Protecting Communications and Documents From IRS Summons Enforcement

When performing services as a tax adviser, an accountant should understand when communications and work product are privileged and when they are not. The IRS is granted significant power to pursue information in examining a tax return or collecting a tax liability, and the courts have interpreted this summons power as broad authority to obtain confidential information in work product produced for, and communications with, a taxpayer. Some communications and work product, however, are considered privileged and not subject to summons enforcement under specific criteria. An accountant may assist in protecting a client’s confidential information by proactively taking steps to ensure these criteria are met.

Two privileges may apply to an accountant’s tax advice to a client: the practitioner-client privilege granted by Sec. 7525 and the work product privilege established by the Supreme Court in Hickman1 and codified in the Federal Rules of Civil Procedure.2 The application of each privilege is based on specific standards that are carefully weighed by the court when the privilege is claimed. If the practitioner and the client have maintained a defensive posture throughout the communication and documentation process, it is more likely that the privilege will be upheld and IRS access will be denied. This can be a vital protection for a client when tax advice contains opinions about gray areas in the tax law and speculation regarding potential litigation in those areas. This article examines the rules and definitions that form the basis for these privileges and identifies certain measures that can increase the protection of sensitive client information.

The Practitioner-Client Privilege

Sec. 7525 extends the common law protections of attorney-client privilege to a client who is communicating with a federally authorized tax practitioner regarding tax advice. The practitioner must be authorized under federal law to practice before the IRS, and such practice must be subject to federal regulation under 31 U.S.C. Section 330. Authorized tax practitioners include licensed attorneys, CPAs, enrolled agents, and enrolled actuaries.3

The practitioner must be rendering tax advice with respect to a matter that is within the scope of the individual’s authority to practice before the IRS.4 Thus the privilege extends only to federal tax matters related to U.S. tax law.5 It does not cover foreign tax advice or matters relating to state or local income tax. It also does not cover tax return preparation services.

The practitioner privilege applies to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney. However, it is more limited in scope than the attorney-client privilege, in that it applies only in noncriminal proceedings before the IRS and federal courts. 6 It does not apply to written communications in connection with the promotion of, or participation in, a tax shelter, nor does it protect against disclosure of communications to any regulatory body other than the IRS. 7

Basic Elements of Privileged Communication

To properly understand the practitioner-client privilege, one must analyze the rules and limitations of the attorney-client privilege. The attorney-client privilege is the most familiar protection of confidential communication in a legal setting and can be invoked in an IRS summons challenge. Certain elements of privileged communication must be present to preserve its protection: The communication must be for the purpose of legal advice, and it must be confidential. These requirements are also elements of the practitioner-client privilege.

The first element needed to successfully invoke attorney-client privilege is that the attorney must be acting in his or her capacity as a lawyer. Communication in which a client seeks or an attorney provides legal advice is protected. Legal advice is protected whether it comes from outside counsel or in-house counsel.8 However, if an attorney is providing accounting services (including tax preparation), giving business advice, facilitating transactions, or receiving or disbursing money, he or she is not doing “lawyer’s work,” and these communications are not privileged. The distinction between legal advice and business advice is not always clear. The same concern exists for the tax practitioner in distinguishing tax advice from other client services, including tax return preparation (see below). Both the source and the content of the communication determine its privilege.

The second element that determines whether communication is protected is confidentiality. The privilege is essentially waived if the communication takes place in the presence of third parties.9 The same is true if the information is intentionally disclosed to a third party.10 Similarly, a client does not acquire protection of previously disclosed information by submitting it to an attorney. Information imparted to an attorney or federally authorized tax practitioner that is intended to be imparted to others is not protected, and information that is already in the public domain (e.g., SEC filings) cannot be considered privileged. In general, determining whether the communication satisfies these requirements requires asking “who, what, and when?” Carefully monitoring these factors may preserve the privilege.

Who?: Since only communication between the client and tax practitioner is privileged, the source and the addressee of any written communication is significant. For example, documents have been found to be unprotected when no recipient was specified, because, without recipients, the documents were not communications.11 In addition, correspondence or emails with copies sent to third parties clearly imply a waiver of the privilege. This means that tax opinion letters and discussions of alternative strategies or hazards of litigation are all subject to disclosure unless they are directed to, or in discussion of, a specific client.

What?: The delineation between legal or tax advice and common business advice or services is not always a bright line. The Court of Federal Claims has noted that a court must “make close, factually-intensive distinctions…in which business planning, tax return preparation and legal advice tend to coalesce.”12 The communication itself must evidence the request or delivery of legal advice between attorney and client.

