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dissertation entitled

AN ANALYSIS OF THE IMPACT OF A CONTINGENT
FEE FOR THE PREPARATION OF A TAX
RETURN ON TAX PREPARER COMPLIANCE

presented by

Daisy Square Beck

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AN ANALYSIS OF THE IIVIPACT OF A CONTINGENT FEE FOR THE
PREPARATION OF A TAX RETURN ON TAX PREPARER CONIPLIANCE

By

Daisy Square Beck

A DISSERTATION
Submitted to
Michigan State University
in partial fulﬁllment of the requirements
for the degree of

DOCTOR OF PHILOSOPHY

Department of Accounting

1998

ABSTRACT
AN ANALYSIS OF THE IMPACT OF A CONTINGENT FEE FOR THE
PREPARATION OF A TAX RETURN ON TAX PREPARER COMPLIANCE
By

Daisy Square Beck

Numerous studies have suggested that tax aggressiveness is prevalent among tax
preparers. Two of the tools used by the Treasury Department to mitigate aggressive tax
reporting are discussed in this study: prohibition against a contingent fee arrangement
between a taxpayer and a tax preparer for the preparation of an original tax return, and the
professional standards set by the Treasury Department. This study experimentally
investigates whether reporting standards mitigate aggressive tax reporting, whether a
contingent fee arrangement between a taxpayer and a tax preparer is related to aggressive tax
reporting, and whether tax preparers who report aggressively will have a higher assessment
of the probability that the IRS will allow the deduction upon audit than tax preparers who do
not report aggressively.

The experimental design consists of a between-subject study of the impact of two
variables (preparer’s fee and reporting standards) on tax preparer’s compliance. Eighty-eight
tax preparers recruited from various ﬁrms were given a tax case and asked to make a
reporting decision on the deductibility of travel and entertainment expense, and to assess the
probability of the deduction being allowed upon audit.

The results of this study indicate that there is not a statistically signiﬁcant difference

in the reporting positions taken by preparers with different fee arrangements or with different

reporting standards. Tax preparers recommended pro-client positions regardless of the fee
arrangement or professional standards. The results support the contention that CPAs view
themselves as client advocates and choose positions favorable to the client. The results also
suggested that tax preparers who made aggressive reporting decisions made a higher
assessment of the probability of the deduction being allowed upon audit than tax preparers
who did not report aggressively.

The results of this study are consistent with prior research that indicates that reporting
standards do not mitigate aggressive tax reporting and tax preparers report aggressively when

there is an incentive to do so.

Copyright by
DAISY SQUARE BECK
1998

This dissertation is dedicated to my husband, Dr. Douglas Eugene Beck, who has shown me

the true meaning of unconditional love.

ACKNOWLEDGMENTS

So many people have helped me in this journey, it is not possible to acknowledge
everyone. For the many who are not listed or mentioned, I would like to extend my sincere
appreciation.

First, I wish to thank the following members of my committee: Dr. Edmund Outslay,
Dr. Sue Haka, Dr. Frank Boster, and Dr.Matthew Anderson. Their patience and
encouragement made the difference in success or failure. I particularly want to thank my
chairperson, Ed Outslay, who stood up for me and guided me with the patience of Job.

I also would like to acknowledge my gratitude to Elizabeth Davis, my dear ﬁ‘iend,
typist, and editor, whose ”hands on” help when needed was unfailingly constant and when
asked for help, day or night, gave the consistent reply, “No problem!”

It would also be remiss on my part not to mention the American Institute of Certiﬁed
Public Accountants (AICPA) and KPMG Peat Marwick for their ﬁnancial support.

Last but not least I thank the Lord for listening and answering my prayers through

every step of the process.

TABLE OF CONTENTS

LIST OF TABLES ................................................... ix
LIST OF FIGURES ................................................... x
CHAPTER 1
INTRODUCTIONS .................................................. 1
CHAPTER 2
LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT ............... 4
2.1 Factors Linked to Tax Preparer’s Aggressiveness .................... 5
2.2 Tools Used to Mitigate Aggressive Tax Reporting ................... 8
2.2.1 Prohibition Against Contingent Fees ........................... 9

The Internal Revenue Service and Prohibition Against Contingent Fees 9
The American Institute of Certiﬁed Public Accountants and

Prohibition Against Contingent Fee Arrangements ............ 11

2.2.2 Professional Standards .................................... 12
CHAPTER 3

RESEARCH DESIGN ............................................... 21

3.1 Research Design and Experimental Task .......................... 21

3.2 Variables ................................................. 26
CHAPTER 4

RESULTS ......................................................... 28

4.1 Subjects .................................................. 28

4.2 Manipulation Check ......................................... 31

4.3 Effects of Reporting Standards by Fees .......................... 32

4.4 Effects of Reporting Standards ................................. 35

4.5 The Effects of the “Realistic Possibility” Standard .................. 35

4.6 The Effects of Fees .......................................... 37

4.7 Covariates ................................................ 37

4.8 Discussion ................................................ 40
CHAPTER 5

SUMMARY AND CONCLUSION ...................................... 43

5.1 Summary ................................................. 43

5.2 Limitations ................................................ 44

vii

5.3 Suggestions for Future Research ............................... 44

5.4 Contributions .............................................. 45
APPENDIX ....................................................... 48
REFERENCES ..................................................... 69

viii

TABLE 2.1

TABLE 2.2

TABLE 2.3

TABLE 4.1

TABLE 4.2

TABLE 4.3

TABLE 4.4

TABLE 4.5

TABLE 4.6

TABLE 4.7

TABLE 4.8

TABLE 4.9

TABLE 4.10

TABLE 4.11

TABLE 4.12

TABLE 4.13

LIST OF TABLES

Violations of Practitioner Responsibilities ...................... 15
Tax Filling Options--Contingent Fee .......................... 20
Tax Filing Options--Constant Fee ............................ 20
Name, Type and Number of Subjects Per Firm .................. 29
Subjects’ Descriptive Information ............................ 3O
Contingency Table for Fee Manipulation ....................... 33
Test Statistics for Fee Manipulation .......................... 33
Contingency Table for Standard Manipulation .................. 33
Test Statistics for Standard Manipulation ...................... 33
Mean Reporting (Standard Deviation) Decisions (in thousands) ..... 34
Analysis of Variance I ..................................... 34
Probability of Deduction Being Allowed upon Audit .............. 36
Analysis of Variance II .................................... 36
Mean, Standard Deviation, and Signiﬁcance of Covariates ......... 39
Assessment of Probability of Success ......................... 41
Percentage of Subjects Familiar with Reporting Standards ......... 42

ix

LIST OF FIGURES

FIGURE 3.1 ........................................................ 23
FIGURE 3.2 ........................................................ 24
FIGURE 3.3 ........................................................ 24
FIGURE 3.4 ........................................................ 27

CHAPTER 1

INTRODUCTION

The role of the tax practitioner in tax compliance has received much attention ﬁom
academic researchers, tax practitioners, and tax administrators. Most taxes are computed by
the taxing agent and a bill is rendered to the taxpayer (e. g., real estate taxes, sales taxes).
However, the federal income tax system operates on a voluntary self-assessment basis (IRS
1991). That is, a taxpayer is required to compute the taxes owed to the federal government,
ﬁle a return, and pay such taxes. Approximately one-half of all individual tax returns and an
even greater percentage of the more complex returns are prepared by paid preparers (IRS
1987, Johnson 1993). The tax practitioner thus plays a major role in tax compliance.
Therefore, the study of the tax practitioner's degree of compliance and its determinants has
important implications for future tax policy.

Because of the important role played by the tax practitioner, the Treasury Department
has guidelines (Circular 230) to regulate the practice of preparers before the IRS. Circular
230 and related regulations suggest that the manner in which tax practitioners determine their
fee affects tax compliance. In particular, the Treasury believes that tax practitioners would
take unwarranted deductions or omit taxable income if they were allowed to have a
contingent fee arrangement with a client. However, no empirical research has been done to

evaluate this supposition.

2

Section 10.28 of Circular 230 prohibits a practitioner ﬁom charging a contingent fee,
except "for reﬁJnd claims that are ﬁled in anticipation of the claim receiving substantive
review. " A contingent fee, as deﬁned in Circular 230, includes a fee based on (1) a
percentage of the reﬁrnd shown on the return, (2) a percentage of the taxes saved, or (3) the
speciﬁc results obtained. The Treasury believes that contingent fee arrangements have a
potential for undermining tax compliance by encouraging the tax practitioner to take positions
that decrease the taxpayer's liability. The American Institute of Certiﬁed Public Accountants
(AICPA) disagrees with the Treasury's limitation on contingent fees. For example, under
AICPA Rule 302 a member may charge a contingent fee in cases not allowed by the Treasury,
such as fees from nonattest clients. The AICPA contends that in these situations, the
professional standards are sufﬁcient to prohibit a tax practitioner ﬁom taking unsupported tax
return positions (Podolin 1991). However, Cuccia et al. (1995) found that neither a vague
verbal standard nor a more stringent numerical standard mitigated aggressive tax reporting,
and tax preparers use the latitude available in vague tax laws to justify aggressive reporting
positions. The Treasury's position prevails.

The purpose of this study is to provide evidence about whether reporting standards
mitigate aggressive tax reporting, whether tax preparers who recommend aggressive reporting
positions make higher assessments of the probability of the deduction being allowed upon
audit than tax preparers who do not recommend aggressive reporting positions, and whether
a contingent fee arrangement between a tax preparer and a taxpayer promotes aggressive tax
reporting. An experimental study was used to investigate these research issues. A tax case
was designed using travel and entertainment expenses as the reporting issue in question.

Some of the travel and entertainment expenses are clearly deductible according to the law;

3

some of the expenses fall within a “gray area” of the law; and some of the expenses are clearly
not deductible.

Eighty-eight tax preparers recruited from various ﬁmrs were asked to make a
reporting decision on the deductibility of travel and entertainment expenses and to assess the
probability of the deduction being allowed upon an audit. Client fees were manipulated at
two levels (a constant fee versus a contingent fee) and reporting standards were manipulated
at two levels (with and without reporting standards where reporting standards are the
standards guiding a preparer in adopting tax return positions). The results indicate that there
is not a statistically signiﬁcant difference in the reporting positions taken by preparers with
different fee arrangements or with different reporting standards. However, tax preparers who
made aggressive reporting decisions had a higher assessment of the probability of the
deduction being allowed upon audit than tax preparers who did not make an aggressive
reporting decision.

The remainder of this paper is organized as follows: Chapter 2 discusses prior
research and describes the development of hypotheses, Chapter 3 describes the research
design, Chapter 4 discusses the results, and the conclusion and discussion appear in Chapter

5.

CHAPTER 2

LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

Tax compliance has been the focus of much experimental and empirical research. The
National Academy of Science Panel (N AS) states that compliance with reporting
requirements means that "the taxpayer ﬁles all required tax returns at the proper time and that
the return accurately reports tax liability in accordance with the Internal Revenue Code,
regulations, and court decisions applicable at the time the return is ﬁled" (NAS 1984, 21).
Under this deﬁnition, underreporting and overreporting income and deductions are forms of
noncompliance. In many cases, the tax preparer acts as an agent for the taxpayer in meeting
the tax compliance requirements.

