Tom Talks Taxes - August 8, 2023

Best practices for reviewing and amending a tax return

I recently reviewed a 2022 joint tax return prepared by another tax professional with a clear error: four long-term residential rentals with $22,000 in net income and no §199A deduction taken. In addition to the rentals, there was wage income and pension income. Amending the return would generate a $1,000+ refund.

This is a familiar situation: a tax professional reviews a tax return, either self-prepared by a taxpayer or prepared by another tax professional, and finds a mistake on the tax return. What are the best practices for handling this process?

Whenever a tax professional reviews a previously filed tax return, they can reasonably rely on information provided by the taxpayer without verification; however, that is not without limits. Circular 230 §10.34(d) states that a practitioner may

…rely in good faith without verification upon information furnished by the client. The practitioner may not, however, ignore the implications of information furnished to, or actually known by, the practitioner, and must make reasonable inquiries if the information as furnished appears to be incorrect, inconsistent with an important fact or another factual assumption, or incomplete.

Treas. Reg. §1.6694-1(e)(1), which relates to §6694 preparer penalties, comports with Circular 230, stating that the tax professional

… generally may rely in good faith without verification upon information furnished by the taxpayer. A tax return preparer also may rely in good faith and without verification upon information and advice furnished by another advisor, another tax return preparer or other party (including another advisor or tax return preparer at the tax return preparer's firm). The tax return preparer is not required to audit, examine or review books and records, business operations, documents, or other evidence to verify independently information provided by the taxpayer, advisor, other tax return preparer, or other party. The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. Additionally, some provisions of the Code or regulations require that specific facts and circumstances exist (for example, that the taxpayer maintain specific documents) before a deduction or credit may be claimed. The tax return preparer must make appropriate inquiries to determine the existence of facts and circumstances required by a Code section or regulation as a condition of the claiming of a deduction or credit.

If the tax professional identifies an error, it is not appropriate for the tax professional to take action on that knowledge without the taxpayer's consent. It is the taxpayer’s tax return, after all. Circular 230 §10.21 only requires that the tax professional

…advise the client promptly of the fact of such noncompliance, error, or omission. The practitioner must advise the client of the consequences as provided under the Code and regulations of such noncompliance, error, or omission.

If the taxpayer declines to amend the tax return, the tax professional does not need to act further; however, if the error is significant, it may be prudent to get the taxpayer’s response in writing just in case the IRS examines the issue later.

If the taxpayer agrees to amend the tax return, the tax professional should execute an engagement letter with an appropriate fee for the services to be rendered. Circular 230 §10.33 states it is a best practice for the tax professional to

…have a clear understanding with the client regarding the form and scope of the advice or assistance to be rendered.

While the primary service will be the amended tax return preparation, additional value-added services could include post-submission troubleshooting and representation if the IRS selects the amended return for examination.

A tax professional may believe that amending a tax return they did not prepare makes them liable for all the positions taken on the original return. Treas. Reg. §1.6694-1(e)(2), which relates to §6694 preparer penalties, explicitly states that this is not true:

…a tax return preparer may rely in good faith without verification upon a tax return that has been previously prepared by a taxpayer or another tax return preparer and filed with the IRS. For example, a tax return preparer who prepares an amended return (including a claim for refund) need not verify the positions on the original return. The tax return preparer, however, may not ignore the implications of information furnished to the tax return preparer or actually known by the tax return preparer. The tax return preparer must make reasonable inquiries if the information as furnished appears to be incorrect or incomplete. The tax return preparer must confirm that the position being relied upon has not been adjusted by examination or otherwise.

A tax professional does not need to re-prepare from scratch a tax return they are amending, nor are they required to verify every position taken on that previously filed tax return. The simple application of the Circular 230 standards described previously will protect the tax professional from exposure to §6694 penalties in this situation.

Let’s apply this information to the example at the beginning of the article. The 2022 return can be amended to add the §199A deduction without verifying each entry on the originally filed tax return. However, the tax professional must exercise due diligence by reviewing the entire return to ensure nothing appears incorrect, incomplete, or inconsistent. If the Schedule E entries appear consistent with the type of rental activity reported, they do not need to be verified with documentation.

The tax professional should also review the 2020 and 2021 Form 1040s as part of this potential engagement. First, these tax years may also be missing the §199A deduction and generally remain open under the refund statute of limitations. Second, it also allows the tax professional to verify there are no qualified business income loss carryforwards that would explain why there is no §199A deduction on the 2022 tax return. While this should be visible on a 2022 Form 8995, §199A errors on tax returns are extremely common, so this extra step is prudent.

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