The CPA's Duty When Discovering a Prior Year Error
You are a CPA preparing the 2025 tax return for client Lisa, a sole proprietor. While reviewing her 2024 return, which you did not prepare, you discover that she failed to report $50,000 of business income. This omission resulted in an underpayment of tax of $12,000. Lisa is unaware of the error. The statute of limitations for 2024 is still open (three years from the filing date, which was April 15, 2025, so until April 15, 2028). Lisa has asked you to prepare her 2025 return. You are concerned about your ethical obligations and the potential consequences for Lisa. Lisa is a good client and has been with your firm for many years. The error appears to be unintentional, but you know that the IRS could assess penalties and interest if it is discovered. Lisa's marginal tax rate is 24%.
1. What are your ethical responsibilities regarding the discovery of the prior year error?
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Under Circular 230 and the AICPA Code of Professional Conduct, you have a duty to advise the client of the error and recommend corrective action. Circular 230 §10.21 requires that you advise the client promptly of any noncompliance with the tax laws. You should inform Lisa of the error and explain the consequences, including the underpayment of tax, potential penalties (e.g., accuracy-related penalty under §6662), and interest. You should recommend that she file an amended return for 2024 to correct the error and pay the additional tax. You should also consider whether you have a duty to withdraw if she refuses to correct. However, you are not required to notify the IRS of the error. The AICPA Code §1.320.010? Actually, the AICPA Code requires confidentiality, but you may disclose if required by law. You should not prepare the 2025 return with knowledge of the error unless you are satisfied that the client will correct it. If she refuses, you should consider withdrawing from the engagement. You should document your advice and the client's response. Additionally, if the error is intentional, you might have additional obligations, but here it appears unintentional. You should also consider whether the error affects the 2025 return (e.g., carryovers, basis). If it does, you must correct it in 2025 or advise the client to amend 2024.
2. If Lisa refuses to amend her 2024 return, what options do you have, and what are the consequences?
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If Lisa refuses to amend, you should: 1) Explain the potential consequences: the IRS may discover the error through matching (e.g., 1099-K or 1099-NEC), and she could face penalties and interest. The accuracy-related penalty is 20% of the underpayment, which would be $2,400, plus interest. If fraud, penalty is 75%, but unlikely here. 2) Advise her that you cannot prepare the 2025 return in a way that perpetuates the error (e.g., if the error affects basis or carryovers). 3) Consider withdrawing from the engagement if you believe the client is not complying with tax laws. Circular 230 §10.51? Actually, §10.51 is for disreputable conduct. But you can withdraw if the client insists on not correcting. 4) If you withdraw, follow proper withdrawal procedures: notify the client in writing, provide copies of records, and refund any fees for services not performed. 5) You are not required to notify the IRS, but you must not sign a return that you know is incorrect. 6) If you continue to prepare the 2025 return, you must ensure it is correct and does not incorporate the error. However, if the error affects 2025 (e.g., inventory, basis), you must correct it, which might require adjusting 2025 income or advising the client to amend 2024. 7) Document all advice and the client's refusal. 8) Consider consulting with legal counsel. Ultimately, your primary duty is to the integrity of the tax system and to not sign a false return. You should not assist the client in evading tax.