The Sec. 7525 privilege relating to taxpayer communications

A federally authorized tax practitioner is any individual authorized under federal law to practice before the IRS and can include professionals such as CPAs, attorneys, enrolled agents, enrolled actuaries, and other types of professionals (Sec. 7525(a)(3)(A) and Section 10.3 of Circular 230, Regulations Governing Practice Before the Internal Revenue Service (31 C.F.R. Part 10)). A tax practitioner may also include in-house practitioners who are eligible to practice under Circular 230 (Eaton Corp., No. 12 MC 24 (N.D. Ohio 8/15/12)).

For the Sec. 7525 privilege to apply, the person asserting the privilege must be a client or be in the process of becoming a client of the tax practitioner. The Sec. 7525 privilege does not apply to communications between the tax practitioner and other parties outside the professional client relationship.

Case law provides guidance on who, in the corporate context, constitutes the "client" for purposes of the attorney-client privilege (and, by extension, the Sec. 7525 privilege). For example, in Upjohn Co., 449 U.S. 383 (1981), the Supreme Court held that the attorney-client privilege applies to communications by any corporate employee, including lower- and middle-level employees and in-house counsel, where the communication is for the purpose of the corporation's obtaining legal advice. This holding specifically rejected the lower court's ruling limiting the privilege to individuals empowered to act on behalf of the corporation (the control group). The Supreme Court declined to establish a specific test but rather held that each case must be evaluated individually to determine whether the purpose of the communication would enable the legal counsel to provide well-reasoned advice to the client.

Other cases have expanded the underlying rationale of Upjohn to include former corporate employees and employees of domestic and foreign subsidiaries (see In re Coordinated Pretrial Proceedings in Petroleum Products Antitrust Litigation, 658 F. 2d 1355 (9th Cir. 1981), cert. denied, 455 U.S. 990 (1982); Admirals Ins. Co., 881 F.2d 1486 (9th Cir. 1989); In re Teleglobe Communications Corp., 493 F.3d 345 (3d Cir. 2007); and Mobil Corp., 149 F.R.D. 533 (N.D. Tex. 1993)). These cases support a determination that communications between a tax practitioner and employees beyond the control group, including those of non-U.S. entities, may be subject to the Sec. 7525 privilege, as long as the employees are acting under the direction of the corporate control group concerning matters within the scope of their corporate duties in order for the corporate taxpayer to obtain tax advice from the tax practitioner.

The term "tax advice" means advice provided by a practitioner within the scope of the practitioner's authority to practice before the IRS (Sec. 7525(a)(3)(B)). The Sec. 7525 privilege applies to information the taxpayer provides to the tax practitioner to facilitate the provision of tax advice, as well as tax advice the tax practitioner provides to the taxpayer. In construing what constitutes tax advice, courts relying on the legislative history have consistently held the privilege does not apply where a communication is made "for further communication to third parties," i.e., for inclusion on a tax return (see Frederick, 182 F.3d 496 (7th Cir. 1999); Evergreen Trading, LLC, 80 Fed. Cl. 122 (2007); BDO Seidman, 337 F.3d 802 (7th Cir. 2003)).

For the Sec. 7525 privilege to apply, the communication between a tax practitioner and the taxpayer is required to be made and maintained in confidence. A "reasonable belief" of the confidential nature of the information exchanged between the tax practitioner and the taxpayer is typically regarded as sufficient evidence of the expectation of confidentiality. Additionally, consistent with the attorney-client privilege, taxpayers asserting privilege bear the burden of demonstrating the Sec. 7525 privilege applies (see Graf, 610 F.3d 1148 (9th Cir. 2010); Evergreen Trading, 80 Fed. Cl. 122 (2007); BDO Seidman, 337 F.3d 802 (7th Cir. 2003); Adlman, 68 F.3d 1495 (2d Cir. 1995)).

As the Sec. 7525 privilege is designed to mirror the attorney-client privilege, it can be waived in a similar manner. Disclosure of the privileged information to a third party can waive the Sec. 7525 privilege. Disclosure may be intentional, implied, or inadvertent.

An implied waiver can occur when the client places the advice in issue. The most common implied waiver occurs when the client asserts a reasonable-cause defense to tax penalties. The courts have found that a litigant cannot use the attorney-client privilege both as a shield and a sword, emphasizing the unfairness to the opponent of making claims that cannot be proved except by admission of material for which privilege is then asserted (see Bilzerian, 926 F.2d 1285 (2d Cir. 1991); AD Investment 2000 Fund LLC, 142 T.C. 248 (2014)). In contrast, an inadvertent disclosure might not result in a waiver as long as the holder of the privilege made efforts that are reasonably designed to protect and preserve the privilege (see De La Jara, 973 F.2d 746 (9th Cir. 1992)).

Deliberate disclosure to a third party constitutes an express waiver of both the attorney-client and the Sec. 7525 privileges. This can be an important point for CPAs who share privileged information with a client's independent auditor, as providing the privileged information to the independent auditor would waive the privilege even if the auditor agreed to keep the information confidential and not further disclose it.

In litigation, taxpayers have attempted to suppress the provision of tax accrual workpapers to the IRS with claims of attorney-client privilege, Sec. 7525 privilege, or protection by the work product doctrine. Courts consistently have found that sharing privileged information with an independent auditor waives both attorney-client and Sec. 7525 privileges (see Textron Inc., 577 F.3d 21 (1st Cir. 2009); Deloitte, LLP, 610 F.3d 129 (D.C. Cir. 2010); El Paso Co., 682 F.2d 530 (5th Cir. 1982)). Providing limited relief from this result, however, in Announcement 2010-76, the IRS stated that it will not claim a waiver of privilege under the attorney-client privilege, the Sec. 7525 privilege, or the work-product doctrine when an otherwise privileged document is provided to an independent auditor as part of an audit of the taxpayer's financial statements. By its terms, this IRS policy applies during an IRS examination.

