Tax Privilege,

A Mixed Blessing

Protection for the client--not the CPA

By James A. Woehlke and Stephen E. Pascarella II

In Brief

Privilege Without a Knowledge of the Rules May Be Hazardous to Your Health

The new IRS Restructuring and Reform Act of 1998 contains a provision that extends the attorney-client privilege to clients of CPAs and other tax advisors authorized to practice before the IRS.

A privilege is a legal barrier that precludes certain confidential communication from disclosure in legal proceedings. The client holds the privilege, not the advisor. For a privilege to apply--

* there must be the right kind of relationship.

* the client must expect the communication to be held in confidence and act accordingly.

* the privilege must be intact.

The privilege will attach to communications made in the course of tax consultations and representation before the IRS, but does not apply to tax preparation. It applies only against the IRS, and does not apply to communications about tax crimes or for corporate tax shelters. There are some open issues and practice problems associated with the new tax section.

ndoubtedly, the provision of the IRS Restructuring and Reform Act of 1998 (H.R. 2676) that will most impact CPAs is a brief, 25-line IRC provision extending the attorney-client privilege to clients of CPAs and other tax advisors authorized to practice before the IRS. (IRC section 7525, "Confidentiality Privileges Relating to Taxpayer Communications," is reprinted in a sidebar.)

To understand this confidentiality privilege, tax practitioners must first understand the attorney-client privilege. That's the rub, because the attorney-client privilege is a very old legal doctrine with many twists and turns. A CPA unfamiliar with how the attorney-client privilege works and exactly how much it has been expanded for tax practitioners could easily "blow the privilege" for the client. That could be malpractice. Once the attorney-client privilege is mastered, artificial limitations to the privilege built into IRC section 7525 must also be understood.

Privileged Versus Confidential Communications

Privilege is a legal barrier that precludes certain confidential communications from disclosure in legal proceedings. All privileged communications are confidential; but not all confidential communications are privileged.

A communication is confidential when its maker intends that it not be disclosed. In most relationships, there is no ethical obligation to maintain a confidence; it's merely good manners. A CPA's relationship with his or her clients is something more, however, and so CPAs impose upon themselves an ethical imperative of maintaining client confidences in rule 301 of the Code of Professional Conduct. State laws and IRC sections 6713 and 7216 also impose confidentiality requirements on CPA tax preparers.

Of course, all confidentiality requirements have exceptions for certain disclosures. For instance, the Code of Professional Conduct places the CPA's obligation to respond to a validly issued subpoena or summons above the requirement to maintain confidentiality. The same is true of the IRC's confidentiality requirements, which permit disclosure in peer reviews. The attorney-client privilege also has exceptions; it will not apply where the client intends to commit a crime or fraud, or to the extent an attorney needs to disclose client information in the attorney's own defense.

Who Holds the Privilege?

CPAs must remember that it is the client and not the consulted professional who holds the privilege and protection. It is the client who asserts and owns a privilege, not the client's professional advisor, unless the professional is asserting it on the client's behalf.

What's Needed for the Privilege?

The new tax advisor privilege is an extension of the attorney-client privilege. So it will never apply where the attorney-client privilege would not. The following conditions must exist for the privilege to apply:

There must be the right kind of relationship. If a client believes she is confiding in a person who is an attorney, but in fact is not, the communication will be privileged. However, if a client confides in an attorney who is acting merely as a friend or business advisor, not as an attorney, the communication will not be privileged.

The client must expect the communication to be held in confidence and act accordingly. So, communications between lawyer and client in the middle of a baseball game or on the golf course with persons present who are outside the privileged relationship will not be privileged. If the client intends the communication to be made to a third party, the privilege will not apply.

The privilege must be intact. A client can waive a privilege, not merely through an expressed, knowing waiver, but also inadvertently. A disclosure of part of a communication can waive privilege for the entire communication. Also, the client's failure to assert a privilege can constitute a waiver.

Where Does the New Privilege Apply in Tax Practice?

The attorney-client privilege will attach to communications made in the course of tax consultation (pre-transaction tax planning) and representation before the IRS. The privilege does not apply to tax preparation for two reasons. First, some courts hold that tax preparation services are not legal services but instead are accounting services. More importantly, communications occurring in the process of tax preparation do not have an expectation of confidentiality. These communications are, after all, intended to result in disclosure to a third party, Uncle Sam. Since this information is to be disclosed to the government, either it was never confidential (and therefore never privileged) or, if it were confidential at one point, the filing of the tax return would constitute a waiver of the privilege. Note that the absence of privilege in tax preparation also applies to attorneys, a fact misunderstood by many lawyers. IRC section 7525 merely extends the attorney-client privilege. It does not create a privilege where one never existed [B. Graves, "Attorney Client Privilege in Preparation of Income Tax Returns: What Every Attorney-Preparer Should Know" 42 Tax Lawyer (Spring, 1989)].

Does privilege attach to communications when tax preparation services are coupled with tax consultation? One court said no, focusing on the requisite relationship. The court held that tax preparation services were not legal services--they were the services of an accountant or a "mere scrivener"--so the attorney-client relationship was never established. Another court answered the question yes, holding that only the actual information disclosed on the return would not be privileged; all other communications would remain privileged. The second court's analysis appears to be the better one. The same dilemma could arise if tax preparation is coupled with tax representation [Canaday v. U.S., 354 F.2d. 849 (8th Cir. 1966) and U.S. v. Schlegel, 313 F. Supp. 177 (D. Neb. 1970)].

