This podcast discussion with Michael Reese, Risk Control Consulting Director (Accountants) — CNA Insurance, centers around the importance of engagement letters for tax practitioners. Michael emphasizes the role engagement letters play in setting expectations, providing clarity and mitigating risks during engagements. He also reviews the necessity of having clear, documented agreements to minimize disputes and liability issues.

What you’ll learn from this episode:

The importance of engagement letters
Common risks in tax engagements
The role of client education and communication in managing risk
How to handle quality control under deadline pressure

AICPA resources

Annual Tax Compliance Kit — Engagement letters, organizers, checklists and practice guides help you manage your tax season workflow.

Say "I do" to engagement letters — Uncover the importance of establishing parameters of client relations and detail the scope of services to be provided.

Other resources

Frequently Asked Engagement Letter Questions — The Accountants Risk Control team at CNA, the endorsed underwriter of the AICPA Professional Liability Insurance Program, summarizes answers to frequently asked questions.

Transcript

April Walker: On today's podcast, listen to hear how you can manage your risk with engagement letters. Hello, everyone, and welcome to the AICPA’s Tax Section Odyssey Podcast, where we offer thought leadership on all things tax facing the profession. I'm April Walker, a Lead Manager from the Tax Section. And I'm here today with Michael Reese. Michael is a risk control director with CNA.

Michael Reese: Good morning, April.

April Walker: Thanks for joining me today. Here at the AICPA, we work really closely with Michael and his team on lots of things and lots of projects. But I'm especially grateful for the partnership that we have with his team for Tax engagement letter templates. Speaking of engagement letters, they are now currently available to Tax Section members. Of course, I will put a link in the show notes so that you're able to access those.

April Walker: Today, we're going to talk about some common questions that we get, and I'm sure that you also get Michael on Tax Engagement Letters and just generally how to manage your risk as a tax practitioner. Welcome, Michael, and thank you for joining me.

Michael Reese: Thank you. Hopefully, what I can provide will be of use to your listeners. These are questions we often get as well. I do want to confirm that, but it's a very important topic. Glad we're talking about it here today.

April Walker: I'm positive that they will be helpful. Sometimes people get answers to questions that they don't really want to hear, but they're important for them to hear.

Michael Reese: Exactly.

April Walker: Just to start off, I'm wondering why you think it's crucial for tax practitioners to have an engagement letter in place not only for every engagement but before they actually start the work.

Michael Reese: April, I think there's two primary answers to this question. First, setting expectations and then setting guardrails in case something goes wrong. From a practice standpoint, it's very important for both the practitioner and the client to know what's going to happen and what work is being done. Your engagement letter hopefully is going to clearly state, "This is what you've asked us to do. This is what we're doing. This is what we collectively need to do to get this completed. This is the info we need and when we need it," etc.

If a practitioner doesn't have this, then they run the risk of a client coming back later and either adding services, sometimes without the added fee, or complaining that a service has not been performed. There needs to be that clarity upfront. For professional liability reasons, having that clarity helps limit your duty of care to the agreed-upon scope.

This way, in the event of a dispute, the practitioner has a strong argument for avoiding liability related to items for which they had no responsibility. That leads me to the second answer involving guardrails. Ideally, the engagement letter is going to set out the agreed-upon rules if something goes wrong.

Dispute resolution is not really something CPAs focus on until they are in the middle of one, but we routinely talk to tax practitioners who are in the middle of an engagement with a problem and they don't have the signed letter to fall back on. If that letter is in place before the work starts, you now have options if something goes wrong, whereas without the letter, you don't.

Now, I'm not ignoring the fact that getting a signed letter back can be a challenge, especially for 1040 clients. But I know there are practitioners out there that have a strict process. No letter, no work. Remember, the onus is on the client because they do need your help. Otherwise, they aren't showing up to your office.

If they want the service, then they need to work with you. April, I would say put it this way. When I go to get work done on my car, even for an oil change, they don't even take my keys until I've signed a piece of paper that says I agree to the service and the terms of service. If I ignore that paper, disappear for some period of time, and then come back like some tax clients, when I come back, my car is still how I left it unrepaired, and I can't now complain that I'm going to be late for work because my car isn't fixed. I can, but I don't know how far it's going to get me. I really would like to think that tax professionals should have no trouble with a similar approach.

April Walker: That's a great analogy. That's where we'll talk about this. Mike, you and I have both been in practice before. And sometimes we struggle with the way we've always done things, in a certain way, but it might not be the way the rest of the world operates. If we're thinking about this in a way of managing your risk, this is definitely a best practice.