Paid preparers prepare more than 50 percent of individual tax returns (IRS 1989).
Rationale for the growing tendency to use preparers includes the increasing complexity of the
federal income tax system, aversions to audits, time eﬁiciency, and tax liability minimization
(Hite and McGill 1992). Scotchmer (1989) concluded that taxpayers View the preparer’s
primary ﬁmction to be one of resolving uncertainty. Survey reports show that taxpayers are
primarily interested in ﬁling a correct tax return (Hite and McGill 1992). Yet, numerous
studies have suggested that tax aggressiveness is prevalent among preparers (Ayres et al.
1989). As a result of these ﬁndings, there has been an increase in research on the preparer’s

level of aggressiveness. Two primary categories of this research have been explored:

5

identifying factors linked to the tax preparer’s aggressiveness, and evaluating the mechanisms
used to mitigate the tax preparer’s aggressiveness.
2.1 Factors Linked to Tax Preparer’s Aggressiveness

A preparer is said to have made an "aggressive" reporting position when the individual
chooses a position favorable to the taxpayer in a situation in which there is no clear authority
to support the position (Cuccia et al. 1995). Milliron (1988) developed a conceptual model
of 24 factors that may affect a preparer's decision in recommending an aggressive reporting
position and tested the model using twelve tax managers and partners to rate the relative
importance of each factor. She concluded that variables inﬂuencing the client’s aggressive
behavior were important; however, the variables associated with the tax preparer, such as
preparer penalties, determined the level of aggressiveness of the preparer. Kramer (1988)
pointed out several problems with this research, including inconsistencies arising ﬁom rating
variables, small sample size, and lack of support for several factors in empirical studies.
However, other studies discussed in this section, have conﬁrmed the importance of several
factors associated with a tax preparer’s aggressiveness. For example, researchers have
studied the effects of ambiguous tax laws, client importance to the ﬁrm, tax preparer’s
professional status, number of years of tax experience, number of years of tax task experience,
and tax preparer’s gender and age on the preparer’s level of aggressiveness (IRS 1987;
Jackson et al. 1988; Cuccia 1992; Roberts and Cargile 1993; Milliron 1988; Johnson 1993;
Reckers et al. 1991)

An important factor associated with tax preparer aggressiveness is ambiguous tax
laws. Tax preparers differ from auditors and other accountants in at least one unique aspect.

Tax practitioners have conﬂicting responsibilities to the client and the tax system. Many areas

6

of the tax law are imprecise, and the amount of tax owed by a taxpayer may depend on how
one interprets the law. For example, with regard to family members' business travel expenses,
the regulations provide that such expenditures are deductible only if a bona ﬁde business
purpose exists for their presence. What constitutes a “bona ﬁde business purpose” is not
deﬁned in the regulations, leaving such issues open to interpretation. Under these
circumstances, a tax preparer may have an incentive and opportunity for aggressive reporting.

However, when the law is ambiguous, the Treasury Department contends that the
preparer’s prevailing obligation is to the tax system (Shapiro 1986; Reckers et al. 1991).
Preparers counter by arguing they owe a duty to assist the client in paying no more taxes than
are legally owed (SRTP 1 [1988 Rev]; Gurka 1992). Johnson (1993) examined the role that
tax preparers play in the application of ambiguous tax laws. In a laboratory experiment, she
asked 107 tax preparers to evaluate evidence related to an ambiguous area of the tax law.
She found that tax preparers weight support evidence more heavily than opposing evidence.
She concluded that in areas of ambiguity, the preparer acts as a taxpayer advocate and relies
on tax authority that supports the taxpayer’s position. These results are consistent with
Helleloid (1989) and Klepper and Nagin (1991).

A second factor associated with tax preparer aggressiveness is the client’s importance
to the ﬁrm. In the audit literature, it is argued that clients generating large revenues become
economically important to the accounting practice. As a result, client leverage (auditor
ﬁnancial dependency) can inﬂuence an auditors‘ judgement (SEC 1979; Reckers et al. 1991).
The inﬂuence of client importance on auditor's judgement is at the center of an extended
debate between the profession and its regulators as to the extent to which auditors may

engage in non-audit services, which increase total revenue ﬁ'om audit clients, and still remain

7

independent (Reckers et al. 1991). In the tax area, Reckers et al. (1991) examined the
impact of client importance on the aggressiveness of CPAs. They used the client's ability to
generate present and future income for the accounting ﬁrm as a surrogate for client
importance. The more important client generated gross income of $360,000, while the less
important client generated gross income of $180,000. In an experimental study, 59 tax
specialists were asked to evaluate the tax consequences of a transaction entered into during
the current tax year. Subjects in the more important client condition took more pro-client
positions than subjects in the less important client position. The results indicated that a higher
level of present and ﬁrture compensation received ﬁom a client increases the aggressiveness
of CPAs when giving advice or signing returns (Reckers et al. 1991).

Another attribute associated with the tax preparer recommending an aggressive
reporting position is the preparer’s professional status. Ayres et al. (1989) found that CPAS
tend to be more aggressive than non- CPAs when completing a task related to an ambiguous
area of the tax law . In an experimental study, 168 tax preparers were asked to make a
reporting decision on the deductibility of ﬁve tax issues related to an ambiguous area of the
tax law. CPAs made more pro-client reporting decisions than unlicensed tax preparers.
These ﬁndings are consistent with prior research (IRS 1987; Jackson et al. 1988).

Robert and Cargile (1993) hypothesized that male CPAs are more aggressive than
female CPAs. In an experimental study, 236 subjects were asked to make a reporting
decision on the deductibility of a tax issue related to an ambiguous area of the tax law. Male
CPAs tended to select positions that reduced the taxpayer’s liability by a greater amount than
did female CPAS. The same results were obtained by McGill (1990) and Ayres et al. (1989).

LaRue and Reckers (1989) hypothesized that older tax preparers will be less

8

aggressive than younger tax preparers. One hundred ten tax managers were asked to make
a decision on the tax consequences of ambiguous tax cases. They found that older taxpayers
did not make less aggressive tax decisions than younger taxpayers. These results are
consistent with Duncan et al. (1989).

The results of prior research on the years of tax experience have been inconsistent.
Several studies cited earlier have found that years of experience were not related to aggressive
tax reporting (Robert and Cargile 1993; Kaplan et al. 1988; Duncan et al. 1989). However,
La Rue and Reckers (1989) did ﬁnd years of experience to be related to aggressive tax
reporting in their study. Robert and Cargile (1993) also found that tax task experience was
not related to aggressive tax reporting.

In summary, prior research has shown that certain variables may inﬂuence tax preparer
compliance. Ambiguous tax laws and client importance to the ﬁrm have been found to
increase tax preparer’s aggressiveness. Other variables that may affect tax preparer
compliance are professional status, gender, and years of experience. These factors will be
measured in this research, and used as controlled variables. To date, no one has tested
whether fee arrangements (contingent or constant) affects a preparer’s level of
aggressiveness. This study attempts to ﬁll that gap.

2.2 Tools Used to Mitigate Aggressive Tax Reporting

Two of the tools used to mitigate aggressive tax reporting are explored here. The ﬁrst
tool is the prohibition of a contingent fee arrangement between a tax preparer and a taxpayer
for the preparation of a tax return. Neither the IRS nor the AICPA allows a tax preparer to
have a contingent fee arrangement with a taxpayer for the preparation of a tax return. These

prohibitions are discussed in Section 2.2. 1. The second tool used to mitigate aggressive tax

9

reporting is the professional standards set by the Treasury Department, the American Bar
Association, and the AICPA. The professional standards are the standards guiding the tax
preparer in adopting tax return positions. These standards are discussed in Section 2.2.2
2.2.1 Prohibition Against Contingent Fees

The Internal Revenue Service and Prohibition Against Contingent Fees

The Internal Revenue Service (IRS) oversees, promotes, and enforces tax compliance.
The IRS's mission is to collect the proper amount of tax revenue at the least cost to the
public, and in a manner that warrants the highest degree of public conﬁdence. Numerous
programs such as the Taxpayer Compliance Measurement Program (TCMP), Compliance
2000, and the market segmentation approach have been implemented to assist the IRS in this
endeavor. The most detailed existing data on the extent of taxpayer noncompliance with
federal income tax laws have been gathered by the IRS under the TCMP. Here, the IRS
periodically selects a random statistical sample from which to take detailed compliance
measurements about the accuracy of ﬁled returns, the extent of individuals failing to ﬁle, and
the characteristics of delinquent taxpayers (Long & Swingen 1989). In its latest TCMP study,
IRS examiners found misreporting on almost two-thirds (64%) of the returns ﬁled (Long &
Swingen 1991).

The TCMP data are used to develop Discriminant Function (DIF)1 programs to select
returns for audit. Because the TCMP process is costly to the RS and places a tremendous
burden on taxpayers, the IRS has discontinued this program. Therefore, the tax authorities
must use other avenues to identify those who do not comply with the tax laws. In its 1992
annual report, the IRS set a goal to raise the Voluntary Compliance Rate (VCR) (the

percentage of taxes voluntarily paid) to 90 percent by the year 2000 (Guttman 1994). As

10
stated earlier, the IRS is taking an active role in enforcing voluntary compliance with the tax
laws through the implementation of numerous programs. The 1994 revision to Sec. 10.28
of Circular 230 was enacted for that purpose.

Section 10.28 of Circular 230, as originally written, stated that "no attorney, CPA or
enrolled agent shall charge an unconscionable fee for representation of a client in any matter
before the IRS." The revision to Section 10.28 continues to prohibit a practitioner from
charging an unconscionable fee, and it also prevents a practitioner from charging a contingent
fee for the preparation of an original tax return and a claim for a I'CfUI‘ld. Treasury is
concerned that permitting contingent fee arrangements for tax return preparation would
undermine voluntary compliance by encouraging return positions that exploit the audit
selection process (Raby 1992). An exception to the prohibition is made for reﬁrnd claims that
are ﬁled in anticipation of the claim receiving substantive review by the IRS, because
according to the Treasury, these claims do not have the same potential for undermining
voluntary compliance (Reg. Sec. 10.28b). If the reﬁmd claim is reviewed, the taxpayer cannot
exploit the audit selection process by gambling on the probability that the return will not be
audited, and therefore an unwarranted deduction will not be detected.

Prior to the 19603, the Treasury allowed a contingent fee arrangement with a
prohibition against "unconscionable" fees. At that time, Circular 230 required disclosure to
the IRS of the existence of a contingent fee arrangement (Raby 1992). The requirement to
disclose the existence of a contingent fee arrangement was discontinued in the 19603. From
1960-1992, no revisions were made to Circular 230 regarding contingent fee arrangements.
However, in 1992, a proposal was made to amend Section 10.28 of Circular 230 to continue

the prohibition of an "unconscionable" fee but to allow contingent fee arrangements in refund

11

claims that are ﬁled in anticipation of litigation. The proposed regulation became ﬁnal in
1994. Recommendations concerning changes to the allowance of a contingent fee continue
to be made based on suppositions about how such an arrangement would inﬂuence tax
preparer behavior. These suppositions provide the motivation for this research.

The American Institute of Certiﬁed Public Accountants and Prohibition Against
Contingent Fee Arrangements

The AICPA also addresses the use of contingent fees by CPAS. AICPA Rule 302
states “a member in public practice shall not prepare an original or amended tax return or
claim for a tax reﬁmd for a contingent fee for any client” (AICPA 1988). Like the Treasury,
an exception to the prohibition of contingent fees exists. The AICPA exception provides that
a contingent fee for preparing a refund claim is permissible if there is a "reasonable
expectation" that the tax agency will give the claim "substantial consideration" (Raby 1992).
The AICPA's purpose is to avoid abuse of the audit selection process and to prevent
exploitation of the client (Raby 1992). If the tax agency gives the claim "substantial
consideration," the preparer cannot exploit the audit selection process because this will
require the tax agency to perform an audit or at least review the issue in question.

