by Arthur V. Pearson and John E. McFadden
Be careful what you wish for, your wish may come true. This bit of ancient wisdom from Aesop, revisited over time by the likes of J.R. Lowell and Oscar Wilde, may come to mind as we explore the privilege of confidential communication conferred on tax advisors by Congress in the Internal Revenue Restructuring and Reform Act of 1998 (the "Act"). Many in the accounting profession have pushed for such a privilege for many years. Now that we have it, what is it and what do we do with it?
As with all things created legislatively, we must examine the law creating the privilege. Briefly, new IRC 7525 provides that "tax advice" given by a "federally authorized tax practitioner" carries the same privilege as does attorney-client communications. The privilege may only be used in certain specified situations and circumstances.
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 new privilege.
The privilege does apply to:
The language of the statute suggests the privilege does not apply to:
Because this is not an absolute privilege, CPAs need to make clients aware of the limitations of the privilege, understanding that it may not engender the total client candor that many had hoped for. On the other hand, the attorney-client privilege has its limitations, but is a far broader privilege concerning 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.
The statute defines tax advice given by an individual with respect to a matter which is within 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 will be in dispute.
It is well known that attorneys who enjoy the privilege of confidential communication in tax matters usually do 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 may need to begin 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. It is a new hazard for CPAs whose engagements may straddle that line.
On a positive note, the Act is likely to limit examining IRS agents in interviewing the tax return preparer, examining the preparer's internal files and memoranda, or intimidating the accountant. Potential problems may arise here, however, if a CPA 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 is 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. Thus, the definition is hardly helpful in understanding the exact nature of "tax advice." While it is safe to assume that tax advice to clients must be 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.
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 lead to "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. Law firms who find themselves in analogous situations typically have to disqualify themselves and possibly withdraw from the entire engagement. Accounting firms may find themselves in the same position. Disclosure may result in waiver of the privilege.
Some suggest 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. 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.
The CPA firm also may find it prudent to advise clients that inadvertent disclosures made by the client to third parties such as banks, leasing companies or sureties could result in loss of the privilege.
The privilege of confidential communication does not apply to state tax issues or state tax proceedings. Consequently, the IRS could obtain that information though 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 the 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 likely be successfully litigated.
The new 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 the 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 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.
In the same Act, Congress enacted a shift in the burden of proof in tax controversies. Questions arise regarding how that might interface with the tax advisor privilege of confidential communication. For example, the taxpayer must cooperate with the IRS at all stages of the examination for the burden of proof to be shifted to the government. If the taxpayer incorrectly asserts the privilege of confidential communication (which a court may subsequently find inapplicable), will that be interpreted as a lack of cooperation by the taxpayer? Will that defeat attempts to shift the burden of proof? The answer is unknown.
The existence of the privilege of confidential communication also may make the IRS more intrusive in its audits and investigations in an attempt to avoid the application of the privilege by using discovery, third party summons, or other legal devices.
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:
"The Internal Revenue Restructuring and Reform Act of 1998 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."
The IRS has never easily conceded much ground when dealing with the attorney-client privilege of confidential communication or attorney work product. It is unknown how the Service will deal with the new tax advisor-taxpayer privilege of confidential communication. It is a safe assumption, however, that the Service will work to narrow the privilege as they have with the attorney-client privilege. 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.
(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.
Arthur V. Pearson is a partner with Murphy, Pearson, Bradley & Feeney. John E. McFadden is a Risk Management Consultant with the Accountants Professional Liability Group at CNA Pro, Chicago, Illinois.