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War Story: Tax Planning and Compliance

By Timothy Batts

Here’s how Mike Montague, CPA, managed to dig a deep hole for himself.

His client, Ira “Iron” Mann, a fiercely competitive triathlete, had developed an extensive, successful chain of bakeries in the Midwest, starting out by baking energy bars in his kitchen for himself and other triathletes. The bars caught on rapidly with all kinds of athletes, and soon Mann was opening bakeries and mass-producing a wide variety of organic, packaged health foods under the name of “High Bar Goods.”

Montague had met Mann during a competition, and when Mann mentioned that High Bar’s financial needs were growing too fast for him to handle by himself, Montague offered his tax and accounting services. The CPA soon was providing a variety of accounting, tax planning and compliance services for Mann’s rapidly expanding chain of bakeries.

After many years of steady growth and expansion into several neighboring states, Mann thought about selling his well-recognized business to a large corporation in order to devote more time to training for competitions. He discussed the idea with Montague, who recommended that Mann consult with a Chicago law firm, Chester, Dexter & Fletcher (CD&F), specializing in business buy-sell agreements for publicly held companies.

Mann met with CD&F, which soon found a buyer in General Cereals, Inc., a large publicly held conglomerate. General Cereals offered $30 million for High Bar Goods, but wanted to spread the payments out over 20 years in annual installments of $1.5 million. Mann was somewhat receptive to the offer but was feeling like the “little guy” up against General Foods, and CD&F seemed to be more in the corner of General Cereals than in High Bar’s corner.

Mann got Montague involved in the conference calls with CD&F as the parties negotiated a final contract for the deal. Montague made it clear during the calls that he had no experience in public company tax and securities issues, and that CD&F would handle all of the technical tax issues.

After numerous calls that left Mann feeling as if he had just completed as many triathlons, the parties finally agreed to a 10-year installment sale with annual payments of $3 million. Montague reviewed the final contract with CD&F before it was signed by Mann and General Cereals, and the CPA filed the tax returns to reflect the sale of High Bar by Mann.

Soon afterward, Mann received a notice from the Internal Revenue Service that his tax return reflecting the sale of High Bar Goods was being audited. Montague assisted with the audit and was informed by the IRS that Mann’s tax return did not reflect the IRC §453A(a)1 requirement for taxpayers to pay the interest on taxes deferred through installment sales of more than $5 million. In Mann’s case the interest amount on deferred federal and state taxes came to about $150,000 for the first year alone.

Mann was highly upset by the news. When he realized that the entire deferred-tax issue had not been raised during the price negotiations with General Cereals, and that the total deferred taxes were close to $1 million for all 10 years, he became more agitated.

Montague’s position was that CD&F, as a law firm specializing in large buy-sell transactions, should have apprised all of the parties of the deferred-tax and interest issues. CD&F’s position, however, was that Montague should have informed his client of the information as part of his tax planning and compliance services.

While Montague and CD&F were busy pointing their respective fingers at each other, Mann filed a lawsuit against both of them, alleging negligence and damages of $1.15 million.

Risk Management Tips

A good engagement letter would allocate, in limiting language, the responsibilities of the CPA, the client, and third parties. Engagement letters communicate to the client and third parties what the CPA will and will not do, and who will be responsible for which tasks and decisions. An engagement letter would have resolved the problem of who was responsible for determining tax liabilities arising out of the buy-sell agreement before it happened.

Documentation would have helped Montague considerably when he had informed his client and the law firm that he would not be handling the technical tax issues associated with the purchase of High Bar Goods. Diligent CPAs document their consultations, providing a brief summary of the issues discussed and the decisions agreed upon. Had Montague documented his consultations, he would have had tangible evidence that the law firm was responsible for handling the technical tax issues.

It is also wise for CPAs to discuss volatile situations with an attorney, risk advisor, or liability insurer before, or as soon as, a problem arises. The potential loss of billable time, money, energy and reputation in dealing with a lawsuit can be minimized with enough advance notice and action. Conversely, late reporting of a problem or potential claim makes it harder to take proactive measures to prevent or mitigate a claim. Clients often are willing to see the positive aspects of a situation in order to resolve the problems fairly and move on with their lives.

Editor’s Note: “War Stories,” drawn from Camico claims files, illustrate some of the dangers and pitfalls in the accounting profession. All names have been changed.
Timothy Batts, J.D., is a professional liability claims specialist with Camico. He has more than 14 years of experience in professional liability claims management, with specific expertise in loss prevention. He earned his bachelor’s degree from Boston University, and his Juris Doctor from University of North Carolina School of Law in Chapel Hill.