Home · Online Publications · The Tax Adviser · Online Issues · October 1998 · Table of Contents · The New CPA-Client Confidentiality Privilege

Section 3411(a) of the Internal Revenue Service Restructuring and Reform Act of 1998 (IRSRRA 98) added Sec. 7525 to provide a new privilege of confidentiality (Confidentiality Privilege) to certain communications between CPAs and other Federally authorized tax practitioners (FATPs) and their clients. The Confidentiality Privilege is similar to the attorney-client privilege, but is limited to certain tax advice. This article provides guidance about the new privilege for CPAs and their clients.

Need for the Privilege

In Couch,¹ the Supreme Court held that Federal law does not recognize an accountant-client privilege.² In Arthur Young & Co.,³ the Supreme Court held that the work-product doctrine did not prevent the IRS from obtaining an independent CPAs tax accrual workpapers, because [t]o insulate from disclosure a certified public accountants interpretation of the clients financial statements would be to ignore the significance of the accountants role as a disinterested analyst charged with public obligations. Since Arthur Young, the AICPA has considered the need for a CPA-client privilege.

The IRSs policy, as described in the Internal Revenue Manual (IRM), is to seek tax accrual workpapers only in unusual circumstances.⁴ However, in recent years, the IRS has become more aggressive, through financial status or life-style auditing, Information Document Requests and summonses and subpoenas to seek tax accrual workpapers, internal tax memos, tax opinions, tax engagement letters, billing statements and other similar documents from taxpayers and their CPA representatives. This led the AICPAs Tax Executive Committee to recommend to the IRS that the IRM be amended to include similar limits on seeking tax advice communicated between CPAs and their clients. The IRS National Office declined to expand the IRM workpaper policy.

Because most taxpayers who are represented before the IRS use CPAs and enrolled agents, rather than lawyers, taxpayer privacy interests dictated a need for CPAs and their clients to seek confidentiality protection similar to the attorney-client privilege. Further, the AICPA contended that taxpayers should have the ability to freely choose their tax practitioners without fear of jeopardizing their privacy in tax matters. Because of these needs and concerns,⁵ the AICPA helped form a coalition that sponsored legislation to create a CPA-client privilege in tax matters before the IRS. These activities contributed to the enactment of the Confidentiality Privilege. According to the IRSRRA 98 Conference Report,⁶ the provision allows taxpayers to consult with other qualified tax advisors in the same manner they currently may consult with tax advisors that are licensed to practice law.

Overview

New Sec. 7525 extends the common-law attorney-client confidentiality privilege to tax advice furnished to a taxpayer-client (or prospective client) by any individual authorized under Federal law to practice before the IRS (FATPs). FATPs are CPAs, attorneys (including those employed by ac-counting firms), enrolled agents and enrolled actuaries. (Hereinafter, all references to CPAs include other FATPs.) Tax advice is defined by Sec. 7525(a)(3)(B) as advice given by a CPA within the scope of authority of his practice with respect to matters under the Code. The Confidentiality Privilege is effective for communications made on or after July 22, 1998, the date the new law was enacted. A last-minute amendment added Sec. 7525(b) (discussed below under Tax Shelters) to prevent the Confidentiality Privilege from applying to certain written communications regarding corporate tax shelters.

Scope of the Attorney-Client Privilege

Because Sec. 7525(a)(1) provides that the Confidentiality Privilege is similar to the common-law privilege between a taxpayer and an attorney, it is necessary to understand the scope of the attorney-client privilege. A common-law privilege of confidentiality exists for communications between an attorney and client for purposes of obtaining legal advice. Communications protected by the attorney-client privilege must be based on facts of which the attorney is informed by the taxpayer, for the purpose of securing the attorneys professional advice in confidence.

The privilege applies only when the attorney is advising the client on legal matters; it does not apply when an attorney is acting in another capacity (such as a business adviser) or when an attorney licensed to practice another profession is performing such other profession. Thus, a taxpayer may not claim the benefits of the attorney-client privilege simply by hiring an attorney to perform some other function. For example, if an attorney is retained to prepare a tax return, the return preparation services will not be protected.