Michael Reese: Yeah, I would agree.

April Walker: Great. Let's talk about some common risks that tax practitioners face during engagement. You've got your engagement letter, for sure. Check one. We are in the engagement. How might having that engagement letter help mitigate some of the risks that can happen as things are going on?

Michael Reese: I'll give you four. We can talk about these. But the first one and we did touch on it before in the prior question, there's risk when there's no alignment on what the client needs. The client may not understand truly what they need to comply. They just know they need to file a return. Once you have the discussion with your client and identify the extent of the need, that engagement letter is going to provide the clarity that we spoke of, so both you and the client understand - this is what we're doing.

Two, once you know what you're doing, there's still a risk that the client doesn't know what's included. Let me give you an example. When I practiced, I had a 1040 business owner client that felt they were paying too much in estimated taxes using the 110% safe harbor method. We ended up doing actual method.

They didn't realize that meant doing quarterly drafts for the business and then calculating actual tax in multiple draft 1040s to figure out how much they owed each quarter. Added a lot of time, added a lot of fees. The client thought it was, "Part of the return." But at the time, the engagement letter didn't really break down for the client what was part of the return and what was not. That subsequent argument about fees could all have been avoided.

Three, there is a small risk someone may use the work for a purpose other than what was originally intended and we don't see this too often in tax. It's more of an attest item, but sometimes we do see it in tax. Just think of how often clients ask for comfort letters and you'll see where I'm going with this. Once you give them the deliverable, you do lose a bit of control as to what they might do with it.

Your engagement letter can anticipate this risk by saying, "We're doing this X." Tax return, consulting project, whatever. "We're doing this X for this specific reason. If you use it for some other reason, that risk and or loss is on you." I helped you with your tax return so that you can file your taxes and not have the IRS sending you nosy letters. If you gave that return to someone else for some other reasons, you've been warned, that's between you and that other person. But if your engagement letter doesn't close that door, you could have an issue.

Fourth, strangely enough, not every client realizes that if you don't file and pay your taxes on time, there's some downside associated with that. A lot of professional liability claims fall into the bucket of, "You didn't tell me," regardless of merit. At minimum, your engagement letter can put the client on notice. "Hey, if you don't do this or you don't take your responsibilities seriously, bad things can happen."

April Walker: I think those are all great examples. I'm specifically thinking about and we may touch on it a little bit later talking about some of the planning that might be around some of the upcoming TCJA sunset items and work you're going to be doing around that. I like your example and that absolutely has happened to me before about the estimated tax payments. The client didn't really understand, "Hey, cash out is also the fees you pay to me." I think that's a interesting one.

But you want to make sure that you're not leaving on the table the assumption that any planning and projection work that you might be doing related to these consulting projects or whatever around TCJA or whatever it might be is specifically either included in the engagement letter or you have a separate engagement letter that talks about that.

Michael Reese: I think you used a very important term when you say assumption. I think a lot of times CPAs are very in tune with the work and what needs to be done and there's an assumption that the client has the same knowledge or the same background. I think you talk to a lot of clients and what the CPA believes to be true isn't always necessarily what the client believes to be true. That's why you'll hear me talk a lot about that alignment between client and CPA. Documenting that and getting that understanding and having it in the engagement letter is very helpful.

April Walker: Like you said, in assurance engagements, you hear more about scope creep. But definitely, it happens in tax engagement too. It's important to think about.

I know this doesn't happen with people who listen to this podcast and are AICPA and tax section members. I know this doesn't happen. But maybe you have friends who do not have an engagement letter for an engagement. What are some examples of situations? Not specific - we're not calling names and calling people out here, but where might there be significant issues for a tax practitioner if they don't have an engagement letter?

Michael Reese: Sure, and you're right. I can't name names, but we've seen enough that I can give you some generic examples inspired by true events. Hopefully one listening doesn't say that's my situation, but that's not where this is intended to go. If you don't have an engagement letter, you may have an oral contract even if you don't realize it. I'm not sure most people are aware. Simple fact pattern. Client calls you for work, you discuss fees, client says, there's an argument, that's a contract. The problem is other than the fee and the return, what are the terms? What's the result if something weird happens and you want to fire the client? Or if the client never pays you for your time, or and I've seen this one before, the person goes MIA, you don't realize they were serious and they show up on the due date with a stack of papers and your fee demanding a tax return.

