CLIENT CONFIDENTIALITY
Revisiting the Tax Advisor Privilege of
Confidential Communication
It’s
been a few years since Congress enacted the tax advisor privilege of
confidential communication with the Internal Revenue Restructuring and Reform
Act of 1998. When we first wrote about
the privilege in 1999, the Service did not provide much guidance and it was yet
to be seen how the Service would interpret the privilege.
However, as we earlier predicted, the Service has worked to narrow the
tax advisor privilege as they have with the attorney-client privilege.
IRC
§7525 created a limited privilege for tax practitioners by extending the common
law attorney-client privilege to tax advice for taxpayer communications with a
federally authorized tax practitioner.Generally, the privilege applies to: (1) non-criminal tax matters before
the Internal Revenue Service; or (2) non-criminal tax proceedings in Federal
court brought by or against the
United States
. However, when first introduced, it was
not clear in what instances the privilege would not apply.
In the intervening years since its inception, the limitations of the tax
advisor privilege have become a little clearer.
While
the primary description of the privilege equates it to the attorney-client
privilege, it is in reality not at all like the "protections of
confidentiality which apply to a communication between a taxpayer and an
attorney." Tax advisors, therefore, should be cautious about making
assumptions regarding the protections actually conferred by this privilege.
The
privilege does apply to:
- Noncriminal tax matters before the Internal Revenue
Service (e.g., examinations, appeals, etc.) and
- Noncriminal tax proceedings in Federal court brought
by or against the United States (e.g., tax deficiency litigation in U.S. Tax
Court, tax refund litigation in U.S. District Court or litigation in the
U.S. Court of Claims). It may have applicability in U.S. Bankruptcy Court.
The language of the statute suggests the privilege does
not apply to:
- Any private civil litigation actions;
- Any criminal proceeding;
- Any civil tax proceedings where written
communications relating to "corporate tax shelters" are relevant,
and
- State tax proceedings.
IRC
§7525 doesn’t provide an absolute privilege, so CPAs need to make clients
aware of the significant limitations of the privilege. The attorney-client
privilege has its limitations, but is a far broader privilege and applies to
most communications between attorneys and their clients.
The
issues which could cause problems in the future are many. Some definitional
issues are immediately apparent, such as identifying who is a tax advisor or
what constitutes tax
advice. Others only become apparent in application, such as waiver of the
privilege, conflicts of interest and so forth.
What
Constitutes Tax Advice
The
statute defines tax advice given by an individual with respect to a matter which
is within the scope of the individual's authority to practice; in other words,
within the scope of a federally authorized tax practitioner's practice.
Attorneys and CPAs are automatically able to practice before the Internal
Revenue Service, as are enrolled agents and actuaries by application. Such
practice includes preparing tax returns, representing taxpayers in audits,
corresponding with the IRS, and appearing before the Office of Appeals of the
IRS.¹
However,
if the communication includes other non-tax related matters such as business
consulting or attestation services, clarity is lost and the fine line between
privileged and nonprivileged communications may be in dispute.
It
is well known that attorneys who enjoy the privilege of confidential
communication in tax matters may not enjoy the privilege when it involves
business advice.² Accounting firms, much more so than law firms, provide both
business and tax advice, and often they are intermingled. How and where the line
may be drawn between business advice and tax advice for purposes of applying the
privilege is simply unknown. More than ever, when rendering services to clients,
accountants should consider methods to isolate their tax practice from other
services in an attempt to afford their clients the protection available to them
under the Act with regard to communications on tax matters. This is a new hazard
for CPAs whose engagements may straddle this line.
One
method of doing this is to designate a tax practitioner within an office who
will solely provide tax services to clients, referring requests for additional
advice and services to others within the firm. In circumstances where this is
not practical and keeping client communications on tax matters privileged is
important, it may become necessary to refer the client to a tax attorney for
ongoing advice on a specific matter.
On
a positive note, the Act may limit the scope of examining IRS agents in their
interviews of a tax advisor, or examination of an advisor's internal files and
memoranda containing tax advice, and it may prevent them from intimidating an
accountant. Potential problems may arise, however, if a CPA or client discloses
information to which the privilege would have otherwise applied but for the
disclosure. As with all privileges, it can be waived by disclosure, even unknowing
disclosure. The privilege is for the protection of the taxpayer rather than the
CPA, and is held solely by the taxpayer.
