The Influence of Ethical Codes of Conduct on Professionalism in Tax Practice

Abstract

Professional integrity is a fundamental principle of the International Ethics Standards Board for Accountants Code of Ethics (IESBA, in Code of ethics for professional accountants, IFAC, New York; IESBA, Code of ethics for professional accountants, IFAC, New York, 2016). This does not apply directly to members of a particular professional body, but rather member organizations from around the globe are required to adopt a code no less stringent than the principles in the IESBA Code. Hence, all professional accountants are required to possess integrity as a core ethical principle. In the USA, certified public accountants must, in addition, also adhere to the principle of client advocacy in relation to their tax clients. Despite extensive prior literature on accounting ethics, firm culture, and ethical codes, no prior research has tested whether the communication of an Integrity ethical standard actually affects practitioners’ actual judgments and decisions. In this study, we use brief interventions to determine whether a prime of two ethical professional standards (Integrity; Advocacy) affects tax practitioners’ recommendations to their clients. One implication for professionalism in tax practice is our finding that a brief intervention of professional standards can directly impact on practitioners’ judgments. Most notably, a joint presentation of Advocacy and Integrity leads to contrasting results that depend on the order of the intervention. In sum, when the Integrity (Advocacy) standard was presented before the Advocacy (Integrity) standard, tax practitioners were significantly less (more) likely to choose a tax-favorable outcome. That is, the order of professional ethical standard intervention significantly affects tax practitioners’ judgments.

Appendices

Appendix 1: Background Questions

Appendix 2: Real Estate Tax Case*

Assume a client, Jim Hunt, asks you whether he must classify some land sales as ordinary or capital. He believes it is an ambiguous tax issue and has asked for your opinion on how it should be reported. Once you have read the scenario, please respond to the follow-up questions regarding your beliefs.

Jim Hunt is the CEO of Delta Electronics, Inc., an important corporate client for whom we have done audit and tax work for many years. You are in the process of preparing Jim’s current income tax return and need to determine whether a $500,000 gain he realized on sales of real estate should be treated as ordinary or capital. I.R.C. Section 1221 defines a “capital asset” by exception. The relevant exception in this case is provided in Section 1221(1), which provides that “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business” is NOT a capital asset.

If Jim’s real estate is considered a Section 1221(1) asset (i.e., Jim is viewed as a “dealer”), then the gain will be treated as ordinary. In contrast, if the property is not considered a Section 1221(1) asset (i.e., Jim is viewed as an “investor”), then the gain will be treated as a long-term capital gain. Obviously, Jim would prefer to be treated as an investor with respect to this property so that his gain will be taxed at the lower, alternative rate for long-term capital gains. Jim’s marginal tax rate on ordinary income is in the highest bracket, approximately 40%.

Summary of Factors

Factors considered by the courts as indicative of dealer vs. investor status are summarized below. Courts have stressed that no one factor is determinative and that each case must be considered on its own facts. Moreover, these factors have not always been applied on a consistent basis.

Remember that whether an asset is considered a Section 1221(1) asset affects the character of the taxpayer’s income or loss as follows:

Section 1221(1) asset: → Dealer → Ordinary Income or Loss

NOT Section 1221 (1) asset: → Investor → Capital Gain or Loss

Number and frequency of sales Generally, the greater the number of sales, the more frequent the sales, and the more continuity in sales activities, the greater the likelihood that the taxpayer will be considered a dealer.

Development activities Generally, the greater the development activities, the more likely the taxpayer will be considered a dealer.

Sales activities Generally, the more the taxpayer advertises, solicits customers, lists the property and otherwise promotes the sale of the property, the more likely the taxpayer will be considered a dealer.

Purpose of acquisition Generally, the purpose for which the property was originally acquired AND the purpose for which the property was held at the time of its disposition are important in deciding whether the taxpayer is a dealer or investor.

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Client Facts

On June 1, 2009, Jim Hunt purchased 40 acres of undeveloped land for $1.3 million. At the time, Jim was confident that the land would appreciate in value due to the planned construction of a regional shopping mall nearby. The land was already zoned for “retail/commercial” use and he hoped to sell the land in a single transaction after construction on the shopping mall began. Unfortunately, plans for the shopping mall fell through in early 2010, and Jim was unable to find a buyer for his property. He began placing advertisements in the local paper once a month, and he put on the property a “for sale” sign that was visible from the highway. Despite Jim’s sales efforts, he was unable to locate a buyer.

In June 2012, Jim decided that the property would be much more marketable if he subdivided the land into individual lots for residential development. Jim solicited the help of a friend (a real estate developer), part time, to assist him in the process of developing and selling the land, to be referred to as “Mountain View Estates.” Jim hired an engineer to plat the property into 110 individual lots and to determine the location of streets, etc. Jim submitted the engineer’s drawings to the City Planning Board along with his application to have the property’s zoning changed to “single family residential.” The zoning change was approved in September 2012. Jim incurred engineering and legal costs of $30,000 in this process.

In October 2012, Jim hired a contractor to build the necessary streets, curbs and drainage systems, and to connect the property to the city’s utility systems (e.g., water, sewer, and electricity). This development was completed by June 2013 at a total cost of $780,000.

Between August and October 2013, Jim sold six developed lots from the Mountain View Estates development for a total of $150,000. In October, a residential builder offered $2.5 million for the remaining 104 lots. Jim accepted the offer and ceased other sales activities. The sale was completed on November 1, 2013. After accounting for the property improvements and selling expenses, Jim had an overall gain of $500,000 computed as follows:

In January 2013, having become knowledgeable about residential land development, Jim decided to purchase and subdivide an additional 60 acres adjacent to Mountain View Estates. An engineer was hired to plat the land into 200 residential lots, known as “Mountain View Estates, Phase II” and the plans were approved by the City Planning Board in April 2013. In July 2013, Jim hired the same contractor who did the development work on Mountain View Estates to do similar work on Mountain View Estates, Phase II. The contractor constructed the streets, curbs and drainage systems for the Phase II development. The contractor also connected the Phase II lots to the city’s utility system. Although development of the Phase II lots was nearly complete by December 2013, none of the Phase II lots had been sold as of the end of 2013. Jim plans to begin selling the Phase II lots to individual buyers during 2014.

*This case was adopted from Cloyd and Spilker (1999).

Questions Related to the Case