Anyone who has even a passing acquaintance with divorce, professionally or personally, will usually concede that it is a steaming cauldron of emotions bubbling up from broken dreams, anger, fear about the future, and the financial disaster that it usually visits on its participants.
Those professionals whose practice is focused on providing services to divorcing couples have made their own bed. This article addresses issues for CPAs who are but innocent bystanders yet who, in standing too close to the conflagration, can get burned.
There are two broad categories of issues to consider for CPAs in connection with the future, ongoing, or past divorce of married clients for whom tax returns are prepared. They are:
- When clients announce their divorce
- Decision time
- Before the divorce is final
- A divorce with a business in the middle
- Discontinuing service
- Providing services post-divorce
- Requests for records
- Informal requests
- Formal requests by subpoena or court order
- Confidentiality issues in responding to records requests
- Requests for affidavit or subpoena for deposition in divorce or support proceedings
While the facts and circumstances surrounding these issues can vary widely, understanding the pitfalls along with your legal and professional responsibilities can help you avoid stepping into the flame.1
WHEN CLIENTS ANNOUNCE THEIR DIVORCE
Did you ever have to make up your mind?
You pick up on one and leave the other one behind
It's not often easy and not often kind
Did you ever have to make up your mind? (John Sebastian – Lovin Spoonful)
When a married couple for whom a CPA provides only income tax return preparation and related services (no business entity) announces their divorce, their interests have instantly become divergent until the divorce becomes final, regardless of whether it is a “friendly” divorce.
After learning of the divorce, the CPA should immediately consider whether he or she wishes to continue providing services to both spouses during the proceedings. Often, the clients assure the CPA that they will not involve the CPA in the drama. Nevertheless, the CPA must make an independent decision as to if this involvement will occur. If no conflict arises in providing tax services to both, and care is taken to maintain the confidentiality of their information2, there is no reason why they can’t continue to be clients.
Before the Divorce is Final
The decision about providing tax advice to both spouses before the divorce is final should be governed by whether the advice raises a conflict of interest. A conflict is raised when the advice may provide a benefit to one spouse at the expense of the other, either at present or in the future. For example, choice of filing status is an issue on every individual income tax return. Another example would include whether to capitalize or take an IRC §179 deduction for a rental property addition.
Once a conflict of interest has been identified, providing tax advice to both spouses under these circumstances is not recommended.
Many divorcing couples will try to file a joint return until the last full year3 of their marriage4 as it usually produces a lower total tax than filing separately. The down side of a joint return is the joint liability created for the return and for the taxes owed. This joint liability issue should be addressed in the filing instructions accompanying the completed tax return.
If the couple elects to file a joint return, the CPA should require that each spouse provide the CPA a letter of instructions (or a joint agreement) from their divorce counsel acknowledging the existence and acceptance of the joint liability risk. This document also should address other potentially controversial issues related to the joint return such as who pays the tax and from what funds, who is entitled to any tax refund, who will pay to defend the return positions if they are challenged, and who will pay any additional tax, penalties or interest assessed.
When preparing such joint tax returns, certain decisions may need to be made, such as if to carry a loss forward or back, or whether income or assets are characterized as community or separate property. A multitude of factors can affect both current and future tax liabilities as well as divorce settlements. If such a situation arises, the CPA should:
- Inform both spouses of the issue that must be resolved,
- Ask both spouses to confer with independent counsel about the most favorable tax treatment for them,
- Require both spouses to confirm, in writing, the preferred tax treatment, and
- Provide a timeframe in which the decision must be made.
If both spouses are not represented by counsel or they do not wish to incur the expense of seeking additional tax advice, the preparation of joint tax returns becomes a more complex issue.
Signed engagement letters should be obtained prior to commencing services. The engagement letter should:
- confirm that both spouses were advised to seek external tax advice regarding filing status,
- list the filing status to be adopted on the tax return,
- acknowledge the existence and acceptance of the joint liability risk,
- acknowledge the existence of a conflict of interest, and
- waive their rights to any future claims related to the filing status chosen for the returns to be prepared and filed.
In the event they choose to file as married filing separately, separate engagement letters should be issued to and signed by the spouses. In addition, a document should be signed by each spouse, acknowledging the conflict and waiving rights to future claims related to the filing status adopted.
In either case, consult with your own attorney regarding language to use in acknowledging the joint liability risk and the conflict of interest, and in waiving future claims related to the filing status selected.
If one the spouses decides at the last minute that he or she does not wish to file a joint return, the decision should immediately be explained to all concerned parties, and a decision made by the CPA whether to continue to provide services to either client.
A Divorce with a Business in the Middle
Divorcing clients who own a business make the process more complicated. When the married couple and their business were one big happy family, the interchange of information and documents was probably very casual. Once the marriage fails and the former spouses become adversaries, legal distinctions become important.