In BDO Seidman,13 the court determined that communication with counsel that sought guidance regarding various Code provisions and regulations was “classic attorney-client material.”14 In another case, discussion of Sec. 199 deductions, advance-pricing agreement calculations, and interpretation of a partnership agreement were considered advice and thus protected.15 In some circumstances, names and numbers have been considered privileged when they revealed aspects of attorney-client communication.16 However, documents or communications that contain both privileged and nonprivileged content do not cause the nonprivileged information to become protected.

While a communication may be privileged, the underlying facts are not.17 Facts do not become protected because they have been included in a privileged communication. So while a taxpayer does not have to disclose what has been communicated, he or she can still be compelled to acknowledge facts that were part of the communication. For example, consider a situation in which a client seeks advice regarding a related-party transaction. Although the exchange between the client and tax practitioner is privileged, the fact that the transaction involves a related party does not become privileged simply because it was included in the practitioner-client communication.

Generally, when the government challenges the claim of privilege, the taxpayer is expected to provide a privilege log listing the documents or communications that have been summonsed and indicating the rationale for claiming the item is privileged. The court will often conduct an in camera review to judge the appropriateness of the claim for each item. Thus, both the addressee and content of the communication may be the first impression the court receives in deciding whether such items are privileged.

When?: The timing of the communication is also relevant. Because tax planning generally takes place before the fact, it is likely to be deemed tax advice. An adviser’s recommendation on how to structure a transaction to minimize taxes and comply with tax rules or estimation of the tax cost of various alternatives is likely to be viewed as advice. At this stage, the claim of privilege is often stronger than for communication after a transaction. An adviser’s subsequent analysis of the reporting of a completed transaction is less distinct from return preparation, and the claim of privilege may be weaker.

Exceptions

Despite careful measures to protect privileged communication, exceptions may override the practitioner privilege. Two exceptions that have long applied to the attorney-client privilege, the crime-fraud exception and the return preparation exception, also apply to the practitioner privilege. Two additional exceptions, the tax shelter exception and the criminal-proceeding exception, are unique to the practitioner privilege.

Crime-Fraud Exception

Neither the attorney-client privilege nor the practitioner privilege applies to communications between a client and adviser in furtherance of a crime or to perpetuate a fraud.18 The Seventh Circuit has pointed out that advice relating to future wrongdoing rather than past wrongdoing does not come under the privilege.19 This is true even if the tax practitioner is unaware of the client’s criminal or fraudulent intent.

Return Preparation Exception

Courts have generally not considered communications made for preparing a tax return to be privileged. In establishing the practitioner privilege, Congress made it clear that “information that is communicated to an attorney for inclusion in a tax return is not privileged because it is communicated for the purpose of disclosure.”20

Some courts have parsed the information to allow a privilege for communications that took place during return preparation but were not divulged on the return.21 In addition, the type of communication that is covered under the privilege is legal or tax advice. Merely placing information on tax forms does not meet the definition of giving advice.

In Davis,22 the Fifth Circuit acknowledged that some knowledge of the law is used in preparing a tax return but said tax return preparation is primarily an accounting service. However, interpreting statutes or case law during an audit of a tax return has been determined to be providing legal advice to which privilege may attach.23

Tax Shelter Exception

Sec. 7525(b) creates an exception to the practitioner privilege for any written communication between a federally authorized tax practitioner and any person “in connection with the promotion of the direct or indirect participation of the person in any tax shelter (as defined in section 6662(d)(2)(C)(ii)).”24 This exception also applies to communication with the person’s director, officer, employee, agent, or representative, or any party holding a capital or profits interest in the person.

In general, the burden of proof in asserting a privilege is on the party claiming the privilege, in this case, the taxpayer. When an exception is claimed, however, the opposing party must exhibit some evidence that the exception applies. When the IRS claims the application of the tax shelter exception, it must introduce evidence that the documents it seeks are related to a tax shelter and were created in connection with promoting participation in that shelter either directly or indirectly. The fact that a communication relates to a tax shelter is not sufficient to overcome the privilege; it must be in promotion of participation.

Case law on this exception is limited. However, two elements have emerged as the subject of significant analysis by the courts: that the communication must be written, and that it must be in connection with the promotion of a tax shelter.

