Creating a Quality Engagement Letter for Tax Services

Overview of Engagement Letters

Effective communication is at the heart of every professional relationship. One of the most effective ways to ensure that both you and your client are on the same page – and stay there – is with an engagement letter. Engagement letters are sometimes viewed simply as the terms of an agreement between you and your client. They are, however, far more than that. Issued before the start of any professional engagement, they are, in fact, the foundation for all professional relationships. When it comes to tax law, as much as any other field, the professional relationship is a key determinant of success.
The primary purpose of the engagement letter is to make sure that both you and your client understand your roles, responsibilities, and limitations . For example, in tax cases, it can be easy for all parties to think – or at least hope – that a failure to act was yours alone. However, the engagement letter uses precise language to establish that clarity at the outset of the relationship and make sure that both you and your client understand where the responsibility rests. It is more than just a contract between you and your client, it also establishes clear lines of communication, setting the boundaries for ongoing conversations and how often they’ll occur during the project. Above all, a clear and unambiguous engagement letter is designed to protect your best interests and make sure that no one can interpret your silence as acquiescence to poor behavior or miscommunication.

Key Elements of a Tax Services Engagement Letter

While the goal of an engagement letter is to avoid any assumptions in regard to the taxpayer’s expectations or your scope of work, that is not the end goal. Your engagement letter should be clear and detailed enough that if there are misunderstandings later, your actions can be justified no matter what happens. The engagement letter should be specific enough that it would be fair to hold them to those specific provisions, but neither so generic nor so narrow that you are not protected.
Here are some essential and common components to include:

1. Scope of Services

There may be many steps in preparing a return. For example, if a company engages you to prepare their annual tax return, is that it? There may be additional work to be performed. If there are different schedules you might file, your engagement letter should address if your fee includes filing all schedules or only certain ones. You should also discuss if you agree to assist them with other matters, such as audits or tax planning.

2. Fees & Terms

Undoubtedly, this should be included in your tax services engagement letter. Your engagement letter should include your payment terms, such as 50% due on the first day of the engagement and 50% due upon deliver of the document. Some examples of how to handle fees might be: "The fee for this service will be based on a calculus of time incurred, knowledge and expertise applied to your situation, and result to be achieved." Alternatively, you may want to go another route and say: "The fee for processing the returns will be $____, which will be due upon delivery of the final documents."

3. Confidentiality

Confidentiality is important to your clients and to the tax profession. To that end, your engagement letter is a good place to remind the client of their confidentiality obligations to you and provide them with some limited exceptions to their obligation. (You may even want to state that they understand that since there are other services being offered in addition to tax preparation, that they may share some of confidential information in relation to those services.)

4. Mutual Responsibility

This type of provision usually dictates that both parties should begin the process in a timely fashion, and each agree to keep the other informed at each step of the way. This provision may also address what happens if either party decides to terminate the agreement before completion of the service.

5. Liability Limitations

You may wish to consider limiting your liability to the amount charged by you for the services or to 2-times the amount of fees paid to you by the client. The engagement letter may also state that, if there is any liability found, the client’s damages may not be greater than the amount paid by you to your provider.

6. Dispute Resolution

When performing legal services, you should also consider including an alternative dispute resolution provision. An alternative dispute resolution provision requires the parties to resolve their issue without resorting to civil litigation. In essence, alternative dispute resolution avoids the expense, time and publicity of litigation.
In your tax services engagement letter, the dispute resolution clause may require mediation before litigation, or could allow arbitration.

Legal and Ethical Issues

When it comes to tax services, the most important legal consideration for an engagement letter is that it describes the relationship in sufficient detail to avoid allegations of an engagement that was beyond the scope of the client’s intent. A client’s expectation that a service is regulated can be difficult to regulate, so unless the engagement letter describes the services to be provided, the level of services and the protocols that apply, the tax professional risks allegations of misrepresentation, negligent conduct, or both.
Limitations on liability are a core issue in engagement letters, and such provisions are subject to the statutory regulations in many states. Where malpractice statutes permit some limitations but not others, it is up to a lawyer to circumvent language that a court might find void under the governing state laws. The American Bar Association (ABA) advises lawyers to validate the limitations on liability against insurance company requirements and their own risk tolerance, and to confirm that such limitations are not prohibited by applicable law.
The consideration of the statutory prohibition on liability limitations means that some lawyers decline the condition of limitation of liability in an engagement letter for high exposure clients or for high exposure services, as insurers may reject the limiting conditions for those extreme circumstances. In an engagement letter scenario where an attorney anticipates a high level of professional risk, careful drafting with clear anticipation of expected issues in advance is crucial. Some lawyers use a checklist to identify detailed information about the relevant law and issued anticipated for a project, and then discuss the issues with the client prior to project inception. Other lawyers use a chart that competes various law provisions so that they can anticipate the regulatory and legal consequences in their geographic jurisdiction, and then apply the desirable provision to their particular situation or needs.
The ABA has recommended that all tax professionals make sure that their engagement letters comply with all IRS rules and guidelines, including Circular 230 and the Treasury Department’s Final Regulations under Section 10.36 after consulting with qualified tax counsel, and that such counsel is thoroughly knowledgeable about the tax codes, regulations and administrative pronouncements that cover the particular engagement.