If the business is simply a Schedule C item and not a separate legal entity, the points made in the discussion above are adequate. If, however, the business is operated in its own legal entity (LLC, corporation, partnership), possibly with other unrelated parties, the landscape is different. The entity is an additional client with rights of its own and duties owed to it.5
With respect to requests for tax and accounting information related to a business owned in whole or in part by either spouse, CPAs must consider both confidentiality obligations and if the requestor is legally authorized to request the records on behalf of the business or has an appropriately executed consent. Even when such requests are informal, CPAs should consult with their own attorney prior to deciding how to best respond.
The “Requests for Records” section addresses the CPA’s responsibilities for response to such requests. These requests should be and usually are complied with based upon the consent of the entity. Moreover, the CPA in possession of the records must require the requesting parties to honor the restrictions contained in the AICPA Code of Professional Conduct.
If the CPA decides to terminate the relationship with one or both spouses, attention must be given to the process in order to ensure that the termination does not occur at a time or in circumstances that would disadvantage the terminated client. The termination should occur when there are no deadlines in the immediate future that would make finding a successor CPA daunting. In addition, the client should be advised of any deadlines looming in the more distant future. Courtesy and cooperation are the bywords here. Keep it simple, civil, and clear.
While the CPA is often the decision maker, sometimes the choice is made by one of the clients or the client’s counsel. Regardless of who makes the decision to terminate, communication with the former client must be transparent, direct, and clear. The CPA should terminate the engagement in writing and copy all concerned parties, including counsel. Concerns to be addressed in this communication include:
- Access to historical tax data,
- Cooperation with the successor CPA, and
- Authorization to share tax information with the successor CPA.
- If tax return information is requested, the authorization must be in accordance with IRC §7216.
In working with the successor CPA, one might consider advising them in the same manner that predecessor auditors coordinate with successor auditors under SAS No. 84. In other words, advise the successor that data is provided for their familiarization and background, and that they must make their own determination as to the proprietary of the tax accounting and return positions should they affect the successor’s work.
No matter how a client leaves a CPA’s practice, consideration must be given to record retention. Records should be retained for the designated time period defined by the accounting firm’s retention policy, even if the client is no longer active in the practice. Tax returns that generate net operating loss, passive loss, capital loss, or other carryforwards or credits should be maintained for periods consistent with the use of the carryforwards involved and the relevant tax statute of limitations, which may be longer than the designated time period defined by the accounting firm’s record retention policy.
Providing Services Post-Divorce
Providing services to one or both spouses post-divorce does not generally create a conflict of interest. However, the duty of confidentiality survives the termination of both a professional relationship and the marriage. Information learned through one confidential client relationship cannot be used for the benefit of another client.
For instance, if the CPA continues to prepare tax returns for both spouses post-divorce, an issue may arise if one spouse treats monthly payments as child support while the other informs you that it is alimony. If such a situation occurs, and the former spouses cannot agree as to the proper tax treatment, the CPA may be forced to withdraw from both engagements.
REQUESTS FOR RECORDS
As the divorce proceeding (litigation by another name) progresses, the attorneys will often issue letter requests for documents. Typically, where no business is involved, these requests are made and fulfilled with relative informality between counsel for the divorcing spouses and with no involvement by third parties, such as their CPAs. However, where one spouse has no access to historical tax and related financial records and the other is uncooperative, third parties who possess these records will often be called upon to provide records. This process becomes more adversarial in subsequent years when the spouses are filing separate returns and one spouse seeks to examine the other’s earnings and finances, including their income tax returns, usually in spousal or child support proceedings.
These requests are often informal. Letters from attorneys are accorded no legal weight, and are similar to any informal request for records one might get from a bank or mortgage broker. If the clients whose records are being sought by the attorney provides a written consent to release the records (in compliance with IRC §7216 if tax return information is requested), they can be provided. However, without such consent, the CPA cannot provide the requested information in response to the informal request
Formal Requests by Subpoena or Court Order
Formal requests are civil subpoenas signed by attorneys, are usually issued by completing a form, and are not generally considered to be court orders. There are also civil subpoenas signed by a judge (or a court clerk in the name of a judge) which may be considered a court order. As noted above, IRC §7216 prohibits production of tax return information in response to a civil subpoena signed by an attorney absent the consent of the taxpayer or a court order. CPAs are not lawyers and should not attempt to discern if the subpoena served on them is validly issued, and is or is not a court order. This is when seeking assistance from your own attorney pays dividends. Moreover, some professional liability insurance carriers may engage an attorney to respond on the CPA’s behalf.
Confidentiality Issues in Responding to Records Requests
When confronted with these requests, CPAs may be wondering about client confidentiality, IRC §7216, or “don’t they already have these records?”