Written communication: Although this might appear to be the least ambiguous of the requirements for the exception, in Countryside Limited Partnership,25 the Tax Court took an interesting viewpoint. It determined that handwritten notes taken by a partner during a series of tax planning meetings with the partnership’s tax accountant merely reflected oral communications that did not meet the requirement of a written communication because they were not communicated to anyone. It was decisive that the notes were not shared with anyone, and this meant there was no transmission of the written material. In BDO Seidman, LLP,26 the Seventh Circuit, in considering the tax shelter exception, noted that oral communications between a practitioner and client remain within the general rule of the privilege.

Promotion: Several courts have applied their own definition of “promotion,” with varying results. Congress did put a boundary on the definition when it excluded routine communications from the exception. Committee reports indicate “[t]he Conferees do not understand the promotion of tax shelters to be part of the routine relationship between a tax practitioner and a client.”27 In Countryside,28 the Tax Court refused to treat the accountant’s input as promotion because it appeared to be part of the routine advice offered over a long-term relationship and was not subject to any unusual billing or special arrangement. The court noted that the tax advice provided was distinct from promotion of a tax shelter. The advice was offered in response to a client request, and the accountant had no stake in the outcome.

In Valero,29 the Seventh Circuit emphasized that promotion would be a preliminary activity and relied on that interpretation to conclude that tax advice on how to structure a substantial foreign currency loss constituted promotion. It refused to confine the exception to “actively marketed tax shelters or prepackaged products”30 and held the exception included advice given on a single transaction that appeared to meet the definition of a tax shelter.

Criminal Proceedings Exception

As mentioned earlier, the privilege for communication with a tax adviser is much more limited than that for an attorney. It does not extend to criminal proceedings and does not go beyond the IRS or federal court system. Consequently, at some point, the client is best protected by relying on representation by an attorney, and it is important for the accountant to recommend that course when it appears the case may become a criminal one.

It may sometimes be important for the accountant to continue to participate in the case even though any advice rendered would not be privileged. When an accountant provides input that enables the client to communicate with an attorney, that communication may be protected under the attorney-client privilege if the accountant is hired by the attorney to provide this clarification. Often referred to as a Kovel31 arrangement, this relationship invokes attorney-client privilege when the accountant’s input enables the attorney to understand the client’s communication.

A Kovel arrangement does not extend attorney-client privilege to the accountant as an adviser. Rather, the accountant plays a similar role to that of a foreign language interpreter in facilitating communication between attorney and client. Engagement letters, confidentiality agreements, and billing invoices may all be evidence in clarifying the distinction between an accountant’s participation as an adviser versus an “interpreter.”

The Kovel court asserted that “the presence of an accountant, whether hired by the lawyer or by the client, while the client is relating a complicated tax story to the lawyer, ought not destroy the privilege.”32 A taxpayer’s advisers must recognize that point in the communication process where the attorney-client privilege should be the prevailing protection. If the accountant’s input is still necessary, a Kovel arrangement might be established and should be carefully documented.

Cavallaro33 illustrates the importance of documenting the role of the accountant in such an arrangement. In Cavallaro, the taxpayers wanted to claim that a Kovel arrangement was created by the presence of an accountant at a family tax planning meeting with their attorneys. The court looked to both the accounting firm’s engagement letter and its invoice to determine the actual designated role of the accountant. The engagement letter indicated that the accounting firm was hired to provide tax planning advice to a corporation controlled by the two Cavallaro sons, and no other documentation indicated any change in that role. An invoice indicated that some tax advice had been provided to both the sons’ corporation and a corporation controlled solely by the parents, but it did not provide evidence that the accounting firm was acting as an agent of the Cavallaro family (or their lawyers) to assist in securing legal advice. On this basis, the court concluded that there was insufficient evidence of a Kovel arrangement. This case illustrates the importance of documenting the accountant’s role, especially where that role might change from the initial designation.

The Work Product Doctrine

The work product doctrine essentially prevents an adversary from benefiting from the efforts of an opponent. It protects materials that are collected or prepared in anticipation of litigation unless the adverse party can demonstrate that the materials are indispensable to the party’s case and there are no other means of obtaining them. Even when that exception applies, however, the court must still protect against disclosure of the “mental impressions, conclusions, opinions, or legal theories of a party’s attorney or other representative concerning the litigation.”34 Thus, the work product privilege may cover work of representatives other than attorneys.

Like the attorney-client privilege, the work product doctrine is subject to confidentiality rules; thus, disclosure to a third party may waive the privilege. However, the disclosure rules are less restrictive in this context. If the third party is not an adversary or a conduit to an adversary, disclosure will not constitute a waiver if, overall, there is a reasonable expectation of confidentiality on the part of the third party.