The new provision does not modify or expand the existing attorney-client privilege, other than to extend it to CPAs. The Confidentiality Privilege applies only to the extent that communications would be privileged if they were between a taxpayer and an attorney. Accordingly, the Confidentiality Privilege does not apply to any communication between a CPA and his client (or prospective client) if the communication would not have been privileged between an attorney and client (or prospective client). Because information disclosed to an attorney for the purpose of preparing a tax return or providing accounting services is not privileged under present law, such information would not be privileged if it were disclosed to a CPA.

The attorney-client privilege is considered waived if the communication is voluntarily disclosed to anyone other than the attorney, the client or certain persons under the direction and control of the attorney or client.

Scope of the Work-Product Doctrine

The work-product doctrine provides an additional defense to compelled disclosure. If a CPAs document is considered work product but the Confidentiality Privilege does not apply, protection from an IRS summons or subpoena becomes more complicated. Neither Sec. 7525 nor the IRSRRA 98 Committee Reports refer to the work-product doctrine. However, a CPAs work product under case law can be protected under the work-product doctrine in two circumstances: (1) when documents are prepared by the CPA as the taxpayers representative, in anticipation of litigation, and (2) when documents are prepared by a CPA under the direction and control of an attorney. (These circumstances are described below under Adlman and Criminal Tax Matters.)

The work-product doctrine that has evolved under case law has been codified in Rule 26(b)(3) of the Federal Rules of Civil Procedure (FRCP), which states that documents prepared in anticipation of litigation or for trial are discoverable only on a showing of substantial need of the materials and the inability, without undue hardship, to obtain their substantial equivalent elsewhere. Even when the showing has been made, however, the court shall protect against disclosure of the mental impressions, conclusions, opinions, or legal theories of an attorney or other representative of a party concerning the litigation. Some courts have made a distinction between factual work product discoverable under the first test, and opinion work product absolutely protected under the second test.⁷

The Confidentiality Privilege

Definition

Sec. 7525(a)(1) states: With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication between a taxpayer and an attorney.

What is tax advice or a communication? Tax advice is defined in Sec. 7525(a)(3)(B), but communication is not. The Committee Reports do not provide any additional insight. Sec. 7525(a)(3)(B) provides that tax advice means advice given by an individual with respect to a matter which is within the scope of the individuals authority to practice... as an FATP. There is no limit as to whether the tax advice should be oral or written, or if written, the form and proximity of the written material to any oral advice being given. Thus, it appears that both oral and written advice by a CPA to a taxpayer on a Federal tax matter can be protected under the Confidentiality Privilege. (Tax advice on state and local matters is not covered by the Confidentiality Privilege,⁸ but may be protected under applicable local law.) In the absence of statutory or committee guidance on these items, one can refer only to Sec. 7525(a)(1), which looks to the common-law protections of confidentiality that would apply if the communication were between a taxpayer and an attorney.

Regulations Proposals

Because Sec. 7525 does not offer clear guidance on the meaning of tax advice or communication and the circumstances or documents that might qualify for the Confidentiality Privilege, it is anticipated that regulations will address these shortcomings. Although the statute refers to the common law as the standard, there is a need for regulations to provide more specific guidance on the various issues that can arise under such vague language.

The regulations should also provide that tax advice communication may be oral or written, and can include thought processes, mental impressions and speculations related to the communication with the client. The term communications should include transmission by telephone, fax or e-mail. As in the case of any oral or written communication, precautions must be taken to avoid inadvertent disclosure to third parties, which could cause the privilege to be waived.

As to the types of documents that qualify for the Confidentiality Privilege, the regulations should acknowledge that tax advice is communicated through many kinds of documents, including discussion memos, notes, letters, opinion letters, planning papers, discussions of alternatives for structuring a transaction, an assessment of audit or litigation chances if challenged by the IRS, analyses of contrary authorities, and transfer-pricing and valuation reports for tax purposes. The tax engagement letter and the tax billing statement are communications to the client that contain information relating to the tax advice, and should also be protected. (Hereinafter, all of these written items are termed tax advice documents.)