Oral contracts are a gray area and frankly, one where I think practitioners should seek legal help if one exists because of the ambiguity around performance, remedy and termination. When I say performance, I mean doing the work. Remedy is what one party can look forward to if the other party violates the agreement and termination I hope is self explanatory. I'll put a plug in here for the engagement letters offered to AICPA members in the tax compliance kit. Those letters include a provision that states the agreement supersedes all previous oral agreements. That's there on purpose. You can hopefully avoid the issues related to possibly having entered into an oral agreement, when you've provided a written proposal, or if the engagement letter scope differs from prior understandings. And that happens frequently enough where you talk about the work and then you put it in the letter and maybe the client doesn't realize the scope has changed a little bit.

Another situation. If you don't have an engagement letter and a good percentage of tax claims actually fall into this category, the disputes and ensuing lawsuits are more difficult to defend and more expensive to defend. You're now trying to piece together all of those conversations, all of those emails, dealing with all of the finger pointing and the convenient lapse of memories, just to figure out what was supposed to happen. Just put it in writing so it's clear upfront what the agreement is. I think an area I would be concerned with here is with SALT (state and local tax) compliance. Here it's more often that there's an engagement letter, but the letter is ambiguous or silent on key scope matters. It's not absence of an engagement letter as in your question, but functionally, it's the same principle because whether you have no letter or the letter is silent, in both cases, you don't have contemporaneous documentation.

A lot of clients forego SALT compliance because to them, the cost outweighs the act. But when the state comes knocking, you're going to have to navigate that lack of documentation. I don't know if too many clients audited by the state who raise their hand and say, no, I told my CPA not to prepare that return. My last example is the long standing client with recurring compliance that all of a sudden has new facts. Sometimes the practitioner isn't even aware of the new information when it's in their possession. If the planned scope anticipates 20 hours of work with commensurate fee, and now all of a sudden you realize the scope needs 50 hours of work. With a commensurate fee, the lack of an engagement letter is going to be a real problem when you send that bill for 2.5 times the fee that the client expected. Fee disputes are common claim drivers.

April Walker: Those are great examples and the SALT one particularly. You just need to make sure I think in the engagement letters that are part of our toolkit, it specifically says that you need to list out the state returns you're going to do, but there needs to be, like you said, some documentation about you may have a nexus and exposure in these particular states and somehow document what the client is telling you to do. Then just a quick note on sometimes people will talk about unilateral engagement letters. Hey, we've had this client forever, and we're doing the same thing for them. Do we really need to get an engagement letter every single year? What's your thought on that?

Michael Reese: I would say yes. You do need to get an engagement letter every single year. I'd say that for a couple of reasons. If your practice is still the practice 10 years later after you gave that original engagement letter, I'd be hard pressed to think that most people's practices and practices internally have changed. I think the engagement letter is a reflection of how your practice evolves and your quality control and what you're doing for a client. Two, depending on what's in your engagement letter, you want the engagement to actually end so that you're not indefinitely keeping open potential statute of limitations or potential liability. I'll give you a high level example. If you have an engagement letter and you say, I'm not going to do an engagement letter, I'll do the evergreen letter where it just continues on indefinitely. There's a question that engagement is still there. It's just an ongoing one really long engagement.

Whereas if you have the engagement letter, you clarify the scope every year. By clarifying the scope every year, you limit your duty of care for that year and then it ends. When you look at the statute of limitations for liability, you can say okay this letter is done with, this statute is done with, anything related to the work done there, that's passed. You can't come back and argue with me about it, but if you have just this amorphous, non defined or ill defined client situation, you interject a lot of ambiguity and that can become a problem for liability purposes. It's really just best to make everything clean, do one letter a year, make sure the clients understand that when that letter ends or when that work delivers, that one's done. I'm not tied to you indefinitely. I may be tied to indefinitely as the client, but I'm not tied to indefinitely visa V that engagement. Next year, when the work comes up, issue another letter. It also helps you understand what the client needs. Or if the client's needs they changed and it's evolved, the letter is going to reflect that every year as opposed to just having one letter, it's old you push out the same one. If their needs have changed, that letter really needs to reflect it.

April Walker: Good thoughts. Michael, I'm thinking about client education. I feel client education and communication is a big part of underlying a lot of what we talked about today. But I'm assuming you think it's an important role that we play in client education. But how can practitioners work on educating their clients about the importance of these engagement letters?