In the public hearing on the proposed regulations, the AICPA stated that they strongly
disagreed with the Treasury's position on contingent fees. They contended that the
regulations are unnecessarily restrictive and do not allow contingent fees in circumstances
where there is not a potential for undermining tax compliance. Such circumstances include
examination, appeal, or the ﬁling of a claim for a reﬁmd where the practitioner reasonably
anticipates that the IRS will audit and allow the claim on its merits without litigation. Under

the AICPA rules, a CPA would be allowed to compete with lawyers, property tax consultants,

12

and others who are not constrained by contingent fee prohibitions (Podolin 1991). However,
both the AICPA and the Treasury prohibit a contingent fee arrangement between a client and
a tax preparer for the preparation of an original income tax return. The AICPA argues that
the professional standards are suﬂicient to prevent tax preparers from taking unsupported tax
positions.

2.2.2 Professional Standards

The provisions of the Internal Revenue Code (IRC)2, Treasury Circular 230, the Tax
Division of the American Bar Association, and the AICPA Statements on Responsibilities in
Tax Practice (SRTP) set standards for tax preparers in recommending tax positions and
preparing tax returns.

The standard of reporting for a taxpayer is more stringent than that required of the tax
preparer. The IRC offers two alternatives for a taxpayer to avoid a penalty for taking a
deduction that is later disallowed by the IRS. IRC Sec. 6662(d)(2) requires that the taxpayer
have "substantial authority" for taking the position or that the taxpayer adequately disclose
the position on the tax return. This standard has never been applied to practitioner conduct.
The " substantial authority" penalty applies to the taxpayer for tax positions that are not
“adequately” disclosed on the tax return. Regulation Section 1.6661-3(d)(1) states that there
is "substantial authority" for the tax treatment of an item only if the weight of the authority
supporting the treatment is substantial in relation to the weight of the authority supporting
contrary positions. An understatement is substantial if it exceeds the greater of (1) 10 percent
of the tax required to be shown on the return, or (2) $5,000 ($10,000 for all corporations
except S corporations and personal holding companies) (Treas. Reg. Sec. 1.6662-4(b)(1)).

The taxpayer penalty for not disclosing return positions lacking substantial authority is 20

13

percent of the amount of the understatement (IRC Sec. 6662(d)(2)). Although the tax
preparer is not subject to the substantial authority penalty, the preparer may agree to pay the
penalty if the understatement of liability is the result of an error made by the preparer.

The IRC also offers two alternatives for a tax preparer to avoid a penalty for
recommending a position that is later disallowed by the IRS. IRC Section 6694(a) requires
that the tax return preparer either adequately disclose the tax return position or have a
"realistic possibility" of success for the position taken on the return. However, Treasury does
not provide an explicit deﬁnition of "realistic possibility." By example, the Treasury indicates
a realistic possibility exists if there is a one-in-three likelihood of the position being upheld in
court (Reg. Sec. 1.6694-2(b)). According to the House Ways and Means Committee report,
this standard was adopted because it generally reﬂects the professional conduct standards
applicable to lawyers and CPAs (U. S. Congress 1989b). The tax preparer penalty for not
disclosing a return position lacking a “realistic possibility” of success is $250. In order to
assess the “realistic possibility” penalty against the tax preparer, the IRS must ﬁrst assess the
“substantial understatement” penalty against the taxpayer.

In summary, the Internal Revenue Code offers two alternatives to a tax return
preparer to avoid a penalty for recommending a tax position that the IRS later disallows. The
ﬁrst approach involves having a reasonable basis and disclosing the controversial tax position
on the client's return. The second approach involves having a “realistic possibility” of success
for the position taken on the return even though the IRS successﬁrlly disallows the position.
As legal support, a tax preparer is allowed to rely on the tax laws, IRS rulings, and
regulations applicable at that time. Circular 230 also provides disciplinary actions against a

practitioner who knowingly provides false or misleading information to the Treasury. This

14

action can range from a request for an explanation to suspension or disbarment (See Table
2.1). These disciplinary actions will not be tested for or discussed in this study. For a more

detailed discussion of these violations see Gurka (1992).

15

 

TABLE 2.1
VIOLATIONS OF PRACTITIONER RESPONSIBILITIES

DISREPUTABLE CONDUCT

Criminal conviction

Offenses involving dishonesty breach of trust

Knowingly providing false or misleading information to the Treasury

Soliciting employment by making false or misleading representations

Suggesting that special consideration from the IRS can be obtained

Willﬁrl failure to make a tax return.

Participation in the evasion of any federal tax or payment thereof

Failure to properly remit ﬁrnds received from a client for the purpose of paying
obligations due to the United States

Directly or indirectly offering, agreeing, or attempting to inﬂuence an IRS employee by
threat, false accusation, duress, coercion, or special inducement.

Disbarment or suspension from practice

Knowingly aiding and abetting another person to practice before the IRS during a
period of ineligibility

Engaging in contemptuous conduct in connection with practice before the IRS

Knowingly, recklessly, or through gross incompetence giving a false opinion on
questions arising under federal tax laws

VIOLATIONS OF DUTIES AND RESTRICTIONS

Failure to furnish records or information to the IRS upon lawful request unless the
practitioner reasonably believes the request is of dubious legality

Failure to promptly notify a client of noncompliance with tax law upon discovery by the
practitioner

Failure to exercise due diligence in representations to the client or IRS

Unreasonably delaying the prompt disposition of any matter before the IRS

Accepting assistance from a practitioner under suspension or disbarment from practice
before the IRS

Charging unconscionable fees

Representing conﬂicting interests before the IRS except by express consent of all
interest parties

Engaging in unauthorized advertising in the solicitation of employment in matters
related to the IRS

Endorsement or negotiation of any taxpayer’s reﬁrnd check, except when the taxpayer
is the practitioner

 

Source: Cirgrlar 29,

16

Like the Treasury, the AICPA also has standards guiding tax preparers in adopting
tax return positions and in preparing returns. AICPA Statement on Responsibilities in Tax
Practice No.1 states that a CPA should not recommend to a client that a position be taken
with respect to the tax treatment of an item on a retum unless the CPA has a good faith belief
that the position has a “realistic possibility” of being sustained on its merits. The AICPA does
not give a numerical deﬁnition of "realistic possibility." However, when a practitioner
believes that more than one position can be substantially supported, the preparer may discuss
the likelihood of audit caused by each position (AICPA 1988; Reckers et al. 1991). The
provisions further state that the CPA's duty is to assist the client in paying no more taxes than
are legally owed.

The Tax Division of the American Bar Association also has standards guiding the
practice of attorneys in adopting tax return positions and in preparing tax returns. The
American Bar Association’s “realistic possibility” standard states that a lawyer may advise
reporting a position on a tax return as long as the lawyer believes in good faith that the
position is warranted in existing law or can be supported by a good faith argument for an
extension, modiﬁcation, or reversal of existing law and there is some realistic possibility of
success if the matter is litigated (Formal Opinion 85-353; Gurka 1992). The lawyer is
required to advise the client when the potential for a penalty exists and under what
circumstances the IRS requires disclosure. However, it is the client's responsibility to
determine whether or not to disclose the tax position taken. This professional standard
requires that the lawyer "zealously and loyally" represent the client's interest. Unsupported
tax positions should not be taken.

The standards contain vague language in describing the threshold at which alternative

l7

disclosure should be made. Cuccia et al. (1995) investigated whether preparers use the
latitude available in interpreting vague professional standards to justify aggressive reporting
positions. In two experimental studies, 138 tax managers were asked to make a reporting
decision, assess the evidential matter, and interpret the practice standard on the taxability of
proceeds from the settlement of a defamation of character lawsuit. The existing authority
indicated that both the inclusion and the exclusion of these proceeds from taxable income are
potentially supportable. In the ﬁrst study, the subjects were given a vague verbal standard,
and in the second study, the subjects were given a more stringent numerical standard (55%
or 60%). Subjects in each study were given an incentive to report either aggressively or
conservatively. They found in both studies that the tax preparers who were given an incentive
to report aggressively did so and used the latitude available in assessing evidential support to
justify their reporting position. These ﬁndings are partially supported by prior research that
has shown that tax preparers report aggressively when they have an incentive to do so
(Reckers et al. 1992). These ﬁndings predict a main affect for reporting standards and lead
to the following hypothesis:

H1: Given the same fee structure, subjects with reporting standards are expected

to be less aggressive than subjects without reporting standards.

Cuccia et al. (1995) used a vague verbal standard and a more stringent numerical standard.
An important, yet unresolved, issue is whether preparers (with or without standards) who
recommend aggressive reporting positions would justify this position by having a higher

assessment of the deduction being allowed. This leads to hypothesis 2:

18
H2: Subjects who recommend aggressive reporting positions make higher
assessments of the probability of the deduction being allowed upon audit than
subjects who do not recommend aggressive reporting positions.

Because the purpose of the standards is to mitigate aggressive tax reporting, the
potential inﬂuences of the professional standards and the client fee incentive may interact.
From a cost-beneﬁt perspective, standards against a certain behavior can be expected to be
effective deterrents when the "costs" associated with the standards are greater than the
compensation received for unacceptable behavior (Graetz and Wilde 1985; Reckers et al.
1991). Therefore, for professional standards to be effective, the "cost" associated with the
standards must be perceived to be greater than the compensation for taking an unsupported
tax position.

In this study, the practitionefs hypothetical compensation is determined by using an
hourly rate (constant fee) or a ﬂat fee plus compensation based on the taxes saved (contingent
fee). For this fee, the practitioner is required to make a decision on the amount of travel and
entertainment expense to deduct for a hypothetical taxpayer. In the contingent fee condition,
the practitioner's fee and the audit detection risk (the probability of the IRS detecting an
understatement of tax liability) increase as the amount of deduction taken increases (Table
2.2). In the constant fee condition, the fee remains the same; however, there is a positive
relation between the audit detection risk and the reporting position taken (Table 2.3). An
aggressive reporting position is deﬁned for the purpose of this study as deducting any amount
greater than $50,000, because the tax laws do not clearly support the deduction of any
amount in excess of $50,000. The practitioner's potential cost is $250 (IRC 6694 (a)). Other

costs that can be associated with failure to comply with reporting standards are potential loss

of client, practitioner's reputation, loss of goodwill, and the loss of the privilege to practice

19

before the IRS. The AICPA's supposition is that the costs associated with the standards are
sufﬁcient to mitigate aggressive tax reporting. This contention suggests the following
hypothesis which predicts a main effect for fees:

H3: Given reporting standards, subjects with contingent fees are expected to be
more aggressive than subjects with constant fees.

