This exception also applies to communication with the person’s director, officer, employee, agent, or representative, or any party holding a capital or profits interest in the person.
In general, the burden of proof in asserting a privilege is on the party claiming the privilege, in this case, the taxpayer. When an exception is claimed, however, the opposing party must exhibit some evidence that the exception applies. When the IRS claims the application of the tax shelter exception, it must introduce evidence that the documents it seeks are related to a tax shelter and were created in connection with promoting participation in that shelter either directly or indirectly. The fact that a communication relates to a tax shelter is not sufficient to overcome the privilege; it must be in promotion of participation.
Case law on this exception is limited. However, two elements have emerged as the subject of significant analysis by the courts: that the communication must be written, and that it must be in connection with the promotion of a tax shelter.
Written communication: Although this might appear to be the least ambiguous of the requirements for the exception, in Countryside Limited Partnership,25 the Tax Court took an interesting viewpoint. It determined that handwritten notes taken by a partner during a series of tax planning meetings with the partnership’s tax accountant merely reflected oral communications that did not meet the requirement of a written communication because they were not communicated to anyone. It was decisive that the notes were not shared with anyone, and this meant there was no transmission of the written material. In BDO Seidman, LLP,26 the Seventh Circuit, in considering the tax shelter exception, noted that oral communications between a practitioner and client remain within the general rule of the privilege.
Promotion: Several courts have applied their own definition of “promotion,” with varying results. Congress did put a boundary on the definition when it excluded routine communications from the exception. Committee reports indicate “[t]he Conferees do not understand the promotion of tax shelters to be part of the routine relationship between a tax practitioner and a client.”27 In Countryside,28 the Tax Court refused to treat the accountant’s input as promotion because it appeared to be part of the routine advice offered over a long-term relationship and was not subject to any unusual billing or special arrangement. The court noted that the tax advice provided was distinct from promotion of a tax shelter. The advice was offered in response to a client request, and the accountant had no stake in the outcome.
In Valero,29 the Seventh Circuit emphasized that promotion would be a preliminary activity and relied on that interpretation to conclude that tax advice on how to structure a substantial foreign currency loss constituted promotion. It refused to confine the exception to “actively marketed tax shelters or prepackaged products”30 and held the exception included advice given on a single transaction that appeared to meet the definition of a tax shelter.
Criminal Proceedings Exception
As mentioned earlier, the privilege for communication with a tax adviser is much more limited than that for an attorney. It does not extend to criminal proceedings and does not go beyond the IRS or federal court system. Consequently, at some point, the client is best protected by relying on representation by an attorney, and it is important for the accountant to recommend that course when it appears the case may become a criminal one.
It may sometimes be important for the accountant to continue to participate in the case even though any advice rendered would not be privileged. When an accountant provides input that enables the client to communicate with an attorney, that communication may be protected under the attorney-client privilege if the accountant is hired by the attorney to provide this clarification. Often referred to as a Kovel31 arrangement, this relationship invokes attorney-client privilege when the accountant’s input enables the attorney to understand the client’s communication.
A Kovel arrangement does not extend attorney-client privilege to the accountant as an adviser. Rather, the accountant plays a similar role to that of a foreign language interpreter in facilitating communication between attorney and client. Engagement letters, confidentiality agreements, and billing invoices may all be evidence in clarifying the distinction between an accountant’s participation as an adviser versus an “interpreter.”
The Kovel court asserted that “the presence of an accountant, whether hired by the lawyer or by the client, while the client is relating a complicated tax story to the lawyer, ought not destroy the privilege.”32 A taxpayer’s advisers must recognize that point in the communication process where the attorney-client privilege should be the prevailing protection. If the accountant’s input is still necessary, a Kovel arrangement might be established and should be carefully documented.
Cavallaro33 illustrates the importance of documenting the role of the accountant in such an arrangement. In Cavallaro, the taxpayers wanted to claim that a Kovel arrangement was created by the presence of an accountant at a family tax planning meeting with their attorneys. The court looked to both the accounting firm’s engagement letter and its invoice to determine the actual designated role of the accountant. The engagement letter indicated that the accounting firm was hired to provide tax planning advice to a corporation controlled by the two Cavallaro sons, and no other documentation indicated any change in that role. An invoice indicated that some tax advice had been provided to both the sons’ corporation and a corporation controlled solely by the parents, but it did not provide evidence that the accounting firm was acting as an agent of the Cavallaro family (or their lawyers) to assist in securing legal advice. On this basis, the court concluded that there was insufficient evidence of a Kovel arrangement. This case illustrates the importance of documenting the accountant’s role, especially where that role might change from the initial designation.