If the request addresses a joint income tax return then, of course, either spouse has the right to obtain a copy of the return and supporting documentation from the return preparer without the permission of the other. See, e.g. IRC §6103 (e)(1)(B).
If the request addresses separate returns prepared either during the marriage or subsequent to its end, many states have enacted laws which require former spouses in divorce related proceedings6 to give the other a copy of their income tax returns7. Sometimes these requests are limited in time or number (e.g. request can be made only once a year) or by other procedures. Generally, state laws incorporate a process in which tax returns are required to be disclosed by one of the former spouses to the other spouse. However, these laws are usually written to compel one of the spouses to produce their tax return but not to compel third parties to produce those tax returns. Third parties such as CPA return preparers have restrictions imposed on them in producing tax return documents. Among those restrictions is IRC §7216.
IRC §7216 casts a wide net in its definition of protected “tax return information.”
“Tax return information is all the information tax return preparers obtain from taxpayers or other sources in any form or manner that is used to prepare tax returns or is obtained in connection with the preparation of returns. It also includes all computations, worksheets, and printouts preparers create; correspondence from IRS during the preparation, filing and correction of returns; statistical compilations of tax return information; and tax return preparation software registration information. All tax return information is protected by §7216 and the regulations.”8
IRC §7216, simply put, prohibits the disclosure of “tax return information” to persons other than the taxpayer unless the taxpayer consents to the production. There are exceptions, however, which allow unconsented production:
(a) under any other provision of the Internal Revenue Code that permits disclosure,
(b) pursuant to a court order that compels production,
(c) in response to a subpoena issued by a federal or state grand jury,
(d) pursuant to an administrative order or subpoena from any federal agency, and
(e) pursuant to an administrative order or subpoena from any state agency or commission charged with licensing or regulating tax return preparers. Treas. Reg. §301.7216-2.
These exceptions do not include a state or federal court subpoena in a civil case signed by an attorney, though an order enforcing that subpoena or a subpoena signed by a judge would likely satisfy the production pursuant to a court-order exception.
Thus, in a divorce or spousal/child support matter absent (1) the consent of the taxpayer whose returns are involved or (2) a court order, IRC §7216 prohibits production in response to an attorney’s letter or even a civil subpoena issued by an attorney.
Ignoring the subpoena because one is confident in the proscription to production offered by IRC §7216 and waiting for a court to issue an order compelling production of the tax return information is not the best choice. First, if you get it wrong and the subpoena actually is in a form considered to be a court order, you could potentially be held in contempt of court. Even if it is not a valid subpoena, a state court may take umbrage at the refusal to honor it, even if it is arguably wrong9, and may attempt to impose on the recalcitrant CPA the costs of getting the order, despite the court being on questionable ground. Arguing with a superior court judge is not recommended, and even if you win the argument, you have likely incurred attorney fees to do so, which you probably cannot recover.
The solution to this problem is to act. Call the attorneys involved and explain your dilemma created by IRC §7216. If the attorneys are uncooperative or contentious, contact your own attorney and your professional liability insurer for assistance. If in the end the party whose records are being sought is going to have to give them up – because that is what the law demands – he or she may simply give you written consent to make the requested production. Indeed, most demands for the production of tax returns are addressed in this manner. If they believe they have a legal basis to resist the production, impose the burden upon them to seek a court determination on the issue10. The wrong things to do are: (1) nothing; (2) refuse to engage in the process to make the production consensual.
Requests for Affidavit or Subpoena for Deposition in Divorce or Support Proceedings
When clients divorce, CPAs may be presented with sworn affidavits for signature by counsel for one of the spouses or compelled to sit for a deposition. A sworn affidavit is any written document in which the signer swears under oath.11
With respect to receiving a subpoena for deposition, experience has taught us that in this situation there are three rules we must never violate.
- Rule One – Have an experienced attorney prepare you for your deposition and be present to defend you at your deposition.
- Rule Two – Don’t be a volunteer expert witness.
- Rule Three – Testify factually about what you know. Avoid assumptions and avoid opinions or characterizations of the facts.
Rule One. The attorneys who will be taking your deposition will have an agenda and a series of points they will seek to establish through your deposition testimony, which is given under oath. The points may relate to the identification and location of assets, location of records, characterization of income and the assets which produce that income (e.g., community or separate property), history of asset disposition or acquisition, etc. By attending without preparation or legal representation, you will have limited or no information regarding the sort of questions that can be asked, those that are objectionable, and if the questions are leading you down a path where you make an uncomfortable admission or conclusion.
Your attorney, that some professional liability insurance carriers may hire on your behalf, can prepare you by reviewing issues that may arise at your deposition and the most appropriate way to respond. Your attorney also may be able to talk with the attorney who noticed the deposition to understand the issues in the proceeding, what the attorney may be seeking to learn in the deposition, and if there are some contentious areas of questioning or implications of possible CPA error, lack of disclosure, or bias in your prior work. Most importantly, you really do not want to appear at your deposition unprepared and unrepresented.