20

 

TABLE 2.2
TAX FILING OPTIONS -- CONTINGENT FEE

Audit Potential

 

 

 

Tax Filing Amount to Tax Preparer's Detection Preparer's
Options Deduct Savings Fee Risk Penalty
A $125,000 $50,000 $3,000 40% $250
B $100,000 $40,000 $2,500 33% $250
C $75,000 $30,000 $2,000 25% $250
D $50,000 $20,000 $1,500 -0- -0-
E -O- -0- $500 -0- -0-
TABLE 2.3

TAX FILING OPTIONS - CONSTANT FEE
Audit Potential

 

Tax Filing Amount to Tax Preparer's Detection Preparer's
Options Deduct Savings Fee Risk Penalty
A $125,000 $50,000 $500 40% $250
B $100,000 $40,000 $500 33% $250
C $75,000 $30,000 $500 25% $250
D $50,000 $20,000 $500 -0- -0-
E -0- -0- $500 -0- —0-

 

CHAPTER 3

RESEARCH DESIGN

The research design used to gather data to test the three hypotheses developed in
Chapter Two is an experimental design consisting of a between-subject study of the impact
of two variables, preparer’s fees and reporting standards, on tax preparer compliance. This
chapter includes a discussion of the experimental task, variables, and additional data
collected.

3.] Research Design and Experimental Task

The research design is a 2 x 2 design with the independent variables (client fees and
reporting standards) manipulated at two levels. The text of the tax case was adopted ﬁ'om an
instrument developed by Gurka (1992). The experimental instruments used in this study are
case scenarios involving a corporate taxpayer (Appendix A). The cases are identical in all
respects in each condition except for the manipulation of the independent variables. The
experimental task required the subjects to determine the deductibility of travel and
entertainment expenses and to assess the strength of the authority (herein called “support
assessment”) to avoid tax preparer and taxpayer penalties. The research ﬂow is shown in
Figure 3.1 and is described in more detail in the following paragraphs.

The experiment consisted of two parts. In part one of the experiment, the subjects

were given a handout containing the information necessary to perform the experimental task.

21

22

This packet included background information on the client, a tax case, the tax law relevant
to the issue, ranges of expenses to choose from, tax savings, hypothetical preparer's fee, audit
detection risk, potential preparer's penalty, and questions related to the study. Inclusion of
the tax laws was deemed necessary to control for effects due to lack of knowledge of the law.
The ﬁrst page of the handout includes the instructions for the experiment. Subjects’
instructions were based on the condition that they were randomly assigned. Figure 3 .2 shows
general instructions given to all subjects. Figure 3.3 shows additional instructions given to
subjects based on the experimental condition to which they were assigned. After reading the
instructions, the subjects were asked to complete part one of the experiment.

Part one of the experiment consists of case scenarios. Each case begins with a brief
introduction to the client's business. Prior research has shown that tax preparers recommend
more aggressive reporting positions for clients more important to the ﬁrm than for clients less
important to the ﬁrm (Reckers et al. 1991). Hence, the case material given to subjects stated
that this is an important client. Prior research has also shown that ambiguity is among the
factors that are positively related to aggressive tax behavior (Johnson, 1993). Therefore, a
case was selected where the tax results are uncertain. In this study, an aggressive reporting
position is deﬁned as deducting any amount in excess of $50,000, the amount that is

unambiguously deductible.

23

FIGURE 3.1

 

 

RESEARCH FLOW
PART 1 PART 2
Constant
Fee
Re ortin
Contingent p g
Fee
Tax

Constant
Fee

Reporting
Standard

 

Contingent
Fee

Case Questionaire

24

 

FIGURE 3.2
GENERAL INSTRUCTIONS

1. Purpose And Nature of Study

The purpose of this project is to study the ways in which tax
practitioners make decisions. There are no right or wrong answers; therefore, please
choose the option that best represent how you would respond in a similar, actual
situation.

The study will last approximately 30 minutes. All your answers will be
anonymous. Your participation in this study is voluntary. You may withdraw at any
time. You indicate your voluntary agreement by completing this study.

11. Overview of The Study

Please assume that you have been engaged to prepare the 1995 tax return for a client.
The amount of mcome tax is uncertain because the allowable amount of travel and
entertainment expense has not been determined. You must determine how much travel
and entertainment expense to deduct.

III. Procedures
Please read the materials and make a decision on the amount of travel and entertainment
expenses to deduct.

 

 

 

 

FIGURE 3.3
ADDITIONAL INSTRUCTIONS
Type of Fee/Standards Instructions
Constant Fee Without Standards Attached is a tax case, the tax laws relevant to the

issue, and questions related to the study.

Constant Fee with Standards Attached is a tax case, the reporting standards, the
tax laws relevant to the issue, and questions
related to the study.

Contingent Fee Without Standards You are to assume that your fee will be $500 plus
5 percent of the tax savings. Attached is a tax
case, the tax laws relevant to the issue, and
questions related to the study.

Contingent Fee with Standards You are to assume that your fee will be $500 plus
5 percent of the tax savings. Attached is a tax
case, the reporting standards, the tax laws relevant
to the issue, and questions related to the study.

 

25

After reading the case and the relevant tax authority, the subjects were asked to make
a reporting decision and assess the support assessment necessary to avoid penalties for the
deduction taken. After the subjects made their decisions and turned in part one, they were
given part two, which consists of questions regarding the subjects’ experience, personal data
and familiarity with the reporting standards. These questions are used to test for the effects
of age, gender, professional status, and experience. The subjects were allowed the time they
needed to complete the experiment, and the average time was 30 nrinutes.

The body of the case discusses facts related to travel and entertainment expenses that
were incurred by the client during the taxable year. Some of the travel and entertainment
expenses are clearly deductible according to the law; some of the travel and entertainment
expenses fall within a "gray area" of the law; and some of the travel and entertainment
expenses are clearly not deductible. The clearly deductible expenses are travel, meals, and
lodging for the company's employees and the customer representatives (Treasury Reg. Sec.
1.162-2 (b)(1)) and the expenses related to the superbowl tickets for Wood's employees and
customer representatives (IRC sec. 274). The ambiguous deductions are travel, meals ,
lodging and entertainment expenses related to the employee's spouse.

With regard to family members, IRC sec. 274 (m) provides that travel expenditures
(airfare and accommodations) are deductible only if a bona ﬁde business purpose exists for
their presence, the family member is an employee of the corporation, and the expenditures are
otherwise deductible. As deﬁned in Mathew (418 F.2d at 879), this requires that the
member provide “substantial services directly and primarily related” to the business function
of the trip. As applied in Danvﬂe PM (16 ClsCt 584), this requires that the primary

function be more than “socially gracious.” Similarly, Wam’ck (236 F. Supp. 761) determined

26

that when a spouse is expected to socialize extensively and establish ties with customers, his
or her traveling expenses are deductible. The tax laws do not clearly deﬁne “bona ﬁde”
business purpose, leaving room for interpretation. Therefore, in this experiment, the
employees' spouses’ expenses fall within the gray area of the law. Expenses related to the
children and the customer representatives' spouses are not deductible (IRC secs. 162 & 274).
3.2 Variables

The independent variables are client fees charged and reporting standards. A
reasonable fee was arrived at through discussion with employees at a Big 6 accounting ﬁrm.
Client fees were manipulated between subjects at two levels: constant fee and contingent fee.
The contingent fee manipulation entailed including in the case an explicit statement that the
practitioner's fee is $500 plus 5% of the tax saved. The subjects were asked to assume that
this fee arrangement is allowed by the Treasury and the AICPA. The options and the
ﬁctitious preparer’s fee are shown in Tables 2.2 and 2.3. The constant fee manipulation states
that the fee remains constant regardless of the option selected ($500). The contingent fee
manipulation is expected to motivate the tax preparer to behave aggressively 0-13). This
predicted response behavior is consistent with the Treasury's perception of contingent fee
arrangement effects (see Chapter 2).

Reporting standards were manipulated between subjects at two levels: with and
without reporting standards. The reporting standards manipulation entailed including in the
case a brief description of the current reporting standards. The without-reporting standards
manipulation entailed including in the case a statement that requires the subjects to assume
that the Treasury and the AICPA do not have reporting standards. Providing the subjects

with the reporting standards is expected to mitigate aggressive tax reporting (HB). This

27

prediction is consistent with the AICPAs perception of reporting standards effects (see
Chapter 2).

The dependent variables are the amount of expense deducted and probability of the
deduction being allowed upon audit. The subjects were given a predetermined set of
deductions from which to choose. These deductions ranged from all of the expenses to none
of the expenses (Tables 2.2 and 2.3). These options were chosen to differentiate between the
expenses that are clearly deductible; the expenses that are ambiguous; and the expenses that
are clearly not deductible. An option labeled “other” was included for subjects who were
unable to select one of the predetermined options.

Data for the second dependent variable were gathered by asking subjects to assess the
probability, on a scale of zero to one-hundred percent, of each deduction being allowed upon

audit. Questions used to assess these probabilities are shown in Figure 3.4.

 

FIGURE 3.4
PROBABILITY ASSESSMENT QUESTIONS

1. What do you believe is the probability that the IRS will allow the entire amount
of the expense (Choice A) on audit?

2. What do you believe is the probability that the IRS will allow all of the expenses
pertaining to customer representatives and their spouses, employees and their
spouses (Choice B) on audit?

3. What do you believe is the probability that the IRS will allow all of the expenses

pertaining to customer representatives, employees and the employees’ spouses
(Choice C) on audit?

CHAPTER 4

RESULTS

This chapter discusses the experimental procedures used to test the hypotheses
developed in Chapter Two. The data used in these statistical tests were gathered ﬁom
professional tax preparers using the research design discussed in Chapter Three. This chapter
provides a discussion of the subjects, results for manipulations of the independent variables,
hypotheses tests of the dependent variables, and possible covariates, and proceeds to discuss
possible alternative explanations for the results obtained.

4.1 Subjects

Prior studies on tax preparer compliance have used experienced tax return preparers.
The only requirement has been that the preparers have the experience necessary to complete
the task. It was detemrined through discussion with employees at a Big 6 ﬁrm that preparers
with one or more years of tax experience routinely encounter issues related to travel and
entertainment expenses. Therefore, tax preparers with one or more years of tax experience
were recruited to participate in this study. To mitigate the effects of ﬁrm speciﬁc training,
subjects were recruited from four ﬁrms and a tax workshop presented by the Michigan
Association of CPAs (MACPA). The four accounting ﬁrms are KPMG (Chicago), KPMG
(Houston), Postlewaite and Netterville (Baton Rouge), and Bougeois and Bennett (New

Orleans). The number of subjects represented by each ﬁrm is shown in Table 4.1.

28

29

 

 

 

TABLE 4.1
NAME, TYPE AND NUMBER OF SUBJECTS PER FIRM
NUMBER OF

FIRM NAME FIRM TYPE SUBJECTS
KPMG (Chicago) Big 6 26
KPMG (Houston) Big 6 22
Postlewaite and Netterville Local 18
Bougeois and Bennett Local 5
MACPA (Michigan) Various 17

 

The ﬁrms were contacted by telephone and asked to participate in a study evaluating
the decision-making process of tax preparers. A special meeting was arranged by each ﬁrm
for the study to be conducted. Tax preparers attending a MACPA workshop were recruited
individually to participate. The experiment was administered in two parts and lasted
approximately 30 minutes. No prediction will be made concerning the type of ﬁrm or the
region of the country, however, these factors will be tested.

Ninety-one tax preparers participated in the experiment. Three of the subjects were
eliminated because they did not complete the instrument, leaving 88 usable responses. The
subjects were assigned randomly to the experimental conditions. Subjects' age range,

professional status, gender, and tax experience are shown in Table 4.2.