A
confusing area of the legislation continues to be its reference to "tax
advice" as advice given with respect to a matter that is within the scope
of practice before the IRS. Treasury Circular 230, which defines practice before
the IRS, focuses on interaction between the tax professional and the Service,
not on communication between the tax professional and the client. This reference
is not helpful in understanding what constitutes "tax advice." While
it is safe to assume that tax advice to clients is included in the nature of
practice before the IRS, because of the ambiguity of this definition, it is not
clear what this will mean on a case by case basis.
Case
law has, however, added a welcome definition. Two federal courts have held that
information used to prepare tax returns is not privileged under IRC §7525.
U.S.
v.
Frederick
(7th Cir. 1999) 182 F.3rd. 496; Long
Term v. Capital Holdings v.
U.S.
(D.
Conn.
2002) 2003-1USTC 50,105.
A
series of tax shelter related cases have held that lists of investors names are
not privileged (U.S. v Sidley, Austin,
Brown & Wood LLP (N.D. Ill. 2004) 2004 WL 816448 [taxpayer identity is
neither a communication nor confidential];
U.S. v BDO Seidman (7th Cir. 2003) 337 F. 3rd. 802
[client’s identity must be disclosed if subject to tax shelter registration
and list keeping under IRC 6111,6112, hence it obviates any expectation of
confidentiality]; U.
S. v. Arthur Andersen (N.D. Ill. 2003) 2003 WL 21956404 [same]; U.S.
v. KPMG, LLP (N.D. Tex. 2004) 325 F. Supp. 2d. 746 [same]). However, where
the IRS sought documents (e-mails, memos, letters, agreements), one district
court found the privilege protected their disclosure (U.S.
v. BDO Seidman (N.D. Ill. 2005) 2005 WL 742642 [documents contained tax
advice and were not used in the preparation of tax returns]).
Conflicts
of Interest
An
obvious example of potential conflict is in the area of audited financial
statements. What happens when a CPA firm audits a client's financial statements
and provides tax advice to the same client? Do the requirements of FASB
Statement 109³ and FASB Interpretation 484 result in "tax
advice" disclosure on financial statements that could constitute a waiver
if made, and a conflict if not? For example, consider the CPA firm that requires
a client to disclose tax information in its financial statements at the same
time that the firm serves as a tax advisor. Disclosure may result in waiver of
the privilege and may require the CPA firm to consider disengagement.
Some
have suggested that accounting firms provide pre-engagement disclosures to their
clients concerning their dual role as tax advisor and auditor and document these
disclosures in the engagement letter. The client may waive the privilege of
confidential communication regarding tax advice in order to comply with
financial statement disclosure requirements. However, if the client does not
waive the privilege and does not include the financial statement disclosures,
the CPA firm is placed in the difficult position of having to evaluate the
impact of the nondisclosure on its audit report. If this occurs, the CPA must be
prepared to explain to the client the need to comply with FASB requirements, or,
if the financial statements do not comply, the need for the auditor to either
qualify the audit report or withdraw from the engagement.
This discussion should be documented in the working papers.
The
CPA firm also may find it prudent to advise clients that disclosures made by the
client to third parties such as banks, leasing companies or sureties could
result in loss of the privilege.
Waiver
The
privilege of confidential communication does not apply to state tax
issues or state tax proceedings. Consequently, the IRS could obtain information
through the back door if state tax litigation becomes a matter of public record.
Furthermore, the privilege of confidential communication does not apply in the
public audit context or in proceedings before an agency other than the IRS such
as the SEC or the Department of Labor. The privilege also appears not to apply
to investigations by a state board of accountancy or the AICPA.
Communications
between a tax advisor and a client and documents prepared in connection with the
investigation would not be privileged and would be discoverable, even by the
IRS.
To
the extent that an accounting firm performs an audit of a client's financial
statements, it is quite possible that some firm personnel may provide advice
that will have an effect on the position a client is taking regarding federal
taxes. These tax positions will very likely end up being incorporated into the
client's financial statements. If these statements were put into the public
realm through filings with the SEC or some other regulatory agency, would the
tax information become a matter of public record? Furthermore, in order to avoid
waiving the privilege with regard to a substantial dispute regarding federal
taxes, the taxpayer may wish to resolve a related state tax dispute first, even
if that dispute could be successfully litigated.
