Tax Ethics: Responsibilities for Taxpayers and Professionals

Tax ethics balances legal requirements with moral and professional duties for both individual taxpayers and the professionals they hire. This involves upholding the integrity of the tax system, which relies on voluntary compliance and honest reporting. For taxpayers, this means providing accurate and complete information. For professionals, it means navigating complex rules designed to protect clients and the public interest.

The principles of tax ethics require an understanding of one’s obligations, which are shaped by personal integrity, societal expectations, and formal regulations. The government relies on ethical conduct to ensure the system functions correctly, while the public has an interest in a fair and transparent system.

The Taxpayer’s Ethical Responsibilities

A taxpayer’s primary ethical duty is to report their financial information honestly and accurately. This responsibility is the foundation of the U.S. tax system. Taxpayers must make a good-faith effort to comply with tax laws, which includes keeping adequate records to substantiate income, deductions, and credits. This duty extends to providing their tax preparer with all relevant financial data, not just information that might lower their tax bill.

A concept in taxpayer ethics is the distinction between tax avoidance and tax evasion. Tax avoidance is the legal use of the tax code to reduce tax liability through legitimate strategies like contributing to a 401(k) or claiming eligible tax credits. These actions are permitted by law to encourage certain behaviors, such as saving for retirement or pursuing higher education.

Tax evasion is the illegal act of intentionally underpaying or not paying taxes. This includes failing to report income, inventing deductions, or falsely claiming dependents. Avoidance uses the law to one’s advantage, while evasion breaks the law to escape paying taxes.

A taxpayer cannot shift the blame for a fraudulent return to their preparer if they knowingly provided false information. While a preparer has a duty of due diligence, the taxpayer is responsible for the accuracy of their own return and must review it before signing. Signing the return is a declaration under penalty of perjury that the information is true, correct, and complete.

Professional Standards for Tax Practitioners

Tax professionals are governed by a stringent set of rules, with the primary authority for federal tax practice being the U.S. Treasury Department’s Circular 230. This document outlines the duties and restrictions for individuals who practice before the IRS, including attorneys, Certified Public Accountants (CPAs), and Enrolled Agents (EAs).

A requirement under Circular 230 is the duty of due diligence. This means a practitioner must exercise care to ensure the accuracy of tax returns and the advice they provide. They must make reasonable inquiries if information appears incorrect, inconsistent, or incomplete, and cannot blindly accept a client’s claims.

Confidentiality is another obligation. A tax professional is entrusted with a client’s sensitive financial data and is prohibited from disclosing it without the client’s permission, except in limited circumstances like a court order. This is paired with the responsibility to avoid conflicts of interest, which arise when a practitioner’s personal interests interfere with their ability to provide objective advice.

Competence is also a standard. Practitioners must possess the necessary knowledge and skill to handle a client’s tax matters. If a preparer encounters a situation beyond their expertise, they have an ethical obligation to consult with another professional or suggest the client seek alternative assistance. For CPAs, these standards are reinforced by guidance from organizations like the AICPA.

Common Ethical Dilemmas in Tax Preparation

A common dilemma involves a client’s desire to claim aggressive or poorly substantiated deductions. A business owner, for instance, might want to claim 100% of their vehicle use as a business expense, even if they use the car for personal trips. The preparer must question the claim and explain the documentation requirements, such as a mileage log, needed to support the deduction.

Another challenge is the discovery of a significant error on a prior-year return that the practitioner did not prepare. Circular 230 requires the practitioner to inform the client of the error and its potential consequences, such as back taxes and penalties. The ethical path is to advise the client to file an amended return, even if the client is hesitant due to the cost.

Dealing with clients who have poor or nonexistent records presents an ethical test. A client who works for cash tips may not have reliable documentation of their income. While a preparer can assist in reconstructing records, they cannot invent numbers or knowingly use unsubstantiated figures, and must refuse to prepare a return they know to be inaccurate.

A fourth scenario involves a client asking the preparer to take a tax position with a low probability of being sustained if challenged by the IRS. Professional standards require a good-faith belief that the position has a realistic possibility of being upheld. The preparer’s ethical duty is to advise the client of the risks and potential for penalties, rather than simply agreeing to take a questionable position.

Consequences of Unethical Tax Practices

Violating tax laws and ethical standards has severe repercussions for both taxpayers and preparers. For the tax practitioner, unethical conduct can lead to professional and financial penalties. The IRS Office of Professional Responsibility can impose sanctions under Circular 230, from a private reprimand to public censure, or even suspend or revoke a practitioner’s right to practice before the agency.

Beyond disciplinary actions, preparers can face direct monetary penalties. The Internal Revenue Code contains provisions targeting preparer misconduct. A penalty can be assessed for preparing a return that takes an unreasonable position, with a much larger penalty for willful or reckless conduct intended to understate a client’s tax liability. These penalties deter preparers from prioritizing client demands over their legal obligations.

Taxpayers are ultimately liable for the correct tax amount, regardless of who prepared their return. If an audit uncovers an understatement of tax, the taxpayer must pay the deficiency plus interest. The IRS can also impose penalties, the most common being the accuracy-related penalty, which is 20% of the underpayment.

If the IRS determines the taxpayer’s actions were fraudulent, the penalties become harsher. A civil fraud penalty can be as high as 75% of the tax underpayment attributable to fraud. In the most egregious cases of tax evasion, the government can pursue criminal charges, which can result in substantial fines, imprisonment, or both.

Selecting an Ethical Tax Professional

The first step in choosing a tax professional is to verify their credentials. All paid tax return preparers must have a Preparer Tax Identification Number (PTIN) from the IRS. You can also check for advanced credentials, such as a Certified Public Accountant (CPA) or an Enrolled Agent (EA), through state boards of accountancy or the IRS online directory.

Inquire about a professional’s experience, particularly with tax situations similar to your own. Asking how many clients they have in your industry or about their experience with specific deductions can provide insight into their competence. An ethical professional will be transparent about their areas of expertise.

Ask about their process for handling questionable or uncertain tax items. For example, you might ask, “If I wanted to claim a deduction but didn’t have perfect records, how would you handle that?” An ethical preparer will explain the need for reasonable substantiation and the risks involved.

Be aware of red flags that may indicate an unethical preparer. Be wary of any preparer who promises a specific, large refund before reviewing your financial documents. Another warning sign is a fee based on a percentage of the refund amount, as this creates an incentive to inflate deductions. An ethical professional will base their fee on the complexity of the return.