30

 

TABLE 4.2
SUBJECTS’ DESCRIPTIVE INFORMATION

Descriptive Information Percent of Subjects

Panel A: Subjects’ Age Range

21-30 years of age 43
31-40 years of age 25
41-50 years of age 15
51-60 years of age 4
Over 60 years of age 2
No Response 11

Panel B: Subjects’ Gender

Male 42
Female 48
No response 10

Panel C: Subjects’ Professional Position

Owner/Partner 21
Manager 28
Senior 18
Tax Specialist 20
No response 13

Panel D: Subjects’ Tax Experience

1-3 years 34
4-6 years 15
7-10 years 8
11-16 years 17
17-24 years 11
Over 25 years 6

No Response 9

31
4.2 Manipulation Check

Data from debrieﬁng questions asked in Part two of the experiment indicated that the
manipulation of fees was partially effective. In order to determine whether subjects
understood the fee manipulation, twenty-six subjects were asked whether or not their fee was
based on the tax saved. The yes-or-no response to this question is shown in Table 4.3 and
is analyzed using a Chi Square test. The responses of the constant fee groups and the
contingent fee groups differ signiﬁcantly (x2 (1) =6.78, p<.01) (Table 4.4). Subjects in the
constant fee condition understood that their fee was not based on the tax saved, however,
only eight (57 percent) of the fourteen subjects in the contingent fee group understood that
their fee was based on the taxed saved. Although the test was statistically signiﬁcant, the
number of subjects in the contingent fee condition who understood the manipulation, was less
than what was wanted to conclude that the manipulation was successﬁrl.

Data from the debrieﬁng questions indicated that the manipulation of standards was
partially successful. Twenty-six subjects were asked the extent to which they rely on the
reporting standards. They were given three options from which to choose (strongly
considered, somewhat considered, and not considered). The response to this question is
shown in Table 4.5 and the result is analyzed using a Chi Square test. The responses of the
groups with standards and the groups without standards differ signiﬁcantly (x2(1) =5.94,
p<.05) (Table 4.6). Subjects with reporting standards relied more on the standards in making
a decision than did subjects without reporting standards. However, nine (56 percent) of the
sixteen subjects without reporting standards indicated that they relied on the standards in
making their decisions. Although the test was statistically signiﬁcant, the number of subjects

in the without-standards condition who did not rely on the standards was less than what was

32

wanted to conclude that the manipulation was successful. Only twenty-six of the eighty-eight
subjects were asked to respond to the questions pertaining to the manipulation of the
independent variables.
4.3 The Effects of Reporting Standards by Fees

Each subject responded to the dependent variable, the amount of expense deducted;
therefore, the appropriate statistical analysis is analysis of variance (ANOVA) with two
independent variables (fees and standards). Table 4.7 presents the mean reporting decisions
(dollars deducted) and the standard deviations for the four groups. The mean reporting
decisions (standard deviations) for constant fee with reporting standards, constant fee without
reporting standards, contingent fee with reporting standards, and contingent fee without
reporting standards conditions in thousand dollars are 76.15 (28.9), 74.74 (20.81), 72.52
(19.43), and 76.59 (22.10), respectively. The expectation was that the cell mean of the
constant fee with reporting standards condition will be the lowest cell mean. This cell mean
was not in the expected direction and will be discussed in Section 4.6. F-statistics for
between-subject design were used to test the signiﬁcance of the mean differences (Table 4.8).
When the interaction is analyzed in a two-factor analysis of variance, the difference is not

signiﬁcant (F (1,84)=.206, p=.651).

33

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

TABLE 4.3
CONTINGENCY TABLE FOR FEE MANIPULATION
Response Contingent Constant
Yes 8
No 6 1 1
TABLE 4.4
TEST STATISTICS FOR FEE MANIPULATION
Test Fees
Chi-Square 6.78
df 1.00
Signiﬁcance 0.01
TABLE 4.5
CONTINGENCY TABLE FOR STANDARD MANIPULATION
Response With Without
Strongly considered 1 4
Somewhat considered 8 5
Not considered 1 7
TABLE 4.6
TEST STATISTICS FOR STANDARD MANIPULATION
Test Standards
Chi-Square 5.94
df 2.00

Signiﬁcance 0.05

34

 

 

 

 

 

 

 

 

 

TABLE 4.7
MEAN REPORTING (STANDARD DEVIATION) DECISIONS (IN
THOUSANDS)
Fees Reporting Standards
With Without
Constant 76. 151 74.74
(28.90)2 (20.81)
n=21 n=24
Contingent 72.52 76.59
(19.43) (22.10)
n=23 n=20
lMean
2Standard deviation
TABLE 4.8
ANALYSIS OF VARIANCE
Source df Sum of Squares Mean Square F Value Pr > F
Within + Residual 84 44301.078 527.394
Fees 1 3.167 3.167 .006 .938
Standards 1 14.457 14.457 .027 .869
Fees By Standards 1 108.518 108.518 .206 .651
Total 87 44424.249 510.624
(Model)
Residual Explained 3 123.171 41.057 .078 .972

 

3 5

4.4 The Effects of Reporting Standards

H1 hypothesizes a main affect for reporting standards. H1 will be supported if the
subjects with reporting standards recommend less aggressive reporting positions than subjects
without reporting standards. When the main affect of reporting decisions (dollar amount)
is analyzed in a two-factor analysis of variance, the difference is not signiﬁcant
(F (1,84)=.206, p=.651). These results do not support H1. Reporting standards did not
inﬂuence tax preparers’ level of aggressiveness in this experiment. This result is tempered by
the fact that subjects without reporting standards may still have considered them when making
their reporting decision.
4.5 The Effects of the “Realistic Possibility” Standard

H2 predicts that preparers who recommend aggressive reporting positions make a
higher assessment of the probability of the deduction being allowed upon audit than preparers
who do not recommend aggressive reporting positions. To test this hypothesis, after
recommending a reporting position, each subject was asked to assess the probability that the
IRS would allow the deduction upon audit. The mean and standard deviation of the subjects’
assessment of the probability of the deduction being allowed upon audit is shown in Table 4.9.
As shown in Table 4.9, the assessment of the probability of the deduction being allowed upon
audit for the subjects recommending $100,000 are 79 (19.72), 66.46 (22.33), and
31.79 (29.25) for reporting positions of $75,000, $100,000, and $125,000, respectively. The
assessments of the probability of the deduction being allowed upon audit for the subjects
recommending $75,000 are 77.34 (13.81), 29.13 (18), and 12.94 (18) for reporting positions
of $75,000, $100,000, and $125,000, respectively. The mean assessment and the standard

deviation of the probability of the deduction being allowed upon audit for subjects

36

recommending $50,000 are 36.99 (19), 14.92 (12.72), and 11.11 (21.77) for reporting
positions of $75,000, $100,000 and $125,000, respectively. F-statistics for the between-
subjects design were used to test the signiﬁcance of the means diﬂ‘erences (Table 4.10).
When the interaction between the amount of the deduction taken and the probability of the
deduction being allowed upon audit is analyzed in a between-subject analysis of variance, the
difference is signiﬁcant (F(4, 76) = 17.12, p<.01). H2 is supported. Subjects recommending
aggressive reporting positions made a higher assessment of the probability of the deduction
being allowed upon audit than subjects who did not recommend aggressive reporting

positions.

 

 

 

 

TABLE 4.9
PROBABILITY OF DEDUCTION BEING ALLOWED UPON AUDIT
Deductions Options
Deduction
Taken n $75,000 $100,000 $125,000
$100,000 24 79.001 66.46 31.79
(19.72)2 (22.33) (29.25)
$75,000 32 77 .34 29.13 12.94
(13.81) (18.00) (18.00)
$50,000 26 36.88 14.92 11.11
(19.00) (12.72) (21.77)

 

I
can
2Standard deviation

37

 

 

 

TABLE 4.10
ANALYSIS OF VARIANCE
Sum of
Source Squares df Mean Square F Value Pr > F
Standards 1.78 1 1.78 <1 >.05
Amount 53680.34 2 26840.17 41.68 <.01
Probability 86855.46 2 43427.73 167.11 <.01
S/S, A 48943.24 76 643.99
Standards by Amounts 668.06 2 334.03 <1 >.05
Standards by Probability 419.46 2 209.73 <1 >.05
Amount by Probability 17791.28 4 4447.82 17.12 <.01
P x S/S, A 39500.24 152 259.87
Standard by Amount by 1705.48 4 426.37 1.64 >.OS

Probability

 

4.6 The Effects of Fees
H3 hypothesizes a main affect for fees. H3 will be supported if subjects with
contingent fee arrangements recommend more aggressive reporting positions than subjects
with constant fee arrangements. When the main affect of reporting decisions is analyzed in
a two-factor analysis of variance, the difference is not signiﬁcant (F (1,84)=.206, p=.651). Fee
arrangements did not inﬂuence the preparers’ recommendation. H3 is not supported.
4.7 Covariates
Four possible covariates were identiﬁed and tested. Research indicates that male tax
preparers recommend more aggressive reporting positions than female tax preparers (Roberts
and Cargile 1993; McGill 1990; Ayres et al. 1989). In order to examine this covariate, the
reporting decisions of the male tax preparers and the female tax preparers were tested. As
shown in Table 4.11, the means (standard deviations) of the reporting decisions in thousands
are 75 (18.90) and 87.50 (24.48) for female and male tax preparers, respectively. A t-test is

used to compare the reporting decisions. The difference is signiﬁcant (t=1.70, p<.05). Male

38

tax preparers were more aggressive than female tax preparers. A Chi Square test was used
to test the difference between the number of male tax preparers and the number of female tax
preparers for each condition. The difference is not signiﬁcant (x2 (3)=l .07). The number of
male tax preparers in each condition is not signiﬁcantly different ﬁom the number of female
tax preparers in each condition. Years of experience, ﬁrm type, and region of the country did
not signiﬁcantly affect the amount subjects chose to deduct (t=1.27, t=.49, t=.33,
respectively).

Recall from Section 4.2, the cell mean for the constant fee with reporting standards
is not in the expected direction. This cell is expected to represent the smallest mean,
however, it has the largest mean. The reporting decisions of all subjects were analyzed. The
results indicated that four of the eighty-eight subjects chose the $125,000 reporting position
and three of the four were in the constant fee with reporting standards condition. Ifthe four
subjects were eliminated, all of the cells will be in the expected direction. Ifthe interaction
is analyzed in a two factor analysis of variance, eliminating the four subjects, the difference

is not signiﬁcant.

39

 

 

 

TABLE 4.11
MEAN, STANDARD DEVIATION, AND SIGNIFICANCE OF COVARIATES
Covariate Mean Standard Deviation Significance
Gender
female 75.00 18.90 t=1.70
male 87.50 24.48 p<0.05
Years of Experience
6 or less 75.00 17.68 t=1.27
more than 6 84.38 27.20
Firm Type
Local ﬁrm 81.25 19.36 t=.49
Big 6 77.38 24.88
Region of the Country
South 75.94 24.43 t=.33
Midwest 74.42 24.43

 

40

4.8 Discussion

The primary objectives of this study are to examine whether reporting standards will
mitigate aggressive tax reporting (HI), whether preparers who make aggressive reporting
decisions would make higher assessment of the deduction being allowed upon audit than
prepareres who do not make aggressive reporting decisions (HZ), and whether a contingent
fee arrangement between a tax preparer and a taxpayer will promote more aggressive tax
reporting (H3). Results of the analysis support HZ but not H1 and H3. Tax preparers were
aggressive regardless of the fee arrangement or the reporting standards. Three primary
reasons for these results were observed.

