Protecting a taxpayer’s privileges

Preserving legally recognized "privileges" that shield what was said between client and accountant from compelled disclosure is a fundamental duty of the CPA tax professional. Generally, this desire for privilege is to prevent a tax authority — for example, the IRS — from accessing communications and related work product, such as written advice, analysis, and recommendations, between the taxpayer and the tax adviser pertaining to a tax issue in dispute. Thus, it is critical that the CPA understand the privileges that are available to a client-taxpayer when communicating with a tax professional.

The scope of those tax privileges, however, is limited at best and nonexistent in many situations. Consequently, in the course of tax practice, the CPA should be ever vigilant in recognizing when to refuse to listen or to stop listening to a client and refer the client to tax legal counsel to prevent possible harm to the client. This includes, of course, both written communications such as email and oral discussions. It is important to note that the many state accountancy laws that address "client confidentiality" do not provide privilege protection regarding tax authority inquiries — that is, confidentiality and privilege protections are different creatures in the law, a fact that is sometimes misunderstood by both the client and the tax adviser.

A lack of knowledge on the part of the CPA of the nature of a client's "privileges" with regard to communications with a tax adviser, or a lack of thoughtfulness with regard to communications between the CPA and the tax client that otherwise should be "off limits" because it is outside the scope of the CPA-client privilege, may result in significant harm to the client should the CPA be compelled to reveal communications to the tax authority or to a court. This problem is exacerbated by the fact that taxpayers often believe their communication with a CPA is subject to privilege similar to a communication with an attorney. Consequently, as a matter of course, the CPA should advise the taxpayer of limitations that apply to what the client might otherwise believe is "privileged."

While the attorney-client privilege does not extend to the CPA, it is necessary to understand that privilege in order to understand and apply any related type of privilege that may apply to client-CPA communications and related limitations.

Basically, the privilege belongs to the client, but the protection from disclosure protects both the client and the lawyer from a compelled disclosure. The communication protection is generally limited to legal advice provided by an attorney in his or her capacity as an attorney; also, the protection understandably includes related documentation (work product). Privilege protection often extends indefinitely — beyond the client engagement or relationship and even death.

However, privilege protection may easily be "waived": for example, when the communication or work product is shared with or is affirmatively revealed to a nonprivileged person (some protection exists for inadvertently shared waiver). Also, once privilege is "waived" — even if only to an aspect of a matter in contention — the government may successfully argue that privilege is waived for the entire matter, i.e., it constitutes subject-matter waiver with regard to the entirety of the communication related to the matter.

Also, there are three significant exceptions to the privilege protection in the tax arena:

• The protection does not apply to "business" advice, and the IRS and Department of Justice have successfully litigated this issue.
• There is a "crime-fraud" exception for privilege claims; that is, communications are not privileged if the attorney is found to participate in or enable a client's fraud (or to cover it up). The IRS has recently indicated an intention to more aggressively pursue this exception to privilege claims.
• Most importantly, as has been held many times in federal courts, communications pertaining to income tax preparation are not privileged. The CPA should carefully note this exception: Obviously, if the privilege exception does not extend to attorneys preparing returns, it certainly will not extend to a CPA tax return preparer. And, overwhelmingly, taxpayer communications with a CPA arise in the context of return preparation.

This is a privilege that derives from the attorney-client privilege. Basically, it extends any applicable attorney-client privilege to any party necessarily retained by an attorney to enable him or her to provide legal advice to a client. Thus, the attorney can retain a CPA to assist in providing tax advice to a client, and the attorney's communication protection extends to the CPA; this may include assistance in determining and calculating a tax liability. However, Kovel privilege does not protect from disclosure any CPA-client (taxpayer) communications and work product that preexisted the Kovel arrangement, so it is often difficult if not impossible for Kovel protection to extend to a CPA who has historically been the client's tax adviser or preparer. It is an issue of when did you know it? And the government will invariably contend that the knowledge was obtained prior to the Kovel retention.

Finally, if the CPA whom the attorney retains prepares tax returns as part of the engagement — for example, amended returns for foreign disclosure items or previously unreported income — communication protection related to the returns is waived retroactively with regard to preparation communications and underlying work product once the returns are submitted.

Sec. 7525 provides a statutory privilege for taxpayer communication with a federally authorized tax practitioner (which includes a properly licensed CPA). However, the statute provides that the protection is no greater or less than the attorney-client privilege. Consequently, it clearly does not extend to communications related to return preparation and filing obligations. It also specifically does not apply to tax shelter advice — whether or not return preparation is involved.

Critically, too, it does not apply to a criminal matter, and it is retroactively removed when the IRS launches a subsequent criminal investigation. This poses a danger for the unaware practitioner who allows a taxpayer to reveal potential criminal motivation or activity believing that privilege applies, only to find that the CPA may be required to serve as a witness for the prosecution in a criminal matter sometime later.

Another privilege, the judicially created work-product doctrine, prevents compelled disclosure of materials and legal analysis and related communications — including those of the lawyer and any expert — created in anticipation of litigation. Notably, it does not protect any information or communication retroactively. Also, there is ample case law that requires more than a mere possibility of litigation. While litigation does not need to have commenced, there should be a realistic possibility.

The work-product doctrine has been the subject of significant litigation over tax opinions provided to independent auditors for purposes of their evaluation of uncertain tax positions in financial statement audits. The government will argue that providing the lawyer's confidential analysis and tax opinion to an auditor for financial statement purposes constituted waiver of the privilege — or, in the alternative, that the tax opinion was not prepared in anticipation of litigation but instead was prepared for business purposes, specifically to satisfy financial statement auditors. Taxpayer-corporations seeking work-product protection for these tax opinions have prevailed in some cases. But, overwhelmingly, in the CPA profession — aside from large taxpayers that self-prepare returns — protecting financial statement tax provision advice is a moot point because the auditor is the CPA who prepares the entity's tax returns (and often provides the tax advice) and the tax return communication is not protected.

CPAs are often approached by a prospective client who has significant income and has not filed returns for one, some, or many years, and who wants to file returns before the IRS "catches up with me."

That nonfiling may arise for any number of reasons. But one thing is certain: The client is "new," and the CPA does not know those reasons. In this situation, the CPA should not even begin to listen to the client; instead, the client should be advised to engage the services of a tax attorney familiar with criminal and civil fraud tax matters. The CPA's duty is absolute in these situations: Protect the client's privilege! The CPA simply does not know what the client may reveal, and once the possibility of a willful intention to evade a tax obligation is revealed, the CPA is in the uncomfortable position of becoming a witness for the prosecution. Recall our discussion of applicable privileges — none apply. What is likely to occur is that the potential client consults with an attorney who sends him or her back to the CPA for preparation of the necessary filing — most likely after a Kovel engagement is in place.

With regard to an existing client subjected to an IRS examination, the CPA should monitor and evaluate the information and activity of the IRS examination and listen very carefully to the client when communicating with the client. Again, at the first sign — from either the IRS or from the client — that something may be "awry," the CPA should consider suspending services and referring the client to a tax attorney for advice and guidance — for the same reason discussed earlier: to protect the client's "privileges." This action is also consistent with AICPA Statement on Standards for Tax Services No. 6, Knowledge of Error: Return Preparation and Administrative Proceedings.

In the course of tax practice, the CPA is in a position to do great harm to the client when it comes to protecting not just confidential client data but also the confidentiality of the client's communications about his or her tax matters. The fundamental duty of the CPA tax practitioner should be similar to that of the Hippocratic Oath of the medical profession: "First, do no harm."