Tailoring Engagement Letters to Individual Clients

It is also very important to customize engagement letters in order to meet the needs of each particular client. For example, the engagement letter for an individual client should differ from the engagement letter for an enterprise, such as a corporation or limited liability company, with regard to, among other things, the identity of the parties named in the letter and the level of detail provided. Even within those categories, the service provider should give serious consideration to the preferences of the client in customizing an engagement letter. In the past, with corporate clients, it has been common practice to use standard engagement letters and standardized client representations in tax engagements, but, increasingly, the IRS is expecting that the tax services engagement letter be part of the overall integrated engagement plan. This trend can impact the complexity and risks of tax engagements.
Some engagement letters also include an Appendix A, which provides a sample of the client representations that the service provider expects to be included in the engagement agreement between the service provider and the client. Such Appendix A is a good place to set forth hypothetical examples of the type of information that the service provider will rely on in performing the services, while clarifying that the service provider is not an attorney and is not responsible for providing legal advice in performing services .
Finally, one of the most important components of customizing the engagement letter is the use of customization and flexibility in providing the scope of services. If a service provider is performing due diligence for clients who are seeking to be eligible for a reduced penalty for noncompliance or are seeking to obtain a private letter ruling, etc., then it should be particularly clear that the client will be expected to actively participate in the process by providing any additional information required by the Treasury Department, IRS, or other regulatory agency. Further, as noted above in the discussion on electronic delivery, in many instances an individual may wish to request additional services on a "lessons learned" basis when they meet with the service provider after completion of the initial services, such as by identifying errors or omissions in the initial presentation. With larger enterprise clients, the client may project that the same problem will recur in the future and requests that the service provider not only remedy the previous error but undertake preventive measures for the future and adjust the upfront plan and expectations accordingly.

Pitfalls to Avoid

Professionals often think they can draft engagement letters without a subscription or use a canned version purchased from an e-commerce site available on the internet, but this is not true. Some of the common mistakes seen in other letters are: Vague Reference to the Scope of Engagement. It is always a good idea to thoroughly describe in your tax engagement letters, the nature of the work agreed. For example, if you do tax compliance work in addition to representation work, make clear what specific compliance year is covered as opposed to a description of what all your compliance work entails. Similarly, while a reference that representation issue involves a "proceeding" is a generally recognized term, it is best to describe the proceeding scope of the representation, whether it is a Tax Court petition, an audit or refund suit, etc. Not Listing All Persons Covered. An engagement letter is directed to a single taxpayer like an individual, or joint taxpayers such as a husband/wife, or an entity. You must consider whether business owners are covered by using trade names, etc., and whether someone else signed the engagement letter. You should be specific about who is included. Changes Need to be Reflected in the Engagement Letter. If there are significant changes during the course of the representation, then an updated engagement letter is strongly recommended. This could happen, for example, if more years are added to an audit or a new entity is involved in a complicated action. A new letter is advisable to a husband/wife couple separating or divorcing. If an important item in the engagement letter changes and an amended engagement letter is not issued, the existing letter terms still bind. In one case, a friend returned to the same CPA (same staff) for the same tax return, but when he passed away a few months later, the engagement letter language signed a year earlier caused the same spouse to be considered a former client and to require a waiver before waiving privilege to her husband’s return. Thinking a Waiver is Always Required. Tax professionals often believe that the IRS rules on conflict waivers must be reapplied and routinely signed by all parties each time a joint return is filed. This was certainly the case under prior IRS Circular 230 final regulations, which, as of June, 2014, were repealed. The same reasoning should not be a routine practice because waiving privilege each time is almost impossible in the case of a death or incapacity. Also, very often spouses do not have equal knowledge of all the family affairs, and therefore the one spouse may have a disadvantage in some areas necessary to understand the waiver. Not Valuing the Benefit. Leaving a spot on the tax engagement letter for the taxpayer/client to indicate the fee provides a suggestion that the document is more like a contract that pricing, and even suggests the pricing is negotiable. This is not an element of attorney-client privilege. The value of the benefit of privilege is often not really appreciated, until the penalty tax is assessed and the CPA is required to testify against the client. Putting all contacts of CPA Staff in the Engagement Letter. A detailed list of all in-person contacts and communications by email may be burdensome and may also give an unwarranted impression of agency. Only those staff members that the taxpayer/client could reasonably believe to be the lawyer are needed for the engagement letter. Value of Privilege – Waiving the privilege. The value of the privilege is so strong that even after paying for legal representation, the privilege applies unless specifically waived. Noted above, this means even when a husband is the taxpayer and pays the professional fee, the privilege belongs to his wife, the former client. Tag on Personal Liability. Finally, many CPA engagement letters are generic. Some could be used equally by attorneys. Consequently, many CPA statutes disclaim personal liability and limits liability to the firm are inappropriate in certain jurisdictions. Generic forms should not be just copied as they may be construed as legal advice that may not apply to your legal situation.

Assessing and Revising Engagement Letters

Engagement letters should be reviewed and updated regularly. Tax laws change; clients’ situations vary and evolve; services offered by your firm can expand or contract. Periodic review and updating can help make sure that you have covered all the bases and that what you have agreed to is accurately reflected in the engagement letter.
How often does there need to be a review? That depends. Best practice is to conduct a review when there are significant changes. Significant changes include such things as a change in the law that could affect the outcome or the procedure. There may also be a review at such times as the beginning of the year for last year’s taxes or to help in planning for the next year’s taxes or a quarterly review if there is a sales tax or VAT liability. An annual review for such things as information returns or trade or business income tax returns could also be undertaken to determine if updates to the engagement letter are needed. In addition , a review should be considered if there is a change in client personnel or location. It is also a good idea to periodically review all your engagement letters on a designated day each year or semi-annually, for example, April 15th or October 15th (given extensions) year after year. Make reviewing effective by maintaining a secure location for all the firm’s engagement letters so that the location can be searched for particular terms or phrases to identify those that may need amendments.
Finally, review engagement letters routinely for compliance with professional ethics rules and responsibilities, such as conflicts of interest.