First, the subjects’ mean assessment of the probability of the deduction being allowed
upon audit was greater than the one-in—three chance of success required by the IRS. After
reading the case and recommending a reporting position, all subjects were also asked to assess
the probability that the reporting position that they recommended would be upheld on audit.
The mean assessments and standard deviations of the reporting position chosen are shown in
Table 4.12. As noted in Table 4.12, the subjects’ mean (standard deviation) assessments of
the probability of success for the deduction taken are .76 (13.36), .65 (21.67), and .78 (13.8)
for reporting positions of $125,000, $100,000, and 75,000, respectively. These probabilities
of success are greater than the one-in-three chance of success required by the IRS. Cuccia
et al. (1995) found that the higher a subject’s support assessment, the more likely the subject

recommended the aggressive reporting position.

41

 

 

 

TABLE 4.13
ASSESSMENT OF THE PROBABILITY OF SUCCESS
Deduction Taken Mean Standard Deviation
$125,000 .76 13.36
$100,000 .65 21.67
$75,000 .78 13.80

 

Second, the subjects had an incentive (client importance) and opportunity (ambiguity)
to report aggressively. The body of research that examines the eﬁ‘ects of incentives on
aggressive tax reporting indicates that tax practitioners report aggressively when they have
an incentive to do so (Cuccia et al. 1995). Prior research has also shown that, in areas of
ambiguity, the tax preparer acts as a taxpayer advocate and places a heavier weight on the
authority that supports the taxpayer’s position (Johnson 1993; Helleloid 1989; Klepper and
Nagin 1991).

Finally, in order for standards to be effective deterrents, tax preparers must be aware
of their existence. More than one-half (.49, AICPA-SRTP, .60 Circular 230, .66 Realistic
Possibility) of the preparers indicated that they were either unfamiliar or vaguely familiar with
the standards of reporting (Table 4.13). This suggests that the preparers used some other

rationale in determining the reporting position. Future research can test this assertion.

42

 

 

 

 

TABLE 4.13
PERCENTAGE OF SUBJECTS FAMILIAR WITH REPORTING
STANDARDS
Familiarity
Standards Very unfamiliar Unfamiliar Familiar Very
Familiar
AICPA-SRTP 1 6 3 3 44 7
IRS Realistic 28 38 28 5

Possibility
Circular 230 29 31 32 8

CHAPTER 5

SUMMARY AND CONCLUSION

5.1 Summary

This research examines a limited number of factors that may inﬂuence a tax preparer’s
propensity to render aggressive tax reporting. In particular, this study examines whether
reporting standards mitigate aggressive tax reporting; whether a contingent fee arrangement
between a taxpayer and a tax preparer is related to aggressive tax reporting; and whether tax
preparers who recommend aggressive reporting positions make higher assessments of the
probability of the deducton being allowed upon audit than preparers who do not recommend
aggressive reporting positions. Aggressive tax reporting is deﬁned as the tax preparer
choosing a tax position that is favorable to the taxpayer in a situation where there is no clear
authority to support the position (Cuccia et al. 1995).

Results reported here suggest that reporting standards and fees did not inﬂuence the
behavior {of the subjects in this experiment. Subjects with reporting standards did not
recommend more aggressive reporting positions than subjects without reporting standards.
Likewise, subjects with contingent fee arrangements did not recommend more pro-client
positions than subjects with constant fee arrangements. However, subjects with reporting
standards who recommended an aggressive reporting position made a higher assessment of

the probability of the deduction being allowed upon audit than subjects who did not

43

44

recommend an aggressive reporting position.
5.2 Limitations

There are limitations that may reduce the generalizability of the results of this study.
First, the subjects in this research were all CPAs. These subjects may not be representative
of all tax preparers. Many tax preparers are not CPAs and may respond diﬁ‘erently to the
independent variables presented in this research. Prior research has shown that CPAs
recommend more aggressive reporting positions than non-CPAS (Ayres et al. 1989). The
second limitation is that the results of this study may be speciﬁc to the ambiguous tax issue
and the more important client status as presented in this study. As discussed in Chapter 2,
Johnson (1993) found that in areas of ambiguity, tax preparers weigh support evidence more
heavily than opposing evidence. Reckers et al. (1991) examined the impact of client
importance on the aggressiveness of CPAs and found that CPAs took more pro-client
positions for more important clients than for less important clients. Therefore, the results of
this study may not be generalizable to other tax settings.

5.3 Suggestions for Future Research

Four primary extensions of this research are envisioned. First, a replication of this
research should be done eliminating client importance as an incentive. The elimination of
other incentives to report aggressively will allow the impact of the contingent fee arrangement
to be measured. Prohibition against a contingent fee arrangement between a tax preparer and
a taxpayer is one of the tools used to mitigate aggressive tax reporting. Therefore, the eﬁ‘ects
of a contingent fee arrangement and the implications for policy setting deserves ﬁrrther study.

Second, researchers need to determine whether preparers are familiar with the

reporting standards and to what extent they are used in making reporting decisions. More

45

than one-half of the tax preparers in this study indicated that they were not familiar with the
standards of reporting. In order for standards to be effective deterrents, tax preparers must
be aware of their existence and use them in making reporting decisions. Third, researchers
need to determine the nature of the standard required to mitigate aggressive tax reporting.
Cuccia et al. (1995) found that neither a vague verbal standard nor a more stringent numerical
standard mitigated aggressive tax reporting. An important, yet unresolved, question is what
type of standards are required to mitigate aggressive tax reporting.

Finally, research should be done showing a comparison of the IRS’s perception of the
probability of a reporting position being allowed with the tax preparer’s perception of the
same probability. Prior research has used tax preparers to determine whether the law is
ambiguous and the probability of the issue being upheld on audit. In an actual situation, the
IRS makes this decision.

5.4 Contributions

This research contributes to the current compliance literature involving tax preparers
by providing empirical evidence on whether a contingent fee arrangement between a taxpayer
and a tax preparer is linked to tax preparer compliance, whether the current reporting
standards mitigate aggressive tax reporting, and whether tax preparers who report
aggressively make a higher assessment of the probability of the deduction being allowed upon
audit than preparers who do not report aggressively. The results of this research indicate
that, at least for this group, the Treasury’s concern about a contingent fee arrangement
promoting aggressive tax reporting is unfounded. The results of this study are consistent with
prior research that indicates that reporting standards do not mitigate aggressive tax reporting,

and tax preparers who make aggressive reporting decisions will justify their position by

46

making a higher assessment of the probability of the deduction beig allowed upon audit
(Cuccia et al. 1995).

This study is also consistent with prior research that indicates that male tax preparers
are more aggressive than female tax preparers (Robert and Cargile 1993; McGill 1990; Ayres
et al. 1989). Years of experience, ﬁrm type, and region of the country did not impact tax
preparer compliance. The study of the variables that affect tax preparers' decisions has
important implications for policy setting. The ﬁndings from this study could beneﬁt the

AICPA and Congress in setting policy for standards of behavior for tax practitioners.

47

Footnotes

1.

Discriminant Function (DIF)- Statistical information developed by the IRS to distinguish
between compliers and noncompliers. This information is developed using TCMP data.

. Preparer's Penalties-

a. IRC Section 6694(a) imposes a $250 penalty on a preparer who knowingly prepares
a return with an undisclosed tax position lacking a realistic possibility of success.

b. IRC Section 6694(b) imposes a $1000 penalty if any part of an undisclosed position
results in an understatement that is considered willfully incurred or due to reckless or
intentional disregard of rules.

c. IRC Section 6701 imposes a $1000 ($10000 in cases relating to Corporations) penalty
for aiding and abetting an understatement of tax liability.

48

APPENDIX

PART 1

1. PURPOSE AND NATURE OF STUDY

The purpose of this project is to study the ways in which tax practitioners make decisions.
There are no right or wrong answers; therefore, please choose the option which best
represents how you would respond in a similar, actual situation.

The study will last approximately 30 nrinutes. All of your answers will be anonymous.

Your participation in this study is voluntary. You may withdraw at any time. You indicate
your voluntary agreement by completing this study.

11. OVERVIEW OF THE STUDY

Please assume that you have been engaged to prepare the 1995 tax return for a client. The
amount of income tax is uncertain because the allowable amount of travel and entertainment
expense has not been determined. You must determine how much travel and entertainment
expenses to deduct.

HI. PROCEDURES

1. Attached is a tax case, the tax law relevant to the issue, and questions related to the
study.
2. Please read the material and make a decision on the amount of travel and

entertainment expenses to deduct.

49

PART 1

1. PURPOSE AND NATURE OF STUDY

The purpose of this project is to study the ways in which tax practitioners make decisions.
There are no right or wrong answers; therefore, please choose the option which best
represents how you would respond in a similar, actual situation.

The study will last approximately 30 minutes. All of your answers will be anonymous.

Your participation in this study is voluntary. You may withdraw at any time. You indicate
your voluntary agreement to participate by completing the study.

II. OVERVIEW OF THE TASK

Please assume that you have been engaged to prepare the 1995 tax return for a client. The
amount of income tax is uncertain because the allowable amount of travel and entertainment
expense has not been determined. You must determine how much travel and entertainment
expenses to deduct.

MﬂIDASSIMIHATXOﬂREEﬂILLBEEiQQELUSEZqQEIHEIAX
SAM EMEWMEWMM
MAREEASSUMETHAIMSWWEW
UNDERTIECLIBRENIGLIDELINES.

III. PROCEDURES

1. Attached is a tax case, the reporting standards, the tax law relevant to the issue, and
questions related to the study.

2. Please read the material and make a decision on the amount of travel and
entertainment expense to deduct.

50

PART 1

PURPOSE AND NATURE OF STUDY

The purpose of this project is to study the ways in which tax practitioners make decisions.
There are no right or wrong answers; therefore, please choose the option which best
represents how you would respond in a similar, actual situation.

The study will last approximately 30 minutes. All of your answers will be anonymous.
The purpose of this project is to study the ways in which tax practitioners make decisions.

Your participation in this study is voluntary. You may withdraw at any time. You indicate
your voluntary agreement to participate by completing the study.

H. OVERVIEW OF THE STUDY

Please assume that you have been engaged to prepare the 1995 tax return for a client. The
amount of income tax is uncertain because the allowable amount of travel and entertainment
expense has not been determined. You must determine how much travel and entertainment
expenses to deduct.

IH. CLIENT FEE

MAREIQASSLMIHAIXQHREEEIYILLBEMBLHSEKQEIHEIAX
SAYINQS. IHELARGERIEDEDILCJIQNIALENIHEQREAIERIQIIREEE.
MAREEMMHWWEW
mmwm

IV. PROCEDURES

1. Attached is a tax case, the tax law relevant to the issue, and questions related to the
study.
2. Please read the material and make a decision on the amount of travel and

entertainment expense to deduct.

51

PART 1

1. PURPOSE AND NATURE OF STUDY

The purpose of this project is to study the ways in which tax practitioners make decisions.
There are no right or wrong answers; therefore, please choose the option which best
represents how you will respond in a similar, actual situation.

The study will last approximately 30 minutes. All of your answers will be anonymous.

Your participation in this study is voluntary. You may withdraw at any time. You indicate
your voluntary agreement to participate by completing the task.

11. OVERVIEW OF THE STUDY

Please assume that you have been engaged to prepare the 1995 tax return for a client. The
amount of income tax is uncertain because the allowable amount of travel and entertainment
expense has not been determined. You must determine how much travel and entertainment
expenses to deduct.

III. PROCEDURES

1 Attached is a tax case, the reporting standards, the tax law relevant to the issue, and
questions related to the study.