For example, in Deloitte & Touche USA LLP,35 documents prepared by a taxpayer corporation were disclosed to an outside auditor. The court held that the privilege was not waived, noting that the auditor was not a potential adversary and the corporation had a reasonable expectation the auditor would keep the documents confidential.36 Although a third party often could become an adversary in some future litigation, the concern in applying the work product rule is whether the third party could be an adversary with respect to the litigation addressed in the protected documents.

Work product protection applies to documents prepared by the taxpayer or the taxpayer’s representative. It does not protect documents prepared by third parties. However, the content of the document itself, rather than its preparation, may determine the privilege. In the appeal of Deloitte & Touche USA LLP,37 the government argued that documents prepared by an outside auditor could not qualify for work product protection because they were not prepared by the taxpayers or their attorneys. The court noted that the issue was not who prepared the document but “whether the document contains work product—the thoughts and opinions of counsel developed in anticipation of litigation.”38

The courts also look at why a document was prepared. Documents that are generated as part of a routine process (i.e., not in anticipation of litigation) are not protected. Most circuits apply a “because of” test; that is, the document must be prepared because of the anticipated litigation.39 This causation test may cover a broad range of types of documents. For example, consider a document containing legal analysis about possible future litigation that was procured to help parties decide whether to go through with a proposed merger. In this circumstance, the Second Circuit held that a document “does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of anticipated litigation.”40

However, other circuits follow a narrower test, requiring that the anticipated litigation be the “primary motivating purpose” behind the document’s creation.41 Because of these differences in interpretations of the privilege in the various federal circuits, it is necessary to refer to the case law of the applicable circuit when evaluating whether the privilege applies.

A special subset of work product that has been the subject of extensive litigation is tax accrual workpapers. In the Second Circuit,42 tax accrual workpapers have been held to be privileged under the because-of test if one of the purposes of creating the workpapers is in anticipation of future litigation with the IRS. In contrast, the Fifth Circuit43 held that tax accrual workpapers would be privileged only if the primary motivating purpose for creating the workpapers was possible future litigation.

However, in Textron,44 the First Circuit, while purporting to follow the because-of test, significantly narrowed it. Textron prepared its tax accrual workpapers by obtaining the opinion of legal counsel regarding estimates of the hazards of litigation for its tax positions. The company claimed work product protection since the documents, while prepared in the course of its financial audit and financial statement preparation, were created because of the anticipation of litigation with the IRS over its tax positions. The court, however, identified the workpapers as routine documents prepared for the purpose of completing financial statements and not prepared for use in litigation. Therefore, the court concluded that the work product privilege did not apply. The decision by the First Circuit appears to change the “prepared in anticipation of litigation” rule to a more restrictive “prepared for litigation” in cases in that circuit.

Overall, the application of the work product doctrine depends on who prepared the document, what it contains, and why it was prepared. It may be possible to avoid ambiguities by having outside counsel create or commission documents and by including in documentation the thoughts and opinions of counsel that clearly anticipate litigation.

Conclusion

The practitioner-client and work product privileges belong to the client, and it is the client who decides whether to waive them. This is true even when information is found to be privileged but the client uses it to provide substantiation for claims of deductions or losses on the client’s tax return. It is at the taxpayer’s discretion whether to provide that information to the IRS. It will also be up to the taxpayer whether to waive the privilege to raise a defense against certain penalties by claiming a good-faith reliance on the advice of counsel or a qualified practitioner. In such cases, advice from counsel can support a claim of substantial authority or reasonable cause for good-faith reporting on the tax return.

By properly clarifying their role as tax adviser—as well as documenting engagements, protecting confidentiality, properly addressing communications and work product, and monitoring their content—accountants will serve clients’ interest in preserving the privileges that may apply to their communication.

Footnotes

¹ Hickman v. Taylor, 329 U.S. 495 (1947).

² Fed. R. Civ. P. 26(b)(3).

³ S. Rep’t No. 105-174, 105th Cong., 2d Sess. 70 (1998).

⁴ Sec. 7525(a)(3).

⁵ S. Rep’t No. 105-174 at 70.

⁶ Sec. 7525(a).

⁷ S. Rep’t No. 105-174 at 71.

⁸ Upjohn Co., 449 U.S. 383 (1981).

⁹ Some exceptions allow the presence of a party with a common legal interest (e.g., a co-defendant) or certain agents of the attorney (e.g., secretary or unlicensed associate).

