potentially subject
to the income tax return preparer penalties. It is not clear
how the IRS could enforce penalties against overseas companies
or enjoin them from practice.
penalties can be avoided in several ways. Penalties will
not apply if a preparer can demonstrate that normal office
procedures and related facts and circumstances suggest that
an error justifying a penalty would rarely occur and that
the procedures were followed for the return in question.
Such procedures would include the following:
Client organizers or data sheets that request pertinent
A checklist to review the thoroughness of taxpayer supplied
A checklist to review the accuracy of the final tax return
examining the facts and circumstances surrounding tax return
errors, IRS agents are instructed to consider the education,
training, and experience of the preparer.
taxpayers retain the services of a tax professional, they
ordinarily have two expectations: that the professional
will render the services involved, and that the information
they convey will remain confidential. The process of outsourcing
challenges both of these assumptions.
the first assumption, tax preparers will argue that the
terms of engagement are not as narrow in scope as assumed.
Taxpayers engage a professional to complete tax returns
in an efficient and cost-effective manner. Professionals
can argue that a taxpayer tacitly permits a tax preparer
latitude to effectuate the desired end, a flawless tax return.
In the minds of many, if the means involves the use of third-party
preparers—whether a data-processing company in the
United States or an accounting firm in India—then
so be it. Effective for professional services rendered after
July 1, 2005, however, Ethics Ruling 112, issued by the
AICPA Professional Ethics Executive Committee, requires
that a member “inform the client, preferably in writing,
that he or she may use a third-party service provider.”
second assumption has less room for interpretation. Most
taxpayers do not want their sensitive tax return information
ever made public. Most firms that outsource do not take
this concern lightly and have taken steps to ensure confidentiality.
In order to safeguard the privacy of their clients, accounting
firms generally insist that the staff of the outsourcing
entity not have printers connected to their computer terminals,
nor a means of saving the relevant documentation onto computer
discs. They hope that this inability to print or save information
will curb the likelihood that outsourcing staff members
will use confidential information in inappropriate ways.
Effective for professional services rendered after July
1, 2005, however, revised Ethics Ruling 1, issued by the
AICPA Professional Ethics Executive Committee, is clear.
It requires that “prior to using such a service provider,
the member should enter into a contractual agreement with
the third-party service provider to maintain the confidentiality
of the information and be reasonably assured that the third-party
service provider has appropriate procedures in place to
prevent the unauthorized release of confidential information
to other.” Whether such contractual safeguards prove
hermetic remains unanswered.
these privacy safeguards, the Gramm-Leach-Bliley Act of
1999 requires other measures to be taken. The law applies
to “financial institutions,” defined to include
firms that are engaged in the practice of preparing tax
returns. Under the act, firms must design, implement, and
maintain safeguards to protect customer information. In
addition, companies must give their customers a privacy
notice that explains the firms’ information-collection
and -sharing practices and supplies customers with an opt-out
right, to limit the sharing of their information.
date, the Federal Trade Commission has not challenged any
accounting firm with respect to its overseas outsourcing
practices. Aside from the act, the IRC imposes stiff penalties
for not maintaining client confidentiality; namely, a criminal
tax penalty of $1,000 and possible imprisonment of up to
one year. The severity of this punishment reflects the importance
that Congress places on the confidentiality of tax return
A. Soled is a professor of taxation at the Rutgers
University School of Business.