Tax Advice Documents

Swidler & Berlin⁹ involved a subpoena by Independent Counsel Kenneth Starr to obtain three pages of handwritten notes by an attorney that resulted from a two-hour initial meeting between the attorney and his client, Vincent Foster. The notes were retained in the attorneys file, and were not sent to the client. The Supreme Court ruled, in part, that the notes were protected by the attorney-client privilege; thus, it was not necessary to decide whether the notes were protected by the work-product doctrine. It would be reasonable to conclude that a CPAs notes of tax advice discussed with the client, even though placed in the file and not sent to him, would be protected under the Confidentiality Privilege. Based on this interpretation, it may be reasonable to further infer that tax advice documents, prepared after a discussion with the client and relating to it, but never transmitted to the client, and instead put in the clients file, may also be related tax advice that would be protected by the attorney-client privilege and, thus, the Confidentiality Privilege. (The primary holding in Swidler & Berlin was that the common-law attorney-client privilege survives the clients death; this principle would also protect the disclosure of tax advice subject to the Confidentiality Privilege after a taxpayer-clients death.)

The next issue is whether tax advice documents, prepared as a case, transaction or other matter subsequently develops, that are placed in the clients file, but never sent to the client, qualify for the Confidentiality Privilege. The argument in favor of the Confidentiality Privilege would be that but for the clients tax matter and the earlier tax advice communication, the tax advice documents would not have been prepared, and they are available for transmittal (or communication) to the client on request.

At this point, it becomes apparent that a CPA should maintain a separate, secure client tax file that contains all tax advice documents available for access and retention by the client. The file and tax advice documents should be labeled Privileged and Confidential Tax Advice Under IRC Sec. 7525 and Work-Product Doctrine. This is crucial to arguing that these tax advice documents are available for communication to the client.

Criminal Tax Matters

Sec. 7525(a)(2) provides that the Confidentiality Privilege may only be asserted in any noncriminal tax matter (1) before the IRS or (2) proceeding in Federal court brought by or against the U.S. Thus, it is crucial to know when an ordinary tax matter may turn into a criminal matter, because at that point, although it is not free from doubt, it appears that the Confidentiality Privilege is stripped away and the IRS can obtain all communications between the CPA and the client, even if they were protected during a pre-criminal referral period. This issue is unclear under Sec. 7525; hopefully, regulations will clarify this issue by providing protection for that earlier period. Clearly, it is a criminal matter if the IRS has referred a case to the Department of Justice and the referral is accepted.

However, because of the potential retroactive loss of the Confidentiality Privilege, the best practice is that at the first hint of criminal activity (usually when an IRS special agent appears), the CPA should recommend to the client that an attorney experienced in criminal tax matters be consulted. Any other approach may result in a waiver of the Confidentiality Privilege and malpractice exposure for the CPA. There is a need for regulatory guidance as to when a civil tax matter becomes a criminal tax matter.

If the CPA is to remain involved in the case after the tax matter turns criminal, the CPA should obtain a new engagement letter from the attorney who will be representing the taxpayer in the criminal matter. This is known as a Kovel letter, from a case¹⁰ holding that the attorney-client privilege extends not just to an attorneys ministerial staff, but also to an accountant working for the attorney. The Kovel letter provides that the CPA is working under the direction and control of an attorney. The attorney-client privilege will be available for tax advice communicated between the CPA, attorney and client; the work-product doctrine should apply to tax advice documents prepared by the CPA for the attorney and client.

Nontax Matters

Because the Confidentiality Privilege can only be used in noncriminal tax matters, it cannot be asserted to prevent the disclosure of information to any regulatory body other than the IRS. The ability of any other regulatory body, such as the Securities and Exchange Commission, the Federal Trade Commission, the Environmental Protection Agency, etc., to gain or compel information in an administrative or court proceeding is unchanged. The Confidentiality Privilege is also not available for assertion in private civil litigation (such as domestic relations and employment disputes), even if tax matters are involved or contested.

Practical Applications

Advising Clients

A CPA should have a separate engagement letter dealing with tax matters covered by the Confidentiality Privilege. The letter should describe the new privilege, its general application, and the clients ability to assert the privilege. The client should be instructed to notify the CPA if the IRS requests information about any tax advice or tax advice documents provided by the CPA. Also, the client should be told that disclosure of any such confidential information to the IRS or other third party may cause the Confidentiality Privilege to be waived, and that the client should be cautious not to inadvertently waive the privilege.