Limitations on the Privilege

The new confidentiality privilege has three important limitations. The attorney-client privilege applies in each of the three cases, but IRC section 7525 specifies that communications between clients and nonlawyer tax practitioners will not be privileged.

IRC section 7525 only applies before the IRS. Therefore, if a client confides tax information to a tax practitioner and the client is later entangled in some nontax litigation, such as a divorce or lawsuit involving a contract or tort claim, the client communication is not privileged. Also, another Federal agency with authority to issue summonses can force a CPA to break the client's tax confidences.

IRC section 7525 does not apply to communications about tax crimes. Only communications related to civil tax matters are covered by the privilege. This means that if a client approaches a CPA with information about unfiled tax returns or unreported income, the CPA must still stop the client from "spilling the beans" and refer the client to an attorney.

Why does IRC section 7525 have these two limitations? The provision began as an AICPA initiative to protect CPA workpapers. Initially, the AICPA had hoped the IRS would voluntarily restrain itself from seeking CPA workpapers. This would have been accomplished via an addition to the Internal Revenue Manual, instructing IRS agents not to issue a summons for CPA workpapers, except in extreme circumstances. The IRS balked at this suggestion, and the AICPA was forced to seek a legislative remedy. Congressional drafters took the approach of extending the attorney-client privilege.

The privilege does not apply for "corporate tax shelters." This was an eleventh-hour addition made by the conference committee after both houses of Congress passed their versions of the confidentiality privilege. The problem with this limitation is that nobody yet knows what Congress meant by the term "corporate tax shelter." Does it refer only to abusive shelters or to the results of corporate tax planning?

Open Issues

There are some open issues with IRC section 7525. One is that it only applies to the extent of the authorization to practice tax. It is unclear, for example, that tax accrual workpapers developed in the course of an audit would be protected under IRC section 7525.

Another issue involves what constitutes practice before the IRS. This is important because the IRC section 7525 privilege applies for "tax advice" that means "advice given by an individual with respect to a matter which is within the scope of the individual's authority to practice." Practice before the IRS is defined in Circular 230 as follows:

Practice before the Internal Revenue Service comprehends all matters connected with a presentation to the Internal Revenue Service or any of its officers or employees relating to a client's rights, privileges, or liabilities under laws or regulations administered by the Internal Revenue Service. Such presentations include preparing and filing necessary documents, corresponding and communicating with the Internal Revenue Service, and representing a client at conferences, hearings, and meetings.

This does not sound as though it covers transactional tax planning.

Finally, all CPAs need to remember that client privilege can be a fragile thing. Behavior by the taxpayer or the tax practitioner that is inconsistent with confidential communication will keep the privilege from attaching.

Practical Suggestions for Working With IRC Section 7525

Tax practitioners should be aware that this new provision can affect the manner in which they manage their tax practice. For example, tax engagement letters (except those involving only tax preparation) may have to be revised to explain the concept of the privilege to the client and when it is applicable. A sample paragraph follows:

The IRS Restructuring and Reform Act of 1998 extended the attorney-client privilege to certain communications between you and your CPA. The communications must be in connection with tax advice and must be such that they would be privileged if made by you to your lawyer. Communications concerning the preparation of a tax return will not be privileged. In addition, your confidentiality privilege can be inadvertently waived if you discuss the content of the privileged communications with a third party. This privilege for communications between you and your CPA only applies to noncriminal tax matters before the IRS and noncriminal tax proceedings brought by or against the government in any Federal court.

Tax practitioners should make it very clear to their clients that statements made to a CPA cannot be assumed to be privileged. "Communications" refers not only to written communications such as letters, faxes, and e-mail, but also oral communications. Therefore, it is important that the firm's staff--both professionals and paraprofessionals--aware of this privilege and when it applies. In-house seminars and other professional education courses in this area should be included as part of the firm's overall educational requirements. Some firms may need to revise their quality control documents and other tax procedure manuals to incorporate practice procedures that safeguard privileged client communications.

Many firm practices may need to be revisited. For instance, it is conceivable that a client could intend that the very existence of her relationship with a CPA should be confidential. This could, therefore, be a privileged communication. If a firm's receptionist is located in a public part of the office, he could violate the privilege by striking up a friendly conversation with the client and mentioning her name in the course of the conversation. Receptionists should be instructed to repeat back telephone numbers but not client names. Another example has to do with the design of CPA offices. Many CPA offices use vast open staff working areas and frequently office visitors are shown through these areas on their way to partners' offices or on office tours. Occasionally client-related office banter occurs in open staffing areas. If staff in these areas openly discuss privileged client matters or privileged client material is left in piles on their desks, there is some exposure for the privilege to be broken.

The new extension of the attorney-client privilege can be a real boon to clients of nonlawyer tax practitioners. However, it is unfortunate that the new confidentiality privilege constitutes so incomplete an extension and leaves so many questions unanswered. *

James A. Woehlke, LLM, CPA, is counsel and director of the technical services division for the NYSSCPA and technical editor (taxes) of The CPA Journal. Stephen E. Pascarella II, CPA, is the managing partner of Pascarella & Trench of Providence, R.I. Pascarella is a member of the AICPA Federal Tax Division and former chairman of the Tax Division's Management of a Tax Practice Committee.