While the Sec. 7525 privilege affords many benefits to tax practitioners, including CPAs, it has certain limitations and exceptions. The Sec. 7525 privilege applies only to civil administrative proceedings with the IRS (e.g., an examination or appeal), or to tax litigation before the Tax Court or other federal courts. The Sec. 7525 privilege does not apply during any criminal tax proceedings, state or local tax matters, or any nontax proceeding (Sec. 7525(a)(2)). In addition, the Sec. 7525 privilege does not apply to information or communications concerning tax return preparation, but it can apply to tax planning advice, tax consulting, and similar communications. Lastly, the Sec. 7525 privilege does not apply to written communications in connection with the promotion of the direct or indirect participation of a person in any tax shelter.

The term "tax shelter" is defined in Sec. 6662(d)(2)(C)(ii) as any entity, plan, or arrangement a significant purpose of which is the avoidance or evasion of federal income tax, but the term "significant purpose" is not specifically defined. Court cases have interpreted "significant purpose" broadly, stating that it merely includes "a" significant purpose, rather than the narrower definition of "the" significant purpose (Valero Energy Corp., 569 F.3d 626 (2009)). Thus, tax practitioners should be aware that the Sec. 7525 privilege may be challenged where the communications relate to an ordinary business transaction if a purpose of the transaction is tax avoidance.

Other court cases have considered the definition of "communications" and "promotion" in the context of whether the Sec. 7525 privilege applies to tax shelters. In Countryside Ltd. Partnership, 132 T.C. 347 (2009), the court found that notes kept by a partner were not communications within the context of the tax shelter exception to the Sec. 7525 privilege and, thus, the tax practitioner was not engaged in the promotion of a tax shelter. During a meeting with the tax practitioner, the partner created two pages of handwritten notes consisting of a record of the main points of the discussion. As these notes were for the partner's use only and were not communicated to anyone or provided to any other party, the court ruled that the notes were not written communication that could be subject to the tax shelter exception to the Sec. 7525 privilege.

When considering whether the tax practitioner was promoting a transaction, the court focused on the long-term relationship between the tax practitioner and the client, and the broad nature of services the tax practitioner provided, which included tax return preparation, assisting with responses to tax notices, and providing advice on both planned and completed transactions. The court also noted that much of the advice provided by the tax practitioner was billed by the hour. Based on these factors, the court found the tax practitioner had not crossed the line from trusted adviser to promoter; as such, the Sec. 7525 privilege applied.

Clients frequently look to the tax practitioner for guidance on the Sec. 7525 privilege. Knowing when the privilege may be asserted, adopting internal best practices, and advising clients on best practices enhance the likelihood that the client can successfully assert the Sec. 7525 privilege.

Below are some suggested best practices for establishing and maintaining the privilege:

Internal steps for tax practitioners

• Understand when a client might assert the privilege;
• Communicate clearly with staff members the confidential nature of the communications with the client and the importance of maintaining the confidential nature of those communications;
• Define which staff members will be part of any privileged communications;
• Maintain only copies of final documents and other supporting materials (e.g., multiple versions of the same document, or old versions and drafts of documents should be discarded) consistent with the practitioner's document-retention policies;
• Clarify with the client before starting the engagement the specific markings or legend the client would like placed on specific documents and email communications (e.g., "Privileged and Confidential Communication Under IRC Section 7525") as applicable and include "Draft" markings on documents that are not yet final;
• Educate staff members on the types of waivers and how waivers can occur;
• Educate staff that communications ultimately may be produced in administrative and/or court settings — as such, they must use professional communication techniques and exercise discretion on what is communicated and how it is communicated;
• Keep privileged documents and communications in separate files from nonprivileged documents and communications; and
• Review the AICPA practice guide Overview of the Federally Authorized Tax Practitioner—Client Privilege Under IRC Sec. 7525, which is available free to members of the Tax Section.

External steps for clients

• Determine who within the client's organization will be party to communications with the tax practitioner;
• Clearly describe the confidential nature of the communications and convey the need to maintain confidentiality to members of the client team;
• Maintain only copies of final documents and other supporting materials (e.g., multiple versions of the same document or old versions and drafts of documents should be discarded) consistent with the organization's document-retention policies;
• Inform the tax practitioner at the start of the engagement of the type of markings or legend to be placed on specific documents and email communications (e.g., "Privileged and Confidential Communication under IRC Section 7525") as applicable and include "Draft" markings on documents that are not yet final;
• Educate personnel that communications ultimately may be produced in administrative and/or court settings — as such, it is imperative to use professional communication techniques and to exercise discretion on what is communicated and how it is communicated; and
• Maintain privileged documents and communications in separate files from nonprivileged documents and communications.

Joint steps for tax practitioners and clients

• Determine the appropriate communications methods to exchange information between the tax practitioner and the client;
• Agree on which tax practitioner and client personnel should be included in the communications — any additional distribution beyond the agreed-upon personnel should be discussed in advance with both the client and the tax practitioner; and
• Make all major discussion points, key determinations, and critical decisions through in-person meetings or via telephone conversations where practical. Attendance at such meetings or conference calls should be in accordance with the agreed-upon personnel list described above.

The Sec. 7525 privilege can help protect communications and encourages a full exchange of information between clients and tax practitioners. To put themselves in the best position to provide advice to clients wishing to avail themselves of this privilege, tax practitioners should understand the requirements to establish the privilege, the exceptions to the privilege, and actions that can cause a waiver of the privilege.