RALLIS * SEGUNDO, P. A.

CLIENT CONFIDENTIALITY

Tax Advisor Privilege of Confidential Communication

This article is brought to you by the AICPA Professional Liability Insurance Program.  For more information, see http://www.cpai.com/business-insurance/professional-liability/Pages/index.aspx.

 

When we first revisited the tax advisor privilege of confidential communication a few years ago,[1] we noted that the Service would likely restrict the scope of the tax advisor privilege, much as they had with the attorney client privilege of confidential communication and attorney work product doctrine.  Initially, it was unclear under what circumstances the privilege would not apply.  Over time, case law clarified that the privilege would be narrowly interpreted by the Service and, in response, CPAs should be cautious in relying on the privilege for protection and be aware of its limitations.  Today, the Service continues its fight to narrow the tax advisor privilege, and CPAs are encountering new issues with respect to the tax advisor privilege in their everyday practice as tax laws and accounting rules change.

 

Renewed Focus on Tax Accrual Workpapers

 

The recent Textron case illustrates the continuing efforts to narrow the privilege with respect to tax accrual workpapers. Tax accrual workpapers refer to those audit workpapers that relate to the tax reserve for current, deferred and potential or contingent tax liabilities and to footnotes disclosing those tax reserves on audited financial statements. These workpapers reflect an estimate of a company’s tax liabilities, including determinations and related documentation of estimates of potential or contingent tax liabilities related to tax positions taken by the taxpayer on certain transactions.

           

They may also indicate whether there was reliance on outside legal advice, may evidence an assessment of the taxpayer’s likelihood of success in the event of examination or litigation, and may discuss other material facts surrounding tax transactions. The workpapers may include documents written by the taxpayer’s employees and officers describing or evaluating the tax strategies. In essence, tax accrual workpapers provide a key to the taxpayer’s evaluation of the hazards of litigation with respect to its tax positions.  Obviously, given the nature of these workpapers, they have been a source of conflict between the Service and taxpayers and would be quite valuable to the Service as they would likely contain a virtual roadmap to the weak points of any tax position

 

Textron

 

Like many large taxpayers, Textron Inc. and its subsidiaries, were subject to regular audits. During the 1998–2001 audit cycle, the IRS learned that Textron had entered into “sale-in, lease-out” financing transactions that were also classified as listed transactions. Textron responded to the majority of IRS Document Requests (IDRs) issued, but refused to respond to IDRs seeking tax accrual workpapers. Textron asserted that these workpapers were protected under the tax advisor privilege, the attorney-client privilege and the attorney work-product doctrine. Initially, the district court found in favor of taxpayers and ruled that the accrual workpapers were afforded protection under the tax advisor privilege, the attorney-client privilege and the attorney work product doctrine. (U.S. v. Textron Inc., 507 F.Supp.2d 138 (D. R.I. 2007)).

 

Although the privilege[2] of confidential communication was waived under the tax advisor and attorney-client privileges by disclosure to Textron’s auditor (E&Y), waiver had not occurred with respect to the attorney work product doctrine.  Specifically, the attorney-client and tax practitioner privileges are waived by disclosure to any third party.  By contrast, the work product protection is waived only if disclosure is in a manner that is inconsistent with keeping the information from an adversary.

 

The tax accrual workpapers in Textron consisted of a spreadsheet containing: (1) lists of items on Textron's tax returns, which, in the opinion of Textron’s counsel, involved issues on which the tax laws are unclear, and therefore maybe challenged by the IRS; (2) estimates by Textron’s counsel expressing, in percentage terms, their judgments regarding Textron’s chances of prevailing in any litigation over those issues (i.e. the hazards of litigation); and (3) the dollar amounts reserved to reflect the possibility that Textron might not prevail in such litigation (i.e. the tax reserve amounts). In addition, back-up workpapers included notes and memoranda written by Textron’s in-house tax attorneys, reflecting their opinions as to which items should be included on this spreadsheet and the hazard percentage that should be applied to each item.

 

In an August 2009 decision by the U. S. Court of Appeals for the First Circuit on this matter (United States v. Textron Inc., No. 07-2631), the court ruled that the IRS can obtain tax accrual workpapers by IRS summons, reversing a lower court ruling. The scope of this ruling is not limited to tax accrual workpapers or tax shelters.

 

While the ruling is law only in the First Circuit[3] it is persuasive authority in other Circuit Courts unless and until there are definitive rulings on the same issue on those other Circuits.

 

The Privilege in Practice

 

What is clear is that this decision will have important implications for CPAs working with attorneys and auditors on certain types of engagements.  While tax advisors should take proactive measures to protect their clients’ workpapers, clients and their counsel should be advised that such workpapers may not be protected by the work-product privilege, and the client should be advised to consult with their counsel on this issue prior to adopting a tax return position.

 

FAS 109 and FIN 48 engagements[4] – The IRS Office of Chief Counsel has advised that FIN 48 workpapers are considered tax accrual workpapers. (Chief Counsel Memorandum, AM 2007-0012).  Public companies that are subject to GAAP for years starting after December 2006, and all nonpublic companies subject to GAAP for years starting after December 2008[5] must comply with FIN 48 in providing reserves for uncertain tax positions.