Rule Two. Working as an expert witness can be exciting and remunerative work which provides a forum for the CPA to demonstrate his or her knowledge, analytical and organizational skills. It is not an appropriate engagement in every setting – especially when you have not been retained to be an expert and you are being asked to give opinions that may be adverse to your client or former client.
As a starting point, a CPA cannot be made to be an expert witness against his or her will. Questions can be posed about the CPA’s work product that is relevant to the case at hand and the technical or professional standards on which the work product is based. To go beyond that and ask questions based upon hypothetical facts or circumstances, or questions unrelated to the work product of the testifying CPA is generally improper.
If asked to testify in a manner in which the CPA is asked questions, the answers to which could be adverse to a current client or former client, the CPA must consider whether he or she can maintain objectivity and integrity if the CPA chooses to respond.
AICPA Code of Professional Conduct §1.100.001.01, Integrity and Objectivity, states, “In the performance of any professional service, a member shall maintain objectivity and integrity, shall be free of conflicts of interest, and shall not knowingly misrepresent facts or subordinate his or her judgment to others.”
Included under this section is §1.110.010.01, “Conflicts of Interest for Members in Public Practice,” which states: “A member or his or her firm may be faced with a conflict of interest when performing a professional service. In determining whether a professional service, relationship or matter would result in a conflict of interest, a member should use professional judgment, taking into account whether a reasonable and informed third party who is aware of the relevant information would conclude that a conflict of interest exists.
A good risk management principle is that no professional, CPAs included, should let themselves be placed into a position or engagement where their objectivity and integrity can be questioned. If the situation an attorney wants to put the CPA into is uncomfortable, there is probably a reason why it is uncomfortable. Therefore, advice ought to be sought on the wisdom of the engagement before starting to walk down that road. Don’t get bullied or bamboozled into doing something you have a suspicion you may regret.
Rule Three. If a CPA is compelled to testify about work he or she has done in the past or about events heard or observed, the answers should be responsive to the question but limited to the facts, events or observations – no more. Avoiding characterizations and opinions also avoids venturing into expert witness territory. If Rule One is complied with, it is unlikely Rule Three will be violated.
Being asked to sign an affidavit is similar to being asked to be an expert witness, or rather, similar to being coerced into being an expert witness. The attorney who makes the request that you sign it typically drafts the affidavit with an agenda. That agenda seeks to establish some fact or circumstance which may intrude into the realm of the CPA’s expertise, in other words, an expert opinion. The affidavit also may be adverse to a client or former client. If the CPA is unaware of the exact issues in the legal matter for which the affidavit is being sought, the CPA may find it difficult or impossible to determine if it is adverse to a client or former client.
The better strategy when asked to sign an affidavit, or even if asked to draft it or provide its contents, is to decline.
Clients who are going through a divorce present CPAs with many opportunities to be drawn into their divorce war. A more finely tuned appreciation of those opportunities, as noted in this article, may help to avoid an unwanted role in that divorce.
Arthur V. Pearson
Murphy, Pearson, Bradley & Feeney
San Francisco, Los Angeles, Sacramento
CNA, Accountants Professional Liability Risk Control, 333 South Wabash Avenue, 36th Floor, Chicago, IL 60604.
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1State law and board of accountancy regulations applicable to conflicts of interest vary by jurisdiction. Consult with counsel when these issues arise.
2In discussing the engagement with the couple, confidentiality should be addressed. For years in which a joint return is/was prepared, there should be no expectation of privacy. Any documentation provided or discussions relative to preparation of the joint tax return is available to both spouses. However, for years in which separate tax returns are prepared, the CPA should not provide information from one spouse to the other without a court order or subpoena and should dampen any expectation to the contrary.
3If divorcing couples do not have a final divorce decree by December 31st, they can usually file a joint return for that last full year of their marriage.
4 See IRC §7703 for the Code’s definition of “marriage” and IRS Publication 504 for the myriad issues relating to tax returns in marriage and divorce.
5 A single member LLC is a disregarded entity for tax purposes and the member will likely report the income of a Schedule C to his/her form 1040. This however, doesn’t obviate the fact that for state law purposes the LLC is still a separate legal entity.
6Proceedings such as spousal or child support adjustments, child custody, and amendments to a divorce decree.
7 See e.g., California Family Code §3664 and §3665.
8 IRS “7216 Frequently Asked Questions” 9-04-14, Q&A #5.
9 Keep in mind that many state court judges have little or no experience in or knowledge of taxation or of the intricacies of the federal tax code. They may not appreciate at first blush the privacy limits imposed by the Code.
10 A letter to the attorney representing the taxpayer whose records are sought indicating that production will eventually occur unless they seek protection from the court may hasten the proceedings.