Michael Reese: I don't know if it's so much educating them about the importance of the letters. They need to understand the letter aspect of it as well, but it really is educating clients on their role in the process and reinforcing the fact that whatever the client brings to your door, it's ultimately the client's responsibility, not the CPA's responsibility. It's the client's tax return. It's the client's tax planning. As your service provider, I can provide you with suggestions, guidance, or advice, but really it's up to you to make the decision. The engagement letter should confirm that and lay out with some specificity what that decision is and what the client needs to do to support that decision.

One problem I saw from my own practice was that most clients concerns, especially around the engagement letter, started and stopped with a fee and the deliverable. It was very transactional. If the practitioner can impress upon clients that you're not a vending machine. They can't just drop off paper and money and expect magic. And that you client have to put some effort into the process too. That right there really helps everyone involved. I'll continue to harp on it, but things go a lot smoother when both practitioner and the client are on the same page. Client education can be a big help here because practitioners shouldn't take for granted that even their longstanding clients fully understand what's going on or what the process requires.

On your question of how. It's never a bad idea to be open and upfront about both the service and the engagement letter and answering any questions the client may have. Some firms take this approach as part of onboarding new clients. I know you and I talked a little bit about onboarding before we got underway, but practitioners should be forewarned. The risks of misunderstandings between practitioner and client are not limited to new clients. Practitioners need to be able to talk about what's in their letter. That may require them to sit down with an attorney that helped draft the letter so that they know what certain provisions mean and where it's okay to be flexible.

I might also challenge practitioners to not be afraid to openly discuss what might happen if things don't go as planned. Now, this doesn't have to be a doom and gloom or threatening conversation. But, hey, I need your help here to make this go smoothly and if I don't get your help, here's what the downside to you client might look like. I would hazard to guess that outside of a small population of clients that repeatedly get fired by their professional, most clients don't think about the prospect of what might happen if they don't hold up their end of the bargain.

Talking about client responsibilities openly and soberly and what happens if the client doesn't support the work might help make this prospect not so remote. Because unless the client just doesn't care about their taxes, and those are out there. I have to believe most clients do not want the prospect of either paying some unexpected amount on the due date or trying to find assistance at the last minute. If you think about it, a lot of client angst really revolves around those two items, paying more than expected or necessary and having the government come back and stress them out later. Use that and have an honest conversation with the client about what they need to do to avoid either of those outcomes. Then make sure it's in your engagement letter.

April Walker: Like I said, our conversation today boils down to communication and so I think those are good thoughts and good conversations to have. I mentioned it earlier but you and I are both in the public accounting world, and we're aware of the pressure that you can face with client demands and deadline demands and all of that. What do you think - do you have to balance that, with the need for thorough quality control? What are some of your thoughts around that question?

Michael Reese: I'll challenge it a little bit just because.

April Walker: That's fine.

Michael Reese: I don't want your listeners thinking that they need to make a choice between quality control and something else. You and I both know when the clock hits the week before deadline, ten, 11, 12th, a lot of things start getting squishy, I guess, maybe is the best way.

April Walker: Squishy is a good word.

Michael Reese: You got hard rules all of a sudden those rules get a little squishy. The term balancing may give some the impression that if one end is weighted more heavily, the other one is up in the air. Practitioners shouldn't view the quality control as optional if their reputation is built on doing quality work.

I think most if not all practitioners would say that's the case. I want to look at both parts of your question, thorough quality control and deadline pressure/client demands. Now, the most obvious answer to me for dealing with the pressure of a tight deadline and client demand is to not have deadline pressure or client demands. I know. Before I get laughed out of the room, I've had my share of deadline horror stories. We all have. The concept really isn't that outlandish. I'm starting to see a lot of evidence slowly, but surely practitioners are challenging that default notion that tax due dates have to be this pressure filled exercise that makes you wonder or question, why do I put up with this every year? If you can create optimal work conditions, that's a huge win rather than simply accepting that there's no alternative and suffering the consequences.

For those that aren't fully to a stress free deadline yet, and I know they're out there as well, your quality control, whether that's informal or it's a 50 page document that no one reads or refers to, it needs to be designed in a more intentional way. To me anytime you talk about quality control, I think you have to look at your process and your process design. Then you have to look at the people integral to the process, including the client. A lot of process is iterative, organic, reactive. When that happens, there's no design, there's no intentionality. You're just patching holes as they appear or responding to the latest impetus.

On the other hand, when there is design, sometimes we fall into the trap of designing to a best case scenario instead of a worst case scenario or realistic scenario. Mistakes happen all the time, but I don't think it's far fetched or controversial thing to say that in periods of high stress and pressure, the likelihood of a mistake is higher.

