Walking a Tightrope: Tax Risk on Audited Financial Statements
By Gary A Porter CPA
CPAs, when faced with a client, who may have a substantial unreported income tax liability in the event of an IRS audit, must contend with several different rules when accepting and performing an audit or other attest engagement for a new or existing client.
Contingent Liabilities
The AICPA requires that a CPA must consider the possibility of unreported liabilities when giving an opinion on the financial statements of any organization. However, one unreported liability that is often overlooked for an association is unreported federal income tax liability.
Generally, there is at least some element of risk associated with most associations, which choose to file Form 1120 instead of Form 1120-H. The risk is due to the fact that with the filing of an 1120 there are related tax elections that could be challenged by the IRS. Potential losses resulting from this risk are considered to be contingent liabilities under generally accepted accounting principles. The issue of tax risk on audited financial statements is a matter of determining whether or not a contingent liability exists. In order to properly evaluate this possible unreported liability, we must first look at the definition of a contingent liability.
For accounting purposes a contingency is defined as an existing condition, situation, or set of circumstances involving uncertainty as to the possible gain or loss to an enterprise that will ultimately be resolved when one or more future events occur or fail to occur. The term loss is used in this section to include many charges against income that are commonly referred to as expenses and others that are commonly referred to as losses.
FASB 5 gives three classifications of contingencies:
1. Probable: The future event or events are likely to occur.
2. Reasonably Possible: The chance of the future event or events occurring is more than remote but less than probable.
3. Remote: The chance of the future event or events occurring is slight.
The determination of whether or not to report a contingency is made as follows:
1. Accrual is required when the loss is probable and can be reasonably estimated.
2. Disclosure is required when it is at least reasonably possible that a loss may be incurred.
3. Disclosure is not required for remote loss contingencies that do not meet one of the two criteria above.
The possibility of an association being audited by the IRS and being required to pay additional taxes as a result of that audit fits the definition of a contingency because the association has a preexisting condition (the filing of the return), which may result in an expense (additional tax due) that will be resolved by an event that may or may not occur in the future (the occurrence of an IRS audit or the expiration of the normal statute of limitations on the return - 3 years unless the IRS believes that there is fraud.)
Tax Audit Risk
Most of the errors that have large income tax implications for an association result from the taxpayer filing Form 1120 and not complying with the rules for Sections 118, 263, 277 or a Revenue Ruling, such as 70-604, or using improper and excessive expense allocations to offset non-membership income. When considering the possible amount of unreported federal income taxes, a CPA should review at least the last three years’ income tax returns, and all required elections, such as votes of the members for any 70-604 elections, the votes of the members for any special capital assessments under IRC 118, and the computation of non-membership income. The effect of errors related to these issues usually is an increase in taxable income.
A CPA evaluates this risk by reviewing the association's tax elections, allocations, and tax accruals. The determination of whether an accrual, disclosure, or nothing is required is made by the CPA using the knowledge he/she has obtained from reviewing these documents of the extent to which the association complied with the regulations that apply to the tax elections taken in the return, in consideration of the chance of the association being audited.
Required disclosures or accruals are often overlooked by the CPA for several reasons:
1. The CPA performing the audit is also preparing the tax return, and he/she believes the returns comply with the regulations.
2. Many tax return preparers do not understand the specialized tax rules that associations must follow.
3. The consequences of not following these rules often have wide ranging effects that are not always straightforward.
4. Many CPAs consider the risk of an IRS audit so remote that it is not even worth considering. (The IRS audits approximately .77% (1 in 130) small corporate tax returns.)
5. Even in the event of an IRS audit, there may not be an adjustment if the CPA can convince the IRS Agent that the returns are filed correctly.