The engagement letter should also provide that the client must give the CPA written consent before the CPA will release any information subject to the Confidentiality Privilege. The client should be asked to acknowledge that tax information shared with auditors may not be covered by the Confidentiality Privilege.

Finally, the client should be informed that if the CPA receives direction from the client to assert the Confidentiality Privilege on the clients behalf, the client will hold the CPA harmless and indemnify him for any attorneys fees and other costs and expenses (including penalties) incurred by the CPA in defending the confidential communication.

The CPA should submit two billing statements, one for tax advice matters and one for all other matters. Although this may be cumbersome, it may be the only clear way to preserve the Confidentiality Privilege for information that may be revealed by the billing statement.

Managing Employees and Auditors

The CPA should explain the Confidentiality Privilege to non-FATP employees and auditors with whom he shares tax information. A dual file system should be instituted, one for all tax advice documents (marked Privileged and Confidential Tax Advice Under IRC Sec. 7525 and Work-Product Doctrine) and one for all nonprivileged material.

The engagement should be managed by the CPA. All non-FATPs, secretaries and other staff should be under the management, supervision, direction and control of a CPA. Privileged information should not be shared with anyone not involved in the engagement. Even privileged information shared within a firm with persons who are not involved in the clients tax matter that is sanitized, with appropriate deletions of identifying information, may still carry a risk of inadvertent waiver of the Confidentiality Privilege. If the CPA needs to retain outside consultants, a Kovel engagement letter providing that the consultant is working under the direction and control of the CPA is needed. That letter should also describe the scope of the Confidentiality Privilege, as contained in the client engagement letter, including warnings against inadvertently waiving the privilege.

Adlman

Although involving facts occurring before the IRSRRA 98, Adlman¹¹ provides an opportunity to test the scope of the Confidentiality Privilege and the work-product doctrine. In that case, an attorney at a CPA firm prepared for Adlman (an in-house corporate tax counsel) a 58-page legal analysis of likely IRS challenges to a proposed reorganization and resulting refund claim. The analysis proposed legal theories and preferred methods of structuring the transaction and predicted the likely outcome of litigation. The district court rejected Adlmans claim that the document was protected by the attorney-client privilege, because it held that Adlman had not consulted the CPA firm to obtain assistance in furnishing legal advice to the corporation. Because the tax analysis might have qualified for the attorney-client privilege had Adlman consulted with outside counsel, it is arguable that now, it would be protected under the Confidentiality Privilege. However, because the CPA firms tax analysis was not protected by the attorney-client privilege at that time, the Second Circuit was asked on appeal to determine whether the work-product doctrine protected the tax analysis from disclosure.

Ultimately, the Second Circuit held that the phrase prepared in anticipation of litigation or for trial in FRCP Rule 26(b)(3) was broader than preparation for trial. It held that the phrase would also protect from discovery a document that was prepared because of the prospect of litigation. The Second Circuit remanded the case to the district court to determine whether: (1) the CPA firms tax analysis would have been prepared irrespective of expected litigation with the IRS, as part of the ordinary course of business of corporate restructuring (not privileged as work product) or (2) the tax analysis was prepared because of anticipation of litigation with the IRS (privileged as work product). The court also stated that a document that was prepared to assess the likelihood of litigation, even if it led to a business decision, could be protected. Thus, it is also possible for this type of CPA tax analysis to be protected under the work-product doctrine.

Attorneys Employed by CPA Firms

Many attorneys employed by CPA firms are engaged in providing the kind of tax advice described in Sec. 7525. Adlman involved an attorney employed by a CPA firm who prepared the tax analysis that the IRS tried to discover. Because the court found that Adlman was not seeking legal advice when he consulted with the CPA firm, the attorney-client privilege did not apply. If Adlman had consulted with a law firm and received the same tax analysis, it may have been protected by the attorney-client privilege. The Confidentiality Privilege should apply to tax advice communicated by an attorney, an FATP, employed by a CPA firm.

