by George G. Jones and Mark A. Luscombe

A number of factors that have been brewing over the last several years are now resulting in litigation that is likely to redefine the relationship between tax professionals and their clients.

On one side has been the Internal Revenue Service’s crackdown on perceived tax shelters and the related disclosure and list-maintenance requirements. On the other side are taxpayers who, as always, continue to seek ways to reduce their tax liabilities.

And in the middle are the tax professionals who, in part due to perceived competitive pressures, as well as out of a genuine sense of service, try to be as proactive as possible in suggesting new ways to reduce clients’ tax liabilities.

A tax advisor who sits back and waits for his client to come to him with a tax-planning question appears to fall into the traditional role of rendering tax advice. The tax advisor who tries to be proactive in suggesting ways to reduce taxes may move from rendering tax advice to promoting tax strategies.

Although the client may not perceive the difference, to the IRS it makes a big difference, and the agency has drawn a battle line on that difference. All the while, some sophisticated clients have themselves been fanning the flames by undertaking tax strategies under the protection of tax opinions that they hope will shield them from those tax penalties that would, in reality, be the only reason that their strategies would not be a success.

The line between aggressive tax planning and abusive tax shelters is not always very clear. Tax practitioners often know that they are playing dangerously close to the line, but feel pressure to come as close to the line as possible.

The tax shelter crackdown

For some time, the IRS has been seeking greater legislative authority to combat corporate and individual tax shelters. Although there are tax shelter registration and investor list requirements in Code Secs. 6111 and 6112, they date from the congressional responses to the individual tax shelter promotions of the 1970s and early 1980s.

More recently, the IRS has been successful in getting legislation passed that attacks specific types of shelter transactions, but it has, thus far, been unable to get the tougher registration requirements that it thinks it needs to quickly and effectively put the spotlight on new shelters as they emerge.

Faced with congressional criticism that the IRS needs better enforcement of existing law rather than new laws, the IRS, through administrative action, has started maintaining a list of transactions that it considers to be abusive tax shelter transactions, as well as generally encouraging disclosure of shelter transactions on tax returns.

The IRS has also initiated a series of administrative summonses to accounting firms, law firms and investment banks that it considers to have been engaged in the promotion of shelters and that it suspects have not been complying with the listing requirements.

Tax practitioner’s privilege

The attorney/client privilege can trace its origins back to common law providing protection to clients against the disclosure of confidential attorney/client communications.

As part of an effort to give the clients of accountants an equal playing field in the receipt of tax advice, the IRS Restructuring and Reform Act of 1998 created a tax practitioner privilege for clients of non-attorneys providing tax advice equal to the attorney/client privilege that is available to clients of tax lawyers. The privilege was extended to federally authorized tax practitioners, CPAs, enrolled agents and enrolled actuaries. Excluded from the tax practitioner privilege were criminal matters and the promotion of tax shelters.

Also excluded from the new tax practitioner privilege, because it has been excluded from the attorney/client privilege through years of judicial decisions, is tax return preparation. This exception developed on the theory that anything done in connection with the preparation of the tax return is not intended to remain confidential and, therefore, is not privileged.

The scope of the tax practitioner privilege, therefore, has some severe restrictions. The activity cannot relate to tax shelter promotion and it cannot relate to return preparation. The use of the privilege requires carving out tax planning services that do not fall into the forbidden categories.

The litigation

In 2002, the IRS issued administrative summonses to firms such as Arthur Andersen, KPMG, Ernst & Young and BDO Seidman, to determine whether they had complied with the registration and listing requirements under the code. The summonses followed announcements that the IRS had reached settlements with PricewaterhouseCoopers and Merrill Lynch over similar issues.

Some of those summonses have resulted in settlements with the IRS. Some have been turned over to the Justice Department for enforcement action. Many of the unnamed clients of the firms have become involved in Joe Doe actions to prevent the release of their identities to the IRS. Many clients have also sued their tax professionals for what they now feel is questionable advice regarding the propriety of recommended transactions.

Ernst & Young. In response to an administrative summons issued in April 2002, Ernst & Young entered into negotiations with the IRS with respect to what transactions were properly within the scope of the IRS summons and what documents would be produced.