While the risk may be remote, a CPA should not underestimate the consequences of an IRS audit. The IRS agent, who is properly doing his/her job and applies the techniques in the IRS Audit Techniques Guide for Timeshare and Other Common Interest Realty Associations, will find the areas where the association did not comply with the rules, and will assess additional tax accordingly. An association that does not strictly comply with IRS regulations could find itself faced with a large tax bill plus many thousands of dollars in professional fees incurred while the case works its way through the audit process.
When facing an IRS audit, it is important to remember that an IRS audit is a procedural matter: either you complied with the rules or you did not, and the tax will be assessed accordingly. It does not matter what should or should not be taxed or whether you already spent the money, the return will be adjusted to follow the rules and the association will need to come up with the money to pay the tax.
Because IRS generally only holds open the last three years of returns, a CPA should review at least the last three years’ income tax returns and their supporting elections and allocations, prior to completing the audit of the current year financial statements. Failure to do so may subject a CPA to a liability claim if IRS audits the client after the report is issued, and IRS assesses a large tax bill for prior years. The current CPA may be subject to a suit for failing to disclose the unreported federal income tax liability along with the CPA who originally prepared the returns, as the association seeks to recover costs, additional taxes, and penalties owed as a result of the audit. In addition, the CPA could also face disciplinary action from his/her state regulatory agency for failure to follow professional standards when performing the audit.
Engagement Acceptance
The possibility of an unreported income tax liability also complicates a CPAs engagement acceptance process. If the CPA is aware of errors on prior tax returns and those errors could result in substantial taxes being assessed against the association, he must make the potential client aware of the problem. If the potential client has stated that they are not going to correct the prior returns, this creates a question as to the ethical practices of the client, which is a negative in the evaluation process when deciding whether to accept a new client. The CPA will need to make a determination as to whether or not the taxpayer’s decision not to file an amended return may be an indication of future behavior that might require the CPA to terminate the relationship with the client. On the other side of the issue, correcting three years of tax returns at this point would subject the association to a large tax bill, which it may be unable or unwilling to pay. In order to accept the association as a client, the CPA must make a determination that this is a morally responsible client that is coming to him/her so that past problems will not be perpetuated, has made the decision to let the general statute run out on prior returns, and intends to comply with the regulations from here forward.
If the CPA can make the determination described above, the greater good is for the CPA to accept the client and assist in filing proper returns in the future. Once a CPA has decided to accept the potential client he/she needs to:
1. Balance the client’s desire to do the right thing,
2. Acknowledge the client’s desire not to file amended returns,
3. Follow the disclosure requirements necessary under GAAP, and
4. Protect himself from liability in the event of an IRS audit.
Inability to Review Tax Elections and Allocations, and Other Documentation
The third standard of fieldwork requires the auditor to obtain sufficient competent evidential matter through, among other things, inspection and inquiries to afford a reasonable basis for an opinion on the financial statements. Section 326, Evidential Matter, paragraph .25 requires the auditor to obtain sufficient competent evidential matter about assertions in the financial statements of material significance or to qualify or disclaim his or her opinion on the statements. Section 508, Reports on Audited Financial Statements, paragraph .24 states that, “When restrictions that significantly limit the scope of the audit are imposed by the client, ordinarily the auditor should disclaim an opinion on the financial statements.”
Thus, the auditor is required to document the results of audit procedures directed at the tax accounts and the related disclosures. This documentation should include sufficient competent evidential matter about the significant elements of the analysis of the client’s contingent tax liability. The documentation should include copies of the client’s documents, schedules, or analysis sufficient to enable the auditor to support his or her conclusions regarding the appropriateness of the client’s accounting for and disclosure of significant tax matters. The audit documentation should reflect the procedures performed and the conclusions reached by the auditor and, for significant matters, should include the client’s documentary support for financial statements amounts and disclosures.
If the auditor is unable to obtain sufficient competent evidence about whether there is a reasonable basis for the client’s position, the auditor should consider the effect of this scope limitation on his or her report.
