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Taxpayers Privilege

California CPA November 2009

There are some common misconceptions regarding the taxpayer privilege legislation that CPAs need to be aware of.
By Kip Dellinger, CPA

AB 129 (Ma), co-sponsored by CalCPA and California’s enrolled agents, reinstates the expired taxpayer privilege enacted in 2000. This privilege is the same as the federal privilege of Internal Revenue Code Sec. 7525 (the statutory privilege) and purports to provide taxpayers the same confidential protections from discovery by the IRS or FTB with respect to tax advice communication with CPAs and enrolled agents that taxpayers would have with an attorney.

However, there is a common misconception about the scope of the privilege as it applies to CPAs and enrolled agents. Indeed, the statutory protections afforded taxpayers with regard to CPA or enrolled agent communication are no less and no greater than the scope of the attorney-client privilege.

In practice, this misconception on the part of a CPA can be very damaging to a taxpayer as the privilege itself will not exist. This is because taxpayers generally communicate with CPAs and enrolled agents about tax services that differ from those provided by a tax attorney—namely preparation of returns rather than advice regarding tax planning or controversy matters.

Only under some circumstances are taxpayers entitled to treat communication with their tax professionals as confidential and privileged. If the communication (and physical information directly pertaining to it) qualifies as privileged, then that information is not discoverable by the IRS or government attorneys in the event of a tax controversy. The claim of privilege actually belongs to the taxpayer with respect to communication between them and their attorney or any other federally authorized tax practitioner—CPA, an enrolled agent or an enrolled actuary.

Nature of the Privilege
When the communication involves an attorney, the taxpayer will assert the attorney-client privilege, which says communication between an attorney and client is protected from compelled disclosure in a controversy when the communication:

  1. is made in confidence (with an expectation of privilege);
  2. occurs in the course of soliciting advice from an attorney in his or her capacity as such (i.e., providing legal advice); and
  3. is relevant to the advice sought.

There also must not be waiver of the privilege. Waiver may occur in a variety of ways, but happens most frequently when a communication is shared with someone other than the attorney (or CPA or enrolled agent in the case of the statutory privilege).

When the communication involves a CPA or an enrolled agent, the client will assert privilege under the more limited statutory provision of IRC Sec. 7525. The federally authorized tax practitioner (FATP) privilege is derived from the attorney-client privilege and, as such, is no greater than the attorney-client privilege in application. In fact, it is further limited by restrictions on its use in IRC Sec. 7525.

The FATP privilege applies (with significant limitations) to communication of tax advice between the FATP and the client that would otherwise be a protected privileged communication if it were between the taxpayer and an attorney. It does not modify the attorney privilege of confidentiality; it merely extends it to other practitioners.

Other Government Agency Inquiries and Criminal Tax Matters
Misunderstandings of this provision are certain to arise, and the consequences to affected taxpayers may be devastating, depending on the type of information mistakenly thought to be covered by the privilege. Also, the privilege does not extend to information sought in investigations by other regulatory bodies, such as the SEC, Federal Reserve Bank and various state tax authorities.

Moreover, the privilege applies only to communications in noncriminal tax proceedings before the IRS or in federal court. Note also that if a civil proceeding becomes a criminal proceeding, the confidentiality privilege disappears retroactively. Consequently, unsuspecting practitioners may become privy to information that clients believe to be confidential, only to have that privilege waived—sometimes with dire consequences for the client—notably, a situation where the tax authority places the preparer in the position of serving as witness against the taxpayer.

Privilege Does Not Apply to Return Preparation
The most likely battles, though, will be over the tax preparer exception to the privilege.

There is a long history of court decisions that deny confidentiality of information disclosed to an attorney for purposes of preparing tax returns. That is one reason why attorneys that specialize in tax controversy matters do not also prepare income tax returns [See U.S. v. Frederick, 182 F3d 496 (7th Cir. 1999), cert. Denied, 528 U.S. 1154 (2000)].

The vast majority of complex income tax returns for individuals and businesses are prepared by, or under the supervision of, CPAs or enrolled agents. As a result, in most cases, it will be difficult for their clients to assert that the confidentiality privilege is applicable.

When the taxpayer makes such an assertion, the IRS will almost surely challenge that argument. It will contend that whatever tax advice was given, and whenever it was given, falls under the category of “tax return preparation” and does not qualify as tax advice for purposes of the confidentiality privilege.

A leading case in the area of privilege (actually, the lack of it) involving tax preparation is United States v. Lawless, 709 F.2d 487 (7th Cir.1983), in which the court
ruled that “information transmitted for the purpose of preparation of a tax return, though transmitted to an attorney, is not privileged information.”

The court continued: “When information will be transmitted to a third party (in this case on a tax return), such information is not confidential.” Significantly, the court stated that “if the client transmitted the information so that it might be used on the tax return, such a transmission destroys any expectation of confidentiality which otherwise might have existed … (so) disclosure of tax information effectively waives the privilege not only to the transmitted data but also as to the details underlying that information.”

A Legal Minefield
There have been instances where some information provided in tax return preparation has been protected under common law principles. However, for the typical tax practitioner to rely on such exceptions is to cross through a legal minefield littered with casualties.

When one of the casualties is a client that may initiate legal proceedings against the practitioner, running the gauntlet necessary to ensure that communication is clearly protected is likely not worth the exposure to the practitioner (particularly where a change to criminal status might rear its ugly head). Nor does the uncertainty surrounding confidentiality with a CPA or enrolled agent serve to encourage clients to use it.

It’s also important to note that most client relationships with a CPA or enrolled agent are ongoing and contain the expectation of a work product, including the preparation of income tax returns. This is different from the normal tax attorney-client relationship, which is transaction based, whether the service is tax advice, estate planning or tax controversy defense representation. In fact, some of the more interesting court issues have involved attorneys losing their privilege in situations where they prepared federal estate tax returns. The privilege issue is more likely to arise in these matters since attorneys more commonly prepare estate tax returns than income tax returns.

Because of the nature of the CPA-client relationship, it’s difficult to structure a tax advice relationship that will meet the standard for privileged communication. Where it may have some application is when practitioners refer clients to others for advice on specific tax matters while retaining the overall client relationship. This is a move that the largest firms are making. However, for the vast majority of clients and practitioners, this type of relationship is not feasible.

Even in large local accounting and tax firms, the courts will probably look skeptically at assertions that advice and preparation are unrelated in serving the client. Consequently, tax practitioners should use an abundance of caution before entering into relationships with current or prospective clients that involve either the federal or California confidentiality privilege.

Kip Dellinger, CPA is senior tax partner at Kallman & Co. LLP, Los Angeles, and is chair of the Tax Practice Responsibilities Committee of the AICPA Tax Division.