2. Please read the material and make a decision on the amount of travel and
entertainment expense to deduct.

52
WSW
WW

IRC Sec. 6662(b)(2)) requires that the taxpayer has "substantial authority" for taking an
undisclosed tax position. This standard never applied to practitioner conduct. Instead, the
"substantial authority" standard applies to the taxpayer for undisclosed positions adopted on
the return by the taxpayer. Regulation Section 1.6611-3(b)(l) states that there is substantial
authority for the tax treatment of an item only if the weight of authorities supporting the
treatment is substantial in relation to the weight of the authorities supporting contrary
positions. The taxpayer penalty for not disclosing return positions lacking substantial
authority is 20% of the amount of the understatement (IRC Sec. 6662(b)(2)).

WWW

AICPA Statement on Responsibilities in Tax Practice No. 1 states that a CPA should not
recommend a position unless the CPA has a good faith belief that the position has a realistic
possibility of being sustained. The AICPA does not quantify what constitutes a "realistic
possibility."

IRC Section 6694(a) states that an undisclosed tax position may be taken by a tax return
preparer only if it has a "realistic possibility" of success. The Treasury indicates that a
realistic possibility exists if there is a one-in-three likelihood of the position being sustained
on its merits. IRC Section 6694 has two approaches for a tax return preparer to avoid a
penalty for recommending a tax return position which the IRS later disallows. The ﬁrst
approach involves disclosing the controversial tax position on the client's return. The second
approach involves having legal support for the position taken on the return even though the
IRS successfully disallows the position upon audit. The tax preparer penalty for not
disclosing return positions lacking a "realistic possibility" of success is $250.

Circular 230 also provides disciplinary action against a practitioner who knowingly provides
false or misleading information to the Treasury. This action can range from a request for an
explanation to suspension or disbarment.

WMMWEMANMMMW
WMWMMMEMMMMQM
IAXREJIM

53

TAX CASE
[NEWS

Below you will ﬁnd information concerning a corporate tax client. Please read this data
carefully as it will provide you with material necessary to complete the remainder of the
instrument.

 

Wood Manufacturing Inc. (Wood), a closely held corporation owned by Thomas and Rose
Buchanen, has been an important client of your ﬁrm for several years. Wood manufactures
and sells custom veneered plywood for use in kitchen cabinets, ﬁrmiture, store ﬁxtures, and
other speciﬁc customized applications. Customers are typically wholesale distributors who
in turn sell the product to cabinet shops, architects, etc. Marketing the ﬁrm’s products has
traditionally involved a personal visit by sales personnel to the customer coupled with a
follow-up telephone solicitation. The cost of such personal visits has never exceeded $48,000
in any prior year. Wood's taxable income before this deduction is $1,200,000.

In an eﬁ‘ort to spur sales, Wood adopted a new marketing technique recently employed with
some success in a related industry. The technique involves inviting both regular and potential
customer representatives to participate in a two-day weekend sales seminar offered in
conjunction with a major entertainment event. Customers who were willing to send two
representatives to attend special seminars on both Saturday and Sunday morning were oﬁ‘ered
free air fare, overnight accommodations, meals, ground transportation, and tickets to the
entertainment event.

The only restrictions placed on the offer were (1) either both customer representatives be
employed by the customer in a "decision-making" capacity, or the individual who is not so
employed be the spouse of the attending representative, and (2) the representative(s) be
willing to attend both seminars and consider the possibility of future purchases from Wood.
During the seminars, customer representatives were shown new products and techniques
employed by Wood in the manufacturing of veneered wood products and introduced to
alternative applications for Wood's products. At the close of the Saturday seminar, an
informal "refreshment hour" was held where sales representatives and upper management of
Wood individually approached potential customers in the effort to obtain additional sales and
leam of speciﬁc customer needs. Arrangements were made with the host facility to provide
suitable space for all functions.

Fourteen ﬁrms sent representatives to Wood's ﬁrst weekend sales seminar, which was held
in conjunction with the 1995 Super Bowl. Twelve made substantial purchases either during
or subsequent to the weekend. Of the attending ﬁrms, only eight sent two customer
representatives. All of the representatives were accompanied by their spouses, and eight of
the representatives' children attended. Representatives arrived Friday evening and were
greeted by employees of Woods. Saturday's seminar began at 9:00 am. and ended at 5:00
pm, with a two hour break allowed for lunch. The refreshment hour commenced at 6:00
pm. and spouses were actively encouraged to attend. During formal seminars, spouses were

54

offered the option to participate in a site-seeing tour of the host city. Sunday's seminar began
at 9:30 am. and ended at 12:30 pm. Transportation was at 3:00 pm. to the Super Bowl.
No business was discussed either at or after the game. Return ﬂights for customers to their
home city departed Monday morning.

Generally a conscientious client, Wood has taken pains to scrupulously document each
activity engaged in, and dollar amount incurred, during the weekend. Fourteen
representatives of Wood attended the seminars, including Thomas Buchanen (CEO) and
thirteen sales persons. All of Wood's employees were accompanied by their spouses and the
CEO brought his three children (ages 14, 16, and 17). Five of the other employees' children
also attended. The employees' spouses duties were to staff a hospitality desk, pass out name
tags and agendas, accompany non-participating attendees, and perform other tasks necessary
to free Wood’s employees. The total cost for the weekend was $125,000 and was incurred
as shown below. These expenses represent an increase from prior years and increase the
probability of an audit.

Customer Representative Expenses

Total Customer Spouses of Children

Reps. Reps of Reps.
Super Bowl $16,875 $6,750 $ 6,750 $3,375
Tickets
Airfare 17,500 7,000 7,000 3,500
Accommodations 28,125 1 1,250 LLZQQ 5,625
Subtotal $62,500 25 000 25 000 M
Employee Expenses
Total Employee Spouses of Children
Employees of
Employees
Super Bowl $16,875 $6,750 $6,750 $3,375
Tickets
Airfare 17,500 7,000 7,000 3,500
Accommodations 28, 125 1 1,250 11,210 5,625
Subtotal $62,500 25 000 $;5,000 §1g500

Total 125 000 50 000 $50.000 $25909

55

Internal Revenue Code (IRC) Section 162 allows the deduction of ordinary and necessary
expenses incurred in carrying on a trade or business.

If the trip includes both business and personal activities the travel expenses will only be
deductible if the primary purpose of the trip is business (Reg. Sec. 1.162-2(b)(1)).

Airfare and Accommodation

With regard to family members, IRC Sec. 274(m)(3) provides that their travel expenditures
(airfare and accommodations) are deductible only if a bona ﬁde business purpose exists for
their presence, the family member is an employee of the corporation, and the expenditures are
otherwise deductible. As deﬁned in Weatherford (418 F.2d at 879), this requires that the
member provide "substantial services directly and primarily related" to the business ﬁrnction
of the trip. AS applied in Me 213553331 (16 ClsCt 584), this requires that their primary
ﬁrnction be more than "socially gracious." Similarly, Magic]; (236 F. Supp. 761) determined
that when a spouse is expected to socialize extensively and establish ties with customers, his
or her traveling expenses are deductible.

Super Bowl Tickets

To be deductible as an entertainment expense, IRC Section 274 ﬁrrther requires that the
entertainment expenses be either "directly related to" or "associated with" the active conduct
of business. The "associated with" test requires a substantial and bona ﬁde business
discussion directly following or preceding the entertainment, and the presence of a clear
business purpose (Reg. Sec. 1.274-2(d)). Reg. Sec. 1.274-2(d)(3)(ii) speciﬁes that
entertainment occurring on the same day as the business discussion will be considered to
directly proceed or follow the discussion.

With regard to family members, Reg. Sec. 1.274-2(d)(2) states that "any portion of an
entertainment expenditure allocable to a person (family member) who was not closely
connected with a person (Wood Inc.) who was engaged in a substantial and bona ﬁde
business discussion" will not be deductible as associated with the active conduct of business.

In order for the expense to be considered "directly related": (1) the taxpayer must have more
than a general expectation of deriving income or beneﬁt, (2) during the period of
entertainment the taxpayer must actively engage in business activity, (3) the principal
character of the combined business and entertainment activity must be the active conduct of
the taxpayer's business, and (4) the expenditure must be allocable to the taxpayer and
person(s) engaged in the active conduct of business (Reg. Sec. 1.274-2(c)(3)). It is not
necessary that more time be devoted to business than entertainment. In addition, the
regulations clearly specify that, absent clear proof, expenses incurred with regard to sporting
events will generally not be considered directly related. However, Reg. Sec. 1.274-2(d)(4)
allows that if any portion of an entertainment expenditure is considered "directly related," then

56

the remaining portion of the expenditure (e.g. the cost incurred to entertain spouses) will be
considered as meeting the "associated with" test.

57

WWMMMEBQMEQBWM
BQRIIQNQEDEMW

How much of the travel and entertainment expenses would you deduct?

Tax Filing Options - Choose one

OPTIONS:

A

DEDUCT ALL EXPENSES INCLUDING EXPENSES RELATED TO THE
CHILDREN.

(Results: amount to deduct=$125,000; tax savings=$50,000; preparer's fee=$500; audit
detection risk=40%; potential preparer's penalty=$250).

DEDUCT EXPENSES PERTAINING TO CUSTOMER REPRESENTATIVES AND
THEIR SPOUSES; ALL OF WOOD'S EMPLOYEES AND THEIR SPOUSES.
(Results: amount to deducF$100,000; tax savings=$40,000; preparer's fee=$500; audit
detection risk=33%; potential preparer's penalty=$250).

DEDUCT EXPENSES PERTAINING T0 CUSTOMER REPRESENTATIVES,
WOOD'S EMPLOYEES AND THE EMPLOYEES’ SPOUSES ONLY.

(Results: amount to deduct=$75,000; tax savings=$30,000; preparer's fee=$500; audit
detection risk=25%; potential preparer's penalty=$250).

DEDUCT EXPENSES PERTAINING TO CUSTOMER REPRESENTATIVES AND
WOOD'S EMPLOYEES ONLY.

(Results: amount to deduct=$50,000; tax savings=$20,000; preparer's fee=$500; audit
detection risk=0%; potential preparer's penalty=$0).

NONE
(Results: amount to deduct=$0; tax savings=$0; preparer's fee=$500; audit detection
risk=0%; potential preparer's penalty=$0).

OTHER
(If you choose "OTHER" please show computations.)

58

XOIIAEEIQASSIMIHAILOIIBELLHEBAIDSEQQELUSSZQQEIHEIAX
SAXII‘LGS

How much of the travel and entertainment expenses would you deduct?

Tax Filing Options - Choose one

A DEDUCT ALL EXPENSES INCLUDING EXPENSES RELATED TO CHILDREN.
(Results: amount to deduct=$125,000; tax savings=$50,000; preparer's fee=$3000; audit
detection risk=40%; potential preparer's penalty=$250).

B DEDUCT EXPENSES PERTAINING TO CUSTOMER REPRESENTATIVES AND
THEIR SPOUSES; ALL OF WOOD'S EMPLOYEES AND THEIR SPOUSES.
(Results: amount to deduct=$100,000; tax savings=$40,000; preparer's fee=$2500; audit
detection risk=33%; potential preparer's penalty=$250).

C DEDUCT EXPENSES PERTAINING TO CUSTOMER REPRESENTATIVES,
WOOD'S EMPLOYEES AND THE EMPLOYEES’ SPOUSES ONLY.
(Results: amount to deduct=$75,000; tax savings=$30,000; preparer's fee=$2,000; audit
detection risk=25%; potential preparer's penalty=$250).