Criminal
Proceedings
The
§7525 privilege does not apply to criminal proceedings, which include such
matters as criminal tax proceedings or money laundering prosecutions. When,
during the course of an examination by an IRS agent, it becomes apparent to a
CPA that the agent is considering the basis for a criminal fraud case, the CPA
must know that the privilege is inapplicable. This most likely means that all
communications with the taxpayer prior to the criminal referral will be subject
to discovery. In such a circumstance, the accountant should immediately advise
the client that their past and continuing communications are not privileged and
should recommend the engagement of legal counsel, under whose broader
attorney-client privilege further communications would be protected.
Communications
With Clients About the 7525 Privilege
CPAs
need to be familiar with the protections afforded and the limitations embodied
in the Act and be able to discuss these matters with their clients. It is
important that clients be informed of the existence of the Act and that this
communication be documented in engagement letters. As is the case with all such
letters, the language used should be tailored to the specific situation and
should be reviewed by the firm's legal counsel before being used. Possible
engagement letter language might read as follows:
“Internal
Revenue Code §7525 provides a confidentiality privilege covering certain tax
advice embodied in taxpayer communications with federally authorized tax
practitioners in certain limited situations. These protections are limited in
several important respects. For example, this privilege does not apply to your
records, which you are required to keep in support of your tax return.
Additionally, it does not apply to state tax issues, state tax proceedings,
private civil litigation proceedings, or criminal proceedings. While we will
cooperate with you with respect to the privilege, asserting the privilege is
your responsibility. Inadvertent disclosure of otherwise privileged information
may result in a waiver of the privilege. Please contact us immediately if you
have any questions or need further information about this matter."
Conclusion
As
predicted, the IRS has moved to restrict the scope of the tax advisor-taxpayer
privilege of confidential communication just as it continues to restrict the
attorney-client privilege of confidential communication or attorney work
product. With this in mind, CPAs should consider this issue in their engagement
planning and performance, disclosures to clients, document and information
control, and internal firm engagement administration. In other words, be
familiar with the privilege and its limitations, incorporate any necessary
related changes into your client and engagement screening and acceptance
procedures, and inform your clients of the existence of the privilege,
preferably in the engagement letter.
Notes
(1)
31 C.F.R., Subtitle A, Part 10 Section 10.2 & 10.3 (published as Treasury
Circular 230).
(2) Matter of Walsh, 623 F.2d 489 (7th Cir. 1980); Matter of Fischel,
557 F.2d 209 (9th Cir. 1977); In re Shapiro, 381 F.Supp. 21 (ND III,
1974).
(3) Financial Accounting Standards Board, Statement 109, Accounting for
Income Taxes, Financial Accounting Standards Board,
Norwalk
, CT.
(4) Financial Accounting Standards Board Interpretation 48, Accounting
for Uncertainty in Income Taxes, Financial Accounting Standards Board,
Norwalk
,
CT.
August
2006
by
Arthur V. Pearson, Murphy, Pearson, Bradley & Feeney, Attorneys at
Law, San Francisco, CA 94108 and John McFadden, CPA, CFE, Risk Control
Consulting Director, CNA, Accountants Professional Liability, Chicago, IL 60604
The
purpose of this article is to provide information, rather than advice or
opinion. It is accurate to the best of the authors’ knowledge as of the date
of the article. Accordingly, this article should not be viewed as a substitute
for the guidance and recommendations of a retained professional. In addition,
CNA does not endorse any coverages, systems, processes or protocols addressed
herein unless they are produced or created by CNA.
The examples used in
this article are fictional and any similarity
to an actual claim is unintentional and purely coincidental.
To the
extent this article contains any descriptions of CNA products, please note that
all products may not be available in all states. Actual terms, coverages,
amounts, conditions and exclusions are governed and controlled by the terms and
conditions of the relevant insurance policies.
Continental
Casualty Company, one of the CNA insurance companies, is the underwriter of the
AICPA Professional Liability Insurance Program.
CNA
is a service mark registered with the
United States
Patent and Trademark Office. Copyright © 2006 CNA.
All rights reserved.
|