¹⁰ Santander Holdings USA, Inc., No. 09-11043-GAO (D. Mass. 8/6/12).

¹¹ Pasadena Refining System, Inc., No. 3:10-CV-0785-K (BF) (N.D. Tex. 4/26/11).

¹² Evergreen Trading, LLC, 80 Fed. Cl. 122 (2007).

¹³ BDO Seidman, LLP, No. 02 C 4822 (N.D. Ill. 6/29/04), aff’d in part, 492 F.3d 806 (7th Cir. 2007).

¹⁴ Id., slip op. at 4.

¹⁵ Pasadena Refining System, Inc., No. 3:10-CV-0785-K (BF) (N.D. Tex. 4/26/11).

¹⁶ For example, in Evergreen Trading, LLC, 80 Fed. Cl. 122 (2007), certain page numbers were redacted since the “numbering system itself could reveal aspects of plaintiffs’ counsel’s understanding of the case” (slip op. at 18).

¹⁷ Upjohn Co., 449 U.S. 383 (1981).

¹⁸ Clark, 289 U.S. 1 (1933).

¹⁹ BDO Seidman, LLP, 492 F.3d 806 (7th Cir. 2007).

²⁰ H.R. Conf. Rep’t No. 105-599, 105th Cong., 2d Sess. 267 (1998).

²¹ Colton, 306 F.2d 633 (2d Cir. 1962).

²² Davis, 636 F.2d 1028 (5th Cir. 1981).

²³ Frederick, 182 F.3d 496 (7th Cir. 1999).

²⁴ Sec. 7525(b) was amended by the American Jobs Creation Act of 2004, P.L. 108-357, to apply to participation of any person (previously, it was participation of a corporation).

²⁵ Countryside Limited Partnership, 132 T.C. 347 (2009).

²⁶ BDO Seidman, LLP, 492 F.3d 806 (7th Cir. 2007).

²⁷ H.R. Conf. Rep’t No. 105-599, 105th Cong., 2d Sess., 269 (1998).

²⁸ Countryside Limited Partnership, 132 T.C. at 354–5.

²⁹ Valero Energy Corp., 569 F.3d 626 (7th Cir. 2009).

³⁰ Id., slip op. at 16.

³¹ Kovel, 296 F.2d 918 (2d Cir. 1961).

³² Id. at 922.

³³ Cavallaro, 284 F.3d 236 (1st Cir. 2002), aff’g 153 F. Supp. 2d 52 (D. Mass. 2001). The tax years at issue were before the enactment of Sec. 7525; thus, the practitioner privilege was not available as an alternative protection.

³⁴ Fed. R. Civ. P. 26(b)(3)(B).

³⁵ Deloitte & Touche USA LLP, 623 F. Supp. 2d 39 (D.D.C. 2009), aff’d in part, 610 F.3d 129 (D.C. Cir. 2010).

³⁶ In this case, the court found it reasonable to expect that CPAs, subject to Rule 301 of the AICPA Code of Professional Conduct, which prevents members from disclosing confidential client information without consent, would keep work product confidential.

³⁷ Deloitte, LLP, 610 F.3d 129 (D.C. Cir. 2010).

³⁸ Id., slip op. at 9.

³⁹ See Adlman, 134 F.3d 1194 (2d Cir. 1998); Rockwell Int’l, 897 F.2d 1255 (3d Cir. 1990); National Union Fire Ins. Co. of Pittsburgh v. Murray Sheet Metal Co., 967 F.2d 980 (4th Cir. 1992); Roxworthy, 457 F.3d 590 (6th Cir. 2006); Binks Mfg. Co. v. National Presto Indus., Inc., 709 F.2d 1109 (7th Cir. 1983); Simon v. G.D. Searle & Co., 816 F.2d 397 (8th Cir. 1987); In re Grand Jury Subpoena, 357 F.3d 900 (9th Cir. 2004); and Equal Employment Opportunity Comm’n v. Lutheran Social Servs., 186 F.3d 959 (D.C. Cir. 1999).

⁴⁰ Adlman, 134 F.3d at 1195.

⁴¹ Davis, 636 F.2d 1028 (5th Cir. 1981).

⁴² Adlman, 134 F.3d 1194 (2d Cir. 1998).

⁴³ El Paso Co., 682 F.2d 530 (5th Cir. 1982).

⁴⁴ Textron Inc., 507 F. Supp. 2d 138 (D.R.I. 2007), rev’d, 577 F.3d 21 (1st Cir. 2009) (en banc), cert. denied.