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Tax Preparer Liability for Taxpayer’s Underpayment of Income Tax

Connecticut Senate Bill 814

In January, Connecticut Senator Patricia Miller introduced S.B. 814, a bill that would hold tax preparers in Connecticut liable for the underpayment of income tax resulting from a tax preparer’s error.

Currently, tax preparer liability is limited to the penalties assessed to underpaid tax caused by the preparer’s error. Actual underpaid income tax is not included as damages because the correct income tax assessment is determined by the tax laws, regardless of error.

The exception is when the taxpayer relies on the preparer's advice and undertakes a transaction that causes a tax assessment that could have been avoided. For example, if a taxpayer asks whether retirement funds can be withdrawn tax-free (they can’t) and the taxpayer relies on the tax professional's advice and withdraws the money, the resulting tax could be considered damages because but for the tax professional’s advice, the taxpayer would not have withdrawn the money and therefore would not have incurred the tax.

Connecticut S.B. 814 seeks to expand liability to the actual underpayment of tax. This effectively requires the tax preparer to indemnify the taxpayer’s tax returns. This doesn’t make sense.

First, the taxpayer signs the tax return under penalty of perjury, attesting to the accuracy and propriety of the tax return. Although a tax professional is required to advise the taxpayer-client with respect to the consequences of potential errors, requiring the tax professional to assume responsibility for the accuracy of the return is unreasonable.

A moment’s reflection shows why: It incentivizes the taxpayer-client to be dishonest or to conceal taxable items from the preparer in order to reduce the income tax reported on their return. If the undisclosed items result in additional tax, the law shifts the taxpayer’s tax liability onto the preparer.

Secondly, undisclosed or unreported income is unlikley to be discovered by the tax authorities unless there is an audit or examination. Dispite the recent increase to the IRS's budget, there is a shockingly low chance that a return is audited. Incentivizing the taxpayer to exclude taxable income from their return allows the taxpayer to 'game' the audit lottery, decreases tax revenue, and increases tax collection costs.

Finally, prudent tax preparers require the taxpayer-client to sign fee agreements that include the client’s responsibility to disclose all taxable information, and to respond to the tax preparer’s requests for information honestly and thoroughly.

If the tax preparer is liable for an underpayment resulting from the client’s willful or accidental exclusion of taxable items, the list of qualifications, contractual obligations, and exceptions within a fee agreement would be unreasonably burdensome.

As a result, S.B. 814 not only incentivizes taxpayer to be dishonest with a tax preparer, it creates widespread opportunity for litigation based on breach of contract and comparative liability between tax preparers and their clients.

This bill is currently in committee. The professional liability insurance companies, who would ultimately bear the costs and consequences of this law, undoubtedly have their lobbyists hard at work to defeat this bill.