D DEDUCT EXPENSES PERTAINING TO CUSTOMER REPRESENTATIVES AND
WOOD'S EMPLOYEES ONLY.
(Results: amount to deduct=$50,000; tax savings=$20,000; preparer‘s fee=$1500; audit
detection risk=0%; potential preparer's penalty=$0).

E NONE
(Results: amount to deduct=$0; tax savings=$0; preparer's fee=$500; audit detection
risk=0%; potential preparer's penalty=$0).

F OTHER
(If you choose "OTHER" please show computations.)

59

Mark your response to the following questions based on the client information above.
Assume you are the preparer of Wood's tax return.

1. What do you believe is the probability that the IRS will allow the entire amount of the
expense (Choice A) on audit? Marked response can be at m point on the scale.)

Illllllllllllllllllll

0% 25% 50% 75% 100%

2. What do you believe is the probability that the IRS will allow all of the expenses
pertaining to customer representatives and their spouses, employees, and their spouses
(Choice B) on audit? (Marked response can be at My point on the scale)

lllllllllllllllllllll

0% 25% 50% 75% 100%

3. What do you believe is the probability that the IRS will allow all of the expenses
pertaining to customer representatives, employees and the employees' spouses (Choice
C) on audit? Worked response can be at any point on the scale)

lllllllllllllllllllll

0% 5% 50%

5% 100%

4. With disclosure, would you be comfortable deducting any expense you did not deduct?
(CIRCLE ONE)
Yes ............................................ 1

No ............................................ 2

6O
5. Ifyes, which one(s)? (Circle one or more.)
A Employees’ Expenses.
B Customer Representatives’ Expense.
C Employees' Spouses’ Expense.
D Customer Representatives' Spouses’ expense.
E Employees' children’ expense.
F Customer Representatives' children expense.

G Other. (If you choose "Other," please explain.)

 

 

 

6. How many clients have you represented in an IRS audit during the last ﬁve years?

0 clients ......................................... 1
1-4 clients ....................................... 2
5-9 clients ....................................... 3

10 or more clients .................................. 4

61

Using the following scale as a guide, circle the extent of your agreement or disagreement with
statements 7, 8 and 9.

Strongly Disagree .................................. 1
Somewhat Disagree ................................ 2
Neutral .......................................... 3
Somewhat Agree .................................. 4
Strongly Agree .................................... 5
(CIRCLE ONE FOR EACH)
Strongly Strongly
Disagree Neutral Agree

7. The strength of authority for the non-disclosed
deduction I recommended is suﬁicient to avoid
a taxpayer penalty under Section 6662 ........ l 2 3 4 5

8. The strength of authority for the non-disclosed
deduction I recommended is sufﬁcient to avoid
a tax preparer penalty under Section 6694 ...... 1 2 3 4 5

9. I feel conﬁdent with not disclosing additional
information on the return ................... l 2 3 4 5

62

PART 2

Experience & Personal Data

 

Use the following scale in answering questions 1 through 4:

Very Unfamiliar (never read it) .............................. 1
Unfamiliar (reviewed it once) ............................... 2
Familiar (reviewed it more than once, but not often) .............. 3
Very Familiar (regularly consider it in practice) .................. 4

1. How familiar are you with AICPA Statement on
Responsibilities in Tax Practice No. 1 (Tax Return
Positions) ...................................... 1 2

2. How familiar are you with Treasury Circular 230
(Regulations Governing the Practice of Attorneys,
Certiﬁed Public Accountants, Enrolled Agents and
Enrolled Actuaries before the IRS)? .................. l 2

3. How familiar are you with Internal Revenue Service
Notice 90-20 (guidance pertaining to positions
satisfying the "realistic possibility" standard)? ........... 1 2

4. How familiar are you with AICPA rule 302 relating
to contingent fee arrangements? ..................... 1 2

Use the following scale in answering questions 5 through 14:

Strongly considered ........................................ 1
Somewhat considered ...................................... 2
Not considered ........................................... 3

5. To what extent do you consider CLIENT FEE when
adopting a tax return position? .................... 1 2

10

11

12

13

63

To what extent do you consider IMPORTANCE OF
THE CLIENT when adopting a tax return position?

To what extent do you consider the CLIENT WH.L-
INGNESS TO ACCEPT RISK when adopting a tax

return position? ................................

To what extent do you consider AICPA STATE-
MENT ON RESPONSIBILITIES IN TAX PRAC-
TICE NO. 1 (Tax Return Positions) when adopting
a tax return position? .......................

To what extent do you consider TREASURY
CIRCULAR 230 Regulations Governing the
Practice of Attorneys, Certiﬁed Public Accoun-
tants, Enrolled Agents and enrolled Actuaries
before the IRS when adopting a tax return posi-
tron ....................................

To what extent do you consider INTERNAL
REVENUE SERVICE NOTICE 90-20 (guid-

ance pertaining to positions satisfying the

"realistic possibility" standard) when adopting

a tax return position? .......................

In this case, to what extent did you consider
CLIENT FEES when determining how much travel
and entertainment and entertainment expenses to
deduct? ..................................

In this case, to what extent did you consider
AICPA STATEMENT ON RESPONSIBILITIES
IN TAX PRACTICE No. 1 (Tax Return Positions)
when determining how much travel and entertain-
ment expense to deduct? .....................

In this case, to what extent did you consider
TREASURY CIRCULAR 230 Regulations Govem-
ing the Practice of Attorneys, Certiﬁed Public
Accountants, Enrolled Agents and Enrolled Actu-
aries before the IRS when adopting a tax return
position .................................

l

1

1

1

1

1

14

15

16.

17.

64

In this case, to what extent did you consider

INTERNAL REVENUE SERVICE NOTICE 90-20

(guidance pertaining to positions satisfying the

"realistic possibility" standard) when determining

how much travel and entertainment expenses to deduct? . 1 2 3

In this case was your fee based on the tax saved?

(CIRCLE ONE)
Yes ............................................ 1
No ............................................ 2
What is your gender?
(CIRCLE ONE)
Male ........................................... 1
Female ......................................... 2
What is your age?
(CIRCLE ONE)
21-30 .......................................... 1
31-40 .......................................... 2
41-50 .......................................... 3
51-60 .......................................... 4
Over 60 ........................................ 5

65

18. What is your professional position?

 

 

 

(CIRCLE ONE)
Owner/Partner ................................... 1
Manager ........................................ 2
Senior .......................................... 3
Other .......................................... 4*
*Please describe (if you circled "other"):
19. What TYPE OF FIRM are you afﬁliated with?
(CIRCLE ONE)
"Big 6" CPA ﬁrm ................................. 1
Other National CPA ﬁrm ........................... 2
Regional CPA ﬁrm ................................ 3
Local CPA ﬁrm .................................. 4
Self-employed ................................... 5
Other .......................................... 6*

*Please describe (if you circled "other"):

 

 

 

66

20. How many years of TAX EXPERIENCE do you have? (Include only those years in
which 25 % or more of your time was devoted to taxpayer client matters.)

(CIRCLE ONE)
1-3 years ....................................... 1
4-6 years ....................................... 2
7-10 years ...................................... 3
11-16 years ...................................... 4
17-24 years ...................................... 5
25-35 years ...................................... 6
Over 35 years .................................... 7
21. What is your highest educational degree obtained?
(CIRCLE ONE)
Bachelors (BA/BS/BSBA) .......................... 1
Masters (MBA/MS/Macc) .......................... 2
Doctorate (PhD/DBA) ............................. 3
Other .......................................... 4

*Please describe (if you circled "other"):

 

 

 

67

 

Debriefing Questions

 

Was sufﬁcient information provided to respond to the questions asked?

 

 

 

(CIRCLE ONE)
Yes ............................................ 1
No ............................................ 2
If not, what was missing?
In your opinion, was the case realistic?
(CIRCLE ONE)
Yes ............................................ 1
No ............................................ 2

If not, what speciﬁcally was not realistic?

 

 

 

26.

68

Have you been involved in an actual tax situation similar to the one described in the
case?
(CIRCLE ONE)
Yes ............................................ 1
No

Assuming the case were real, would Wood Inc. be an important client to your ﬁrm?

(CIRCLE ONE)
Yes ............................................ I
No ............................................ 2

Did you consider the potential Internal Revenue Code preparer penalty severe or mild?

(CIRCLE ONE)
Severe ......................................... 1
Mild ........................................... 2

Do you have any other comments?

 

 

 

69

REFERENCES

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Practice. New York, NY: AICPA.

Ayres, F., B. Jackson, and P. S. Hite. 1989. The Economic Beneﬁts of Regulations:

Evidence from Professional Tax Preparers. The Accounting Review (October ):
300-312.

Cuccia, AD. 1992. An examination of the effort and aggressiveness of professional tax
preparers: The effects of economic sanctions. Working papers, Louisiana State
University.

Cuccia, A, Hackenbrack, and Nelson 1995. The ability of professional standards to mitigate
aggressive tax reporting. The Accounting Review (April): 227-248.

Duncan, W. A., D. La Rue, and P. M. J. Reckers. 1989. An empirical examination of the
inﬂuence of selected economic and noneconomic variables on decision making by tax
professionals. Advances in Taxation 2: 91-106.

Gurka, G. 1992. An investigation into the conﬂicting responsibilities of tax practitioners and
the role neutralization strategies play in this conﬂict. Ph.D. dissertation, Michigan
State University, East Lansing, MI.

Guttman, G. 1994. Increasing voluntary compliance to over 90 percent unlikely. Tax Notes
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Helleloid, R. T. 1989. Ambiguity and the evaluation of client documentation by tax
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Internal Revenue Service. 1990a. Annual Report 1989. Washington, DC: Government
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Internal Revenue Service. 1991. Compliance 2000. Washington, DC: Government Printing
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.r~ A —_4_ __4 Ash.
. I
.. I

 

70

Internal Revenue Service. 1992. Compliance 2000. Washington, DC: Government Printing
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Jackson, Betty R, V C. Milliron and D. R Toy. 1988. Tax practitioners and the government.
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Klepper, S., and D. Nagin. 1991. The role of tax practitioner in tax compliance. Journal of
Law and Economics: 205-229.

Long, S., and J. Swingen. 1989. Taxpayer compliance: setting new agendas for research.
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McGill, GA. 1990. The CPA’s aggressive position recommendation decision: Situational,
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Podolin, L. Tax Division Newsletter, March/April, 1991.

Raby, W. L. 1992. Circular 230 still leaves gaps between the profession and the IRS. Tax
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Reckers, P., D. Sanders, and R. Wyndelts. 1991. An empirical investigation of factors
inﬂuencing tax practitioner compliance. The Journal of the American Taxation
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Robert, ML, and B. R Cargile. 1993. Advocacy versus independence: CPAs’ responses to
conﬂict in auditing and tax situations. Paper presented at the 1993 USC/D&T Audit
Judgement Symposium.

Scotchmer, Suzanne, "The Effects of Tax Advisors on Tax Compliance," in J. A. Roth and
J. T. Scholz (eds) "Taxpayer Compliance: Social Science Perspectives, Vol. 2,
University of Pennsylvania Press 1989, 182-199.

 

71

Shapiro, L. S. 1986. Professional responsibility in the eyes of the IRS. The Tax Advisor
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U. 8. Congress, House Ways and Means Committee Report, “Revenue Reconciliation Act
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