Informed by Ernst & Young of its intent to comply with at least part of the IRS summons, some of the firm’s clients filed an action for a temporary restraining order to prevent the disclosure of their identities.

One case in Chicago became moot when the IRS revealed that it had discovered the identity of the plaintiffs by undisclosed means. Ernst & Young actively opposed in court filings efforts of its own clients to get injunctive relief.

The IRS, in July 2003, announced a settlement with Ernst & Young involving the payment by the firm of $15 million and E&Y’s agreement to work with the IRS to insure future compliance with the registration and listing requirements of the code.

A law firm involved in rendering opinions with respect to some of the transactions entered into by Ernst & Young clients, the Chicago office of Jenkens & Gilchrist, was itself the subject of an IRS administrative summons in June 2003 with respect to that firm’s compliance with the listing requirements for transactions promoted by that firm.

A district court in North Carolina recently denied an effort by investors in transactions involving Wachovia Bank and Jenkens & Gilchrist to keep the bank from turning over investor lists to the IRS.

KPMG. The IRS has turned to the Justice Department to enforce its summons against KPMG. Filings by the IRS in that case included the now famous disclosure by the IRS in court filings of the names of investors in transactions promoted by KPMG. The action resulted in an apology from the IRS, but it may also have had an impact on the governor’s race in California in the 2002 elections.

The Federal District Court for the District of Columbia issued a memorandum opinion in December 2002, identifying a fairly narrow scope for the assertion of privilege in tax matters and appointing a special master to review the KPMG documents in accordance with the court’s instructions. The special master has recommended that most of the documents be disclosed to the IRS. KPMG clients have also filed suit to prevent disclosure of their identities.

BDO Seidman. The IRS has also turned to the Justice Department to enforce its summons against BDO Seidman, this time with Chicago as the venue, rather than Washington.

BDO Seidman and its clients have been more united in fighting the IRS summons in litigation, but without any better apparent results. The district court ordered the documents to be turned over to the IRS and denied the right of BDO Seidman clients to intervene. The Seventh Circuit remanded the case to the district court to do a more thorough review of the documents.

That review resulted in a finding that the identity privilege might exist in certain limited circumstances, but that it probably does not go so far as to restrict any identification of the clients to the IRS. The case is now back before the Seventh Circuit.

Summary

Where we stand now is that the IRS has been fairly successful in using the tools that it has to attack tax shelter transactions at the source to try to discourage their promotion and adoption. Accounting firms are now not only under attack by the IRS, but also are being sued in some situations by their own clients for promoting tax strategies that have turned out not to have the promised tax benefits.

The IRS is still trying to get more forceful legislation with respect to the registration of corporate tax shelter promotions, but is probably fairly pleased with the way things have gone in the courts so far, even if things have gone too slowly. One of the main architects of the strategy, chief counsel B. John Williams, has now declared victory and decided to move on to private practice.

Efforts by accounting firms and their clients to use the tax practitioner privilege to prevent the disclosure of client identities to the IRS appears unlikely to succeed at this point Ñ though there may still be some hope that the process can be dragged on long enough for statutes of limitations to expire.

The concept of a client identity privilege in the face of statutory listing requirements and client identity associated with tax return preparation seems unlikely at this point to ultimately permit clients to conceal their identities in the face of IRS enforcement actions.

The overall trend seems to be for accounting firms and others faced with IRS summonses to cut their losses, take what may appear to be a good deal from the IRS for themselves and their clients when weighing “the hazards of litigation,” and put the issue behind them.

Many practitioners seem to believe that many of the “sweet” deals being offered by the IRS will continue, at least for awhile, since the IRS strategy seems to be to push current litigation forward primarily to scare off the future use of aggressive transactions.

If everyone plays by the same rules, the competitive pressures to be more proactive than the next guy may lessen in the future. In the future, clients may separately farm out their tax return preparation work and their tax planning work to help preserve the concept of a tax practitioner privilege, but overall that is likely to still mean just as much work for tax professionals Ñ it will just come from some different sources.

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