Avoiding Waiver

The Confidentiality Privilege may be waived in the same manner as the attorney-client privilege. Waivers may occur through an express and voluntary surrender of the privilege, partial disclosure of a privileged document, selective disclosure to some outsiders, but not all, and inadvertent overhearing or disclosures.¹² Usually, an intent to maintain confidentiality is necessary to avoid a waiver.

Massachusetts Institute of Technology¹³ (MIT) involved whether MITs disclosure of law firm billing statements and minutes of the corporation and its executive and audit committees to the auditing agency of the Department of Defense caused it to lose its attorney-client and work-product privileges in defending against the IRSs document request. The First Circuit ruled that MIT had made a voluntary disclosure by choosing to become a government contractor and submitting to the required audit requests. According to the court, disclosure to an adversary (real or potential) forfeits work-product protection. Because the audit agency was a potential adversary, the privilege had been waived. To avoid the risk of malpractice, the CPA should take steps to prevent the waiver, using the precautions described above (under Advising Clients and Managing Employees and Auditors).

Responding to Subpoenas and Summonses

AICPA Code of Professional Conduct Rule 301.01 provides that [a] member in public practice shall not disclose any confidential client information without the specific consent of the client. The accompanying explanation states that [t]his rule shall not be construed(2) to affect in any way the members obligation to comply with a validly issued and enforceable subpoena or summons, or to prohibit a members compliance with applicable laws and government regulations.... Clearly, the rules explanation has been superseded by Sec. 7525, which gives legal support to the ethical obligation of Rule 301. However, it also puts the burden on the CPA to defend against an IRS subpoena or summons that seeks to obtain information protected by the Confidentiality Privilege.

If a CPA contemplates resisting an IRS subpoena or summons, he should obtain the clients consent and the advice of counsel. Only the client has the right to assert or waive the Confidentiality Privilege, not the CPA. The CPAs engagement letter should provide that the CPA will be indemnified for any attorneys fees and other costs and penalties incurred in defending the clients rights under the Confidentiality Privilege.

Tax Shelters

Sec. 7525(b) states that the Confidentiality Privilege will not apply to any written communication between an FATP and any director, shareholder, officer, employee, agent or representative of a corporation in connection with the promotion of the direct or indirect participation of such corporation in any tax shelter described in Sec. 6662(d)(2)(C)(iii). That provision defines a tax shelter as any partnership, entity, investment plan or arrangement or any other plan or arrangement a significant purpose of which is the avoidance or evasion of Federal income tax. Tax shelters for which no privilege of confidentiality will apply include, but are not limited to, those required to be registered as confidential corporate tax shelter arrangements under Sec. 6111(d). The Conference Report states that the conferees do not understand the promotion of tax shelters to be part of the routine relationship between a tax practitioner and a client; accordingly, they do not anticipate that the tax shelter limitation will adversely affect such routine relationships.¹⁴ This is strange language given that a CPAs routine relationship with a corporate client will often result in offering the client advice on ways to minimize the Federal income tax aspects of a proposed transaction (i.e., avoidance). The language appears to create a distinction between relationships with recurring and nonrecurring clients, such that the promotion of a corporate tax shelter may not refer to the rendering of tax planning ideas to recurring clients.

Conclusion

Sec. 7525 provides a much-needed and long-awaited Confidentiality Privilege for CPAs, who now have the same common-law protection of confidentiality for tax advice in most noncriminal tax matters as do attorneys. To paraphrase the Supreme Court in Upjohn Co.,¹⁵ safeguarding communications between CPA and client encourages disclosure to the CPA that better enables the client to conform his conduct to the requirements of the law and to present legitimate claims or defenses when litigation arises.

A CPAs tax practice generally involves a combination of return preparation, tax planning and tax controversies. The following summarizes the likely effect of the Confidentiality Privilege in these areas.

Return preparation

Tax returns: Because Federal returns are intended to be disclosed to revenue officials, and are not intended to be confidential, the Confidentiality Privilege does not extend to any of these returns, nor to the basis for the numbers and calculations included in the returns.

Tax reconciliation workpapers: These are usually workpapers used in assembling and compiling financial data preparatory to placing it on a return. Because this is financial data, not tax advice, the Confidentiality Privilege likely does not apply.