The work product doctrine essentially prevents an adversary from benefiting from the efforts of an opponent. It protects materials that are collected or prepared in anticipation of litigation unless the adverse party can demonstrate that the materials are indispensable to the party’s case and there are no other means of obtaining them. Even when that exception applies, however, the court must still protect against disclosure of the “mental impressions, conclusions, opinions, or legal theories of a party’s attorney or other representative concerning the litigation.”34 Thus, the work product privilege may cover work of representatives other than attorneys.
Like the attorney-client privilege, the work product doctrine is subject to confidentiality rules; thus, disclosure to a third party may waive the privilege. However, the disclosure rules are less restrictive in this context. If the third party is not an adversary or a conduit to an adversary, disclosure will not constitute a waiver if, overall, there is a reasonable expectation of confidentiality on the part of the third party.
For example, in Deloitte & Touche USA LLP,35 documents prepared by a taxpayer corporation were disclosed to an outside auditor. The court held that the privilege was not waived, noting that the auditor was not a potential adversary and the corporation had a reasonable expectation the auditor would keep the documents confidential.36 Although a third party often could become an adversary in some future litigation, the concern in applying the work product rule is whether the third party could be an adversary with respect to the litigation addressed in the protected documents.
Work product protection applies to documents prepared by the taxpayer or the taxpayer’s representative. It does not protect documents prepared by third parties. However, the content of the document itself, rather than its preparation, may determine the privilege. In the appeal of Deloitte & Touche USA LLP,37 the government argued that documents prepared by an outside auditor could not qualify for work product protection because they were not prepared by the taxpayers or their attorneys. The court noted that the issue was not who prepared the document but “whether the document contains work product—the thoughts and opinions of counsel developed in anticipation of litigation.”38
The courts also look at why a document was prepared. Documents that are generated as part of a routine process (i.e., not in anticipation of litigation) are not protected. Most circuits apply a “because of” test; that is, the document must be prepared because of the anticipated litigation.39 This causation test may cover a broad range of types of documents. For example, consider a document containing legal analysis about possible future litigation that was procured to help parties decide whether to go through with a proposed merger. In this circumstance, the Second Circuit held that a document “does not lose work-product protection merely because it is intended to assist in the making of a business decision influenced by the likely outcome of anticipated litigation.”40
However, other circuits follow a narrower test, requiring that the anticipated litigation be the “primary motivating purpose” behind the document’s creation.41 Because of these differences in interpretations of the privilege in the various federal circuits, it is necessary to refer to the case law of the applicable circuit when evaluating whether the privilege applies.
A special subset of work product that has been the subject of extensive litigation is tax accrual workpapers. In the Second Circuit,42 tax accrual workpapers have been held to be privileged under the because-of test if one of the purposes of creating the workpapers is in anticipation of future litigation with the IRS. In contrast, the Fifth Circuit43 held that tax accrual workpapers would be privileged only if the primary motivating purpose for creating the workpapers was possible future litigation.
However, in Textron,44 the First Circuit, while purporting to follow the because-of test, significantly narrowed it. Textron prepared its tax accrual workpapers by obtaining the opinion of legal counsel regarding estimates of the hazards of litigation for its tax positions. The company claimed work product protection since the documents, while prepared in the course of its financial audit and financial statement preparation, were created because of the anticipation of litigation with the IRS over its tax positions. The court, however, identified the workpapers as routine documents prepared for the purpose of completing financial statements and not prepared for use in litigation. Therefore, the court concluded that the work product privilege did not apply. The decision by the First Circuit appears to change the “prepared in anticipation of litigation” rule to a more restrictive “prepared for litigation” in cases in that circuit.
Overall, the application of the work product doctrine depends on who prepared the document, what it contains, and why it was prepared. It may be possible to avoid ambiguities by having outside counsel create or commission documents and by including in documentation the thoughts and opinions of counsel that clearly anticipate litigation.
The practitioner-client and work product privileges belong to the client, and it is the client who decides whether to waive them. This is true even when information is found to be privileged but the client uses it to provide substantiation for claims of deductions or losses on the client’s tax return. It is at the taxpayer’s discretion whether to provide that information to the IRS. It will also be up to the taxpayer whether to waive the privilege to raise a defense against certain penalties by claiming a good-faith reliance on the advice of counsel or a qualified practitioner. In such cases, advice from counsel can support a claim of substantial authority or reasonable cause for good-faith reporting on the tax return.
By properly clarifying their role as tax adviser—as well as documenting engagements, protecting confidentiality, properly addressing communications and work product, and monitoring their content—accountants will serve clients’ interest in preserving the privileges that may apply to their communication.
