Outsourcing Tax Return Preparation and Its Implications

By Jay A. Soled

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MARCH 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.

The 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.

The 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 24-hour operations.

Finally, 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.

Outsourcing 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.

How to Outsource

Outsourcing 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).

Once 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).

Aside 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.

When 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.

Application of Tax Return Preparer Penalties

The 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 the taxpayer.

The 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 as such?

The 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

Not 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 the return.)

As 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 the liability.

The 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 licenses.

The 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.

Preparer 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 tax information;
  • A checklist to review the thoroughness of taxpayer supplied items; and
  • A checklist to review the accuracy of the final tax return itself.

In examining the facts and circumstances surrounding tax return errors, IRS agents are instructed to consider the education, training, and experience of the preparer.

Taxpayer Expectations

When 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.

Regarding 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.”

The 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.

Beyond 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.

To 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 information.


Jay A. Soled is a professor of taxation at the Rutgers University School of Business.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 



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