"Dear client,
Even though we clearly asked in writing last year and you replied that you did not rent property in 2019, it has become known to us this year that you have been operating as a landlord for one or more properties. This must be reported to the IRS and the appropriate states for each year for which you had rental activity. This will require amended tax returns and filings for each state, as appropriate. Failure to do so could result in tax and penalties from the IRS and the state, and this could be considered to be a willful understatement of tax. Filing these amendments and tax returns are beyond the scope of our engagement and we will not be available to provide these services. We recommend that you engage with a professional who can help you with these right away.
Addressing the U.S. Federal income tax issues (not the state issues):
Under the U.S. Internal Revenue Code, there is no
general legal requirement to file an amended Federal income tax return.
The Internal Revenue Code does not require a taxpayer to file an amended return to correct a mistake discovered after the filing of the original tax return. The words ‘‘amended return’’ scarcely appear in the code.
[ . . . ]
In Broadhead v. Commissioner, the Tax Court held that Treasury regulations do not require a taxpayer to file an amended return, even after being advised to do so by an accountant.
---T. Keith Fogg and Calvin H. Johnson, from
Amended Returns - Imposing a Duty to Correct Material Mistakes, 120 Tax Notes 979 (Sept. 8, 2008) (footnotes not reproduced).
I would go a step further and say that I know of no Code or Treasury regulation general
requirement to file an amended return, even where the taxpayer
knew the original return was materially false. This concept might seem to defy common sense -- but were are talking about law here, not common sense.
The following applies to AICPA members, and to CPAs licensed in states (such as Texas) where this rule has been incorporated by reference into the Rules of the applicable State Board:
A member [of the American Institute of Certified Public Accountants] should inform the taxpayer promptly upon becoming aware of an error in a previously filed return, an error in a return that is the subject of an administrative proceeding, or a taxpayer’s failure to file a required return. A member also should advise the taxpayer of the potential consequences of the error and recommend the corrective measures to be taken. Such advice and recommendation may be given orally. The member is not allowed to inform the taxing authority without the taxpayer’s permission, except when required by law.
[ . . . ]
Although recognizing that the taxpayer may not be required by statute to correct an error by filing an amended return, a member should consider whether a taxpayer’s decision not to file an amended return or otherwise correct an error may predict future behavior that might require termination of the relationship.
--from
Statement on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings, Tax Executive Committee, American Institute of Certified Public Accountants (effective Jan. 1, 2010) (emphasis added).
In the letter to the client, I would leave out the part about "willful understatement of tax." Instead, I would tell the client to consider consulting with a tax attorney.
As an aside: The willful understatement (if any) would relate to the filing of the original return -- not to the failure to file an amended return.