 

Internal Revenue Manual, Section 4.10.20 announces that it may request tax accrual workpapers of taxpayers that have engaged in listed transactions. Announcement 2002-63, 2002-2 CB 72. Further, the IRS has stated that FIN 48 disclosures "should be considered by examiners and agents when conducting risk assessments."[6]

 

Protection of the tax advisor, attorney-client and work product privilege for tax and audit clients with tax provisions and FIN 48 analysis may require measures to isolate and restrict the flow of information.  Some have suggested that CPAs obtain confidentiality agreements from auditors.  In addition, some recommend stating in the engagement letter that audit clients will have ownership control over any protected documents in the workpaper files. However, in the end, the client should be advised that it is their responsibility to consult with their counsel regarding:

·   the implications of adopting tax return positions and work-product privilege with respect to the preparation of and reporting on the company’s financial statements, and

·   the risks of adopting a tax return position which could be challenged by taxing authorities and result in a material change to the company’s financial statements.    

 

Litigation Support Work, including Preparation of Amended and Delinquent Returns – With complex financial litigation cases, accountants are increasingly being hired by attorneys as litigation consultants.  In addition, with tax amnesty programs and increasingly severe tax penalties, accountants are more frequently being approached by taxpayers and/or attorneys to assist with the preparation of amended or delinquent tax returns.  For instance, existing clients “fess up” and seek assistance to resolve past delinquencies that were previously not disclosed to their accountant.  In addition to obvious privilege problems, this raises the issue of the need to amend prior year returns signed by the accountant that were inaccurate because relevant information had been withheld by the client.

 

 

Kovel Letters.  Despite difficulties with protections under the tax advisor privilege, accountant-client communications and work product may still be protected from disclosure when the accountant works as an agent or an attorney rendering legal services, i.e. the so called Kovel rule. (U.S v. Kovel, 296 F.2d 918 (2nd Cir. 1961), U.S. v. Judson, 322 F.2d 460 (9th Cir. 1963))  Accountants are presented with Kovel letters by attorneys which indicate that all work product is prepared at the direction of the attorney, and that all supporting workpapers are property of the attorney’s law firm and must be surrendered to the law firm at their request, with the accountant prohibited from maintaining copies.

 

With each of the above types of engagements, tax accountants and auditors are understandably uneasy about the implications these arrangements have to their independence.  For instance, if an accountant signs a confidentiality agreement, would that result in possibly losing audit evidence that supports their conclusions on a client’s tax provision?  

 

Absent the full cooperation of the client’s attorney, agreeing to surrender supporting workpapers to the law firm clearly jeopardizes the ability of the accountant to defend their work in the event of a malpractice claim. While as a practical matter there are good reasons for a Kovel letter to maintain the cloak of privilege, ultimately the accountant needs to satisfy themselves regarding the competence, integrity and professionalism of the client’s attorney prior to agreeing to accept the engagement. For obvious reasons, it’s also a good idea to obtain verification that the law firm maintains adequate professional liability insurance prior to accepting such an engagement.  

 

As we previously identified, to the extent that an accounting firm performs an audit of a client's financial statements, it is quite possible that those 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, an issue would be whether the tax information becomes a matter of public record. 

 

At a minimum, if a practitioner wants to ensure work-product protection for its workpapers, measures should be taken to limit access to those workpapers. Those measures could be as simple as stamping materials as confidential work product.  Additional measures could include confidentiality agreements by all persons to whom the documents are disclosed and use restrictions to prevent inclusion of such workpapers in any other document.

 

An additional measure that could be taken with tax accrual workpapers would be to segregate the more substantive tax opinions and legal analysis that could be protected under the work product doctrine from more general lists and summary workpapers without any substantive analysis, which could be more freely discoverable in the event of an IDR request. In other words, perhaps files could be organized according to different levels or tiers, which would separate accrual workpapers from underlying analysis that should remain privileged.

 

Finally, when a tax practitioner has a client who has potential fraud or criminal exposures the practitioner should refer the client to an attorney experienced in these areas as the earliest possible time. Communication between the tax practitioner and the taxpayer will not be privileged and may be discovered by the authorities. The attorney will be able to manage communications to maximize the scope of the attorney-client privilege. The tax practitioner should consider disengaging from other ongoing work for the client, as well as their obligations under the Statements on Standards for Tax Services and Circular No. 230 to notify the client regarding previously prepared tax returns that may be inaccurate based upon information that came to the practitioner’s attention.

 

Lastly, should the attorney wish to engage the practitioner to perform further tax services on behalf of the client, the practitioner should consider the risks of continued association with the client, and consult with their own attorney prior to agreeing to undertake the engagement or signing a Kovel letter.  

 

Conclusion

 

The continuing efforts to narrow the scope of the tax advisor privilege should remain an issue of concern and CPAs should be aware of how to protect their client engagements.  It would appear based upon the decision of the First Circuit Court of Appeals in Textron that tax accrual workpapers will not be protected from IRS discovery, although this decision will likely be submitted for review by the Supreme Court and other circuit courts have taken contrary positions.  In the meantime, CPAs should continue to heed our earlier advice to consider this issue in their engagement planning and performance, disclosures to clients, document and information control, and internal firm engagement administration. In addition, CPAs should continue to remain 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.

 

Arthur V. Pearson, J.D. LLM (tax)

Karen Neville, JD

Murphy, Pearson, Bradley & Feeney

88 Kearny Street Suite 1000

San Francisco, California 94108

 

 

 

 

[1] Revisiting the Tax Advisor Privilege of Confidential Communication 

[2] The tax advisor privilege, since it is modeled on the attorney client privilege, is in fact a two part privilege. First, it protects confidential communications between the advisor and the taxpayer. Second, it protects the work product of the tax advisor.

[3]  The First Circuit covers Maine, New Hampshire, Massachusetts, Rhode Island, and Puerto Rico.

[4] (FASB Interpretation 48: Accounting for Uncertainty in Income Taxes — an interpretation of FASB Statement No. 109)

[5] See FASB 48-3.

[6] Memorandum for Executive Managers and Examiners-Large and Midsized Business Division (May 2007, LMSB-04-0507-044).