Tax accrual workpapers: These are workpapers that reflect the estimate of a companys tax contingency liability. Arthur Young held that when they were prepared by an independent CPA firm, they were being prepared for the public and shareholders, and were not subject to an accountant-client privilege. These workpapers would not be viewed as tax advice, because of the CPAs public role in preparing the workpapers. Because they are not communicated in confidence, they would not be protected by the Confidentiality Privilege. (Note, however, that IRM 4024 remains in effect as an IRS self-imposed limitation on seeking such workpapers.)

Contingency reserve technical memorandum: This is usually a detailed memorandum discussing items reflected on the return, in which the ultimate tax treatment is unclear. This may contain mental impressions, thought processes and speculations on possible adverse IRS positions, the likelihood of success on the issues if challenged by the IRS, and various negotiation and settlement positions. This type of document may be distinguishable from return preparation, and may be viewed as tax planning. If the CPA communicated this document to the taxpayer, it might be tax advice protected by the Confidentiality Privilege. Alternatively, this may be protected as CPA work product prepared in anticipation of litigation.

Tax Planning

Tax advice directly to the client: These are items such as personal discussions, letters, memoranda, notes, reports, etc. This direct tax advice and the tax advice documents describing tax interpretations, opinions, mental processes, thoughts, tax positions, likelihood of success, etc., should be eligible for the Confidentiality Privilege.

Tax memoranda and other tax documents to the file: These tax advice documents may be eligible for the Confidentiality Privilege, particularly if they are kept in a separate file and access is limited to the CPA, his staff and the client.

Tax opinions: These tax advice documents are eligible for protection under the Confidentiality Privilege, provided the communication is limited to the client. If the tax opinions are disclosed to bankers, securities brokers, financial advisers and others, the privilege may be waived unless they have a role in the tax advice process. Also, a written tax opinion relating to a tax shelter could lose the Confidentiality Privilege.

Tax Controversies

Information responses to the IRS, protests, appeals, briefs: When these documents are sent to the IRS, they will likely be treated as similar to a tax return. The basis for numbers, calculations, statements of facts and other information made to support a position in these documents may be subject to discovery by the IRS. However, any backup research or memoranda reflecting mental impressions, thought processes, likelihood of success, etc., may be eligible for the Confidentiality Privilege; alternatively, the work-product doctrine is more likely to protect these items, because the controversy with the IRS may indicate that they were prepared for litigation.

Highlights

Some of the highlights of the new Confidentiality Privilege are as follows:

1. Both oral and written tax advice by a CPA to a taxpayer-client can be protected.
2. Tax advice on state and local tax matters is not covered, but may be protected under state CPA-client confidentiality laws.
3. The Confidentiality Privilege does not extend to criminal tax matters, which should be referred to an experienced criminal tax attorney. A Kovel letter, which provides that the CPA is employed by an attorney, protects CPA-client communications.
4. Separate engagement letters, billing statements and files are essential to preserve the Confidentiality Privilege for tax advice communications, including tax advice documents.
5. Engagement letters should address the Confidentiality Privilege, but it is the clients responsibility to establish and assert the privilege. The engagement letter should include an indemnity clause to reimburse the CPA for defending the clients rights under the Confidentiality Privilege.
6. The CPAs notes to the client file, mental impressions and thought processes may be protected under the Confidentiality Privilege.
7. If a CPA does not communicate a tax advice document to the taxpayer-client, but retains it in his file, and if the document is closely related in time and material to the tax discussion, under Swidler it may qualify for the Confidentiality Privilege.
8. If the tax advice document is not communicated to the taxpayer-client, and is remote in time or materiality to the tax discussion, the document may still be protected by the work-product doctrine if prepared in anticipation of litigation or pursuant to employment by an attorney under a Kovel letter.
9. The Confidentiality Privilege may be waived if a CPA communicates a tax advice document to the taxpayer-client and sends a copy to the latters banker or financial adviser; the disclosure to a third party may cause the privilege to be waived.
10. Attorneys employed by CPA firms are FATPs who may qualify under the Confidentiality Privilege.
11. Attorneys in law firms have a stake in the reasonableness of regulations under new Sec. 7525, because unduly narrow definitions of privileged tax advice communications may affect the IRSs view of the scope of the attorney-client privilege in tax matters.

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