When I say process design requires intentionality, I'm really trying to highlight that the design needs to operate from the base assumption that the players involved aren't always going to do things in a rational, uniform or expected manner.

The question is, can your process for quality control withstand the sheer hysteria of those last days before the due date? Because if it can, you're not really balancing quality control or sacrificing quality. Your system accounts for the insanity as a given and then responds appropriately.

For those that have QC in place, I want you to ask yourself, are they rules or do they become suggestions in the face of competing interests? Do they become squishy, as we said before? Is it easy to rationalize an exception to the rule on April 13th compared to January 13th?

Part of this depends on what habits you have as a professional. If you have strong habits, the answer or choice you make doesn't change regardless of day or situation. I think the last thing I want to say about QC design is often practitioners are challenged because they don't know what they don't know, and that is a real and legitimate hurdle. We completely understand that.

We get a lot of calls on the risk management hot line where practitioners have never had to deal with this before and I get it. You can't design for what you don't know. But that's where I think you tap into your professional network, attend conferences, like National Tax Conference, where you and I will be and understand what resources are available to you, whether it's a tax section or your insurance carrier or your state society. There's tons of ideas out there, maybe too much, but there's nothing that says you have to keep doing it the same way and expecting a different outcome. I think that's called insanity.

April Walker: I particularly love that we start off talking about engagement letters, but then we circle back to thinking about a new way to operate in tax, which I do think is possible and one of my passion projects. I love that.

I just wanted to note another important aspect of quality control that in my mind, is a best practice for firms to minimize errors and omissions, and those are checklists that help you consider, have you addressed these key issues and making that not just a rote check.

It's a real part of your procedures and really stepping away and making sure you have a process for all of the things. Making sure you have a process for getting your signed engagement letter before you start your work, making sure every return has some review procedure.

Even if you're a very small practitioner you should have some kind of [review process]. Is it stepping away for a period of time before you look at the return again or something like that. Speaking of the checklist, they will be available soon in mid December as part of the annual tax compliance kit. Look forward to those.

Thank you so much Michael for this discussion today. I think it was a good one and hopefully a educational one for our listeners. In closing on these podcasts, if you're a listener, I hope you are. You know that this next question is coming and so it's Tax Section Odyssey we're taking a journey together towards a better profession.

In doing so I like to hear about my guest other journeys outside of tax. Talk to me about something that's on your bucket list or a recent trip you've had, something that you've got on the horizon.

Michael Reese: I have not had any recent trips, but I do have an upcoming trip next month and then I will give you a bucket list one as well because I'm always happy to talk about bucket list travel. Next month and we started this maybe eight or nine years ago. We took our daughter to Vienna for Christmas. We got away from the house for Christmas. I'm taking the family including the grandmothers. We are going to Germany to do Christmas markets. We're going to trips around Germany for about two weeks and visit a couple of Christmas markets and we'll make a pit stop in France to do some markets there. And my mother has never been overseas and so I'm really looking forward to that just reliving that child like joy that comes around the holiday season. That's what we'll be doing next month, lots of plans going into that. That will be a little bit of an odyssey as well because we'll see how well I can survive with my mother for 12 plus days. Shouldn't be an issue, but we'll see. Fingers crossed.

April Walker: Inter-generational trips.

Michael Reese: Exactly. I would say bucket list and I was talking to a couple of friends about this actually earlier this week, I would love to go to Easter Island and see the Moai and the Rapa Nui. That's a really long trip. But that's one that I think has been on my bucket list. If I can take that one off that would be really cool . I think maybe was it last month where Easter Island had the full solar eclipse? I would have loved to have been down there for that. But if I can get down there and check that out, I will definitely be in a good spot.

April Walker: Wonderful. I look forward to hearing about your trip to Germany and the Christmas markets. That's definitely on my bucket list as well.

Michael Reese: I will tell you all about it.

April Walker: Again this is April Walker from the AICPA Tax Section. This community is your go to source for technical guidance and resources designed especially for CPA tax practitioners like you and mine. This is a podcast from AICPA & CIMA together as the Association of International certified Professional Accountants. You can find us wherever you find your podcast, and we encourage you to follow us so you don't miss an episode. If you already do thank you so much, and please feel free to share with a like minded friend.

You can also find us at aicpa-cima.com/tax check out our other episodes and get access to all the resources, including those wonderful engagement letters mentioned during the episode. Thank you so much for listening.

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