1 Hickman v. Taylor, 329 U.S. 495 (1947).
2 Fed. R. Civ. P. 26(b)(3).
3 S. Rep’t No. 105-174, 105th Cong., 2d Sess. 70 (1998).
4 Sec. 7525(a)(3).
5 S. Rep’t No. 105-174 at 70.
6 Sec. 7525(a).
7 S. Rep’t No. 105-174 at 71.
8 Upjohn Co., 449 U.S. 383 (1981).
9 Some exceptions allow the presence of a party with a common legal interest (e.g., a co-defendant) or certain agents of the attorney (e.g., secretary or unlicensed associate).
10 Santander Holdings USA, Inc., No. 09-11043-GAO (D. Mass. 8/6/12).
11 Pasadena Refining System, Inc., No. 3:10-CV-0785-K (BF) (N.D. Tex. 4/26/11).
12 Evergreen Trading, LLC, 80 Fed. Cl. 122 (2007).
13 BDO Seidman, LLP, No. 02 C 4822 (N.D. Ill. 6/29/04), aff’d in part, 492 F.3d 806 (7th Cir. 2007).
14 Id., slip op. at 4.
15 Pasadena Refining System, Inc., No. 3:10-CV-0785-K (BF) (N.D. Tex. 4/26/11).
16 For example, in Evergreen Trading, LLC, 80 Fed. Cl. 122 (2007), certain page numbers were redacted since the “numbering system itself could reveal aspects of plaintiffs’ counsel’s understanding of the case” (slip op. at 18).
17 Upjohn Co., 449 U.S. 383 (1981).
18 Clark, 289 U.S. 1 (1933).
19 BDO Seidman, LLP, 492 F.3d 806 (7th Cir. 2007).
20 H.R. Conf. Rep’t No. 105-599, 105th Cong., 2d Sess. 267 (1998).
21 Colton, 306 F.2d 633 (2d Cir. 1962).
22 Davis, 636 F.2d 1028 (5th Cir. 1981).
23 Frederick, 182 F.3d 496 (7th Cir. 1999).
24 Sec. 7525(b) was amended by the American Jobs Creation Act of 2004, P.L. 108-357, to apply to participation of any person (previously, it was participation of a corporation).
25 Countryside Limited Partnership, 132 T.C. 347 (2009).
26 BDO Seidman, LLP, 492 F.3d 806 (7th Cir. 2007).
27 H.R. Conf. Rep’t No. 105-599, 105th Cong., 2d Sess., 269 (1998).
28 Countryside Limited Partnership, 132 T.C. at 354–5.
29 Valero Energy Corp., 569 F.3d 626 (7th Cir. 2009).
30 Id., slip op. at 16.
31 Kovel, 296 F.2d 918 (2d Cir. 1961).
32 Id. at 922.
33 Cavallaro, 284 F.3d 236 (1st Cir. 2002), aff’g 153 F. Supp. 2d 52 (D. Mass. 2001). The tax years at issue were before the enactment of Sec. 7525; thus, the practitioner privilege was not available as an alternative protection.
34 Fed. R. Civ. P. 26(b)(3)(B).
35 Deloitte & Touche USA LLP, 623 F. Supp. 2d 39 (D.D.C. 2009), aff’d in part, 610 F.3d 129 (D.C. Cir. 2010).
36 In this case, the court found it reasonable to expect that CPAs, subject to Rule 301 of the AICPA Code of Professional Conduct, which prevents members from disclosing confidential client information without consent, would keep work product confidential.
37 Deloitte, LLP, 610 F.3d 129 (D.C. Cir. 2010).
38 Id., slip op. at 9.
39 See Adlman, 134 F.3d 1194 (2d Cir. 1998); Rockwell Int’l, 897 F.2d 1255 (3d Cir. 1990); National Union Fire Ins. Co. of Pittsburgh v. Murray Sheet Metal Co., 967 F.2d 980 (4th Cir. 1992); Roxworthy, 457 F.3d 590 (6th Cir. 2006); Binks Mfg. Co. v. National Presto Indus., Inc., 709 F.2d 1109 (7th Cir. 1983); Simon v. G.D. Searle & Co., 816 F.2d 397 (8th Cir. 1987); In re Grand Jury Subpoena, 357 F.3d 900 (9th Cir. 2004); and Equal Employment Opportunity Comm’n v. Lutheran Social Servs., 186 F.3d 959 (D.C. Cir. 1999).
40 Adlman, 134 F.3d at 1195.
41 Davis, 636 F.2d 1028 (5th Cir. 1981).
42 Adlman, 134 F.3d 1194 (2d Cir. 1998).
43 El Paso Co., 682 F.2d 530 (5th Cir. 1982).
44 Textron Inc., 507 F. Supp. 2d 138 (D.R.I. 2007), rev’d, 577 F.3d 21 (1st Cir. 2009) (en banc), cert. denied.
Linda Burilovich is a professor in the Department of Accounting and Finance at Eastern Michigan University in Ypsilanti, Mich. For more on this article, contact Prof. Burilovich at email@example.com.