Often a scope limitation of this type occurs when the client cannot provide the evidence of the tax elections and the allocation schedules, there has been a change in the CPA performing the audit and preparing the tax return, and/or the former CPA will not release or does not have copies of the documentation used in the preparation of the prior years’ tax returns. In this situation, the current CPA is unable to determine whether or not there could be a material unrecorded tax liability in the event of an IRS examination of the client’s prior tax returns. Consequently, under the AICPA professional standards the client has imposed a scope limitation on the audit and the report must be modified accordingly.
Tax Return Preparation
When a CPA finds errors on a tax return, particularly if the errors were caused by the prior accountant, the CPA cannot perpetuate the error, and needs to advise the client as to options for straightening out the problems. In this situation, the CPA is in the difficult position of balancing professional standards with the client's desire to not pay a huge tax bill. The AICPA’s Statement on Standards for Tax Services (SSTS) No. 1 defines an error as any position, omission or method of accounting that at the time the return is filed, fails to meet the standards set forth in SSTS No.1. The term also includes positions taken on a prior year’s return that no longer meets these standards due to legislation, judicial decisions, or administrative pronouncements that have a retroactive effect. This statement applies whether or not the member prepared or signed the return that contains the error.
This statement requires that:
A member should inform the taxpayer upon becoming aware of an error in a previously filed return or becoming aware of failure to file a required return. A member should recommend the corrective measures to be taken. Such recommendations may be given orally. The member is not obligated to inform the taxing authority and may not do so without the taxpayer’s permission, except where required by law.
If a member is requested to prepare the current year’s return and that taxpayer has not taken steps to correct an error on the prior year’s return the member should consider whether to withdraw from preparing the tax return and whether to continue a professional relationship with the taxpayer. If the member does prepare the current year’s tax return the member should take reasonable steps to ensure that the error is not repeated.
Many associations, when faced with a large potential tax liability if amended returns were filed with the elections that either were made improperly or were not made at all, elect not to file the amended returns.
Form 1120-H is often filed as a break point between 1120 years when problems exist, since it does not carry the risks associated with a Form 1120. By filing Form 1120-H for three years, the statute is effectively closed on the 1120 years without perpetuating the errors that were created in those returns. While this does not actually close the statute or eliminate the liability for taxes that would have been assessed if the returns were audited, in the event that the taxpayer’s liability is substantially understated, it does, however, reduce the possibility of an agent questioning returns that IRS would generally consider closed.
Summary
Unreported tax liabilities present a number of problems for CPAs who work with community associations that have previously filed incorrect Forms 1120. A CPA must evaluate the risk of potential personal and firm liability due to the association’s unreported income tax liability when determining whether to accept an engagement. As part of his/her evaluation, the CPA should, at minimum, review the last three years’ returns and discuss with the client its plan to deal with any unreported income tax liability before accepting an attest engagement for any community association.
Gary Porter, CPA began his accounting career with the national CPA firm Touche Ross in 1971. He is licensed by the California Board of Accountancy and the Nevada Board of Accountancy. Mr. Porter has restricted his practice to work only with Common Interest Realty Associations (CIRAs), including homeowners associations, condominium associations, property owners associations, timeshare associations, fractional associations, condo-hotels, commercial associations, and other associations.
Gary Porter is the creator and coauthor of Practitioners Publishing Company (PPC) Guide to Homeowners Associations and other Common Interest Realty Associations, and Homeowners Association Tax Library. Mr. Porter served as Editor of CAI’s Ledger Quarterly from 1989 through 2004 and is the author of more than 200 articles. In addition, he has had articles published in The Practical Accountant, Common Ground and numerous CAI Chapter newsletters. He has been quoted or published in The Wall Street Journal, Money Magazine, Kiplinger’s Personal Finance, and many major newspapers.
Mr. Porter is a member of Community Associations Institute (CAI), American Resort Development Associations (ARDA), and California Association of Community Managers (CACM). Mr. Porter served as national president of CAI in 1998 – 1999.