by George G. Jones and Mark A. Luscombe

The so-called tax practitioner privilege came into the law in 1998 as part of the IRS Restructuring and Reform Act of 1998 (Code Sec. 7525). The goal was to put tax practitioners other than tax attorneys on a more equal playing field in terms of their ability to engage in privileged communications with clients who are seeking tax advice.

The Code Sec. 7525 privilege was designed to apply to tax practitioners and their clients the same types of privilege that would be available to attorneys and their clients under the attorney/client privilege, with several exceptions provided in the statute.

The combination of those statutory exceptions, the limitations on the attorney/client privilege, the Sarbanes-Oxley Act, and several recent judicial decisions in the tax shelter area, has increasingly brought into question the viability of the tax practitioner privilege and the wisdom of tax practitioners or their clients in relying on it.

The Code Sec. 7525 privilege

Under the general rule of the Code Sec. 7525 tax practitioner privilege, the same common-law protections of confidentiality that apply to a communication between a taxpayer and an attorney are also to apply to a communication between a taxpayer and any federally authorized tax practitioner.

The tax practitioner privilege, therefore, is tied to the attorney/client privilege, and has the same limitations as that privilege. A “federally authorized tax practitioner” is defined in the code to mean any individual who is authorized under federal law to practice before the Internal Revenue Service, if such practice is subject to federal regulation as defined in the statute, such as an enrolled agent, an enrolled actuary or a CPA.

The tax practitioner privilege, however, has several statutory limitations unique to it. The tax practitioner privilege is limited to tax advice. Code Sec. 7525 defines “tax advice” as advice given by an individual with respect to a matter that is within the scope of the individual’s authority to practice as a federally authorized tax practitioner.

This limitation is significant since, as we shall see, the attorney/client privilege is limited to legal advice. It becomes a significant question, therefore, as to when tax advice is also legal advice — especially when given by someone not otherwise authorized to practice law.

The tax practitioner privilege is limited to non-criminal matters. At first glance, this is not a concern for most tax work. It can become an issue, however, when a matter that did not initially appear to be a criminal tax matter evolves into a criminal matter. The criminal aspects of the case may suddenly relate back and involve the entire history of the involvement, including the point at which it appeared to the tax practitioner to be a non-criminal matter.

The tax practitioner privilege is also limited to tax matters before the Internal Revenue Service or in federal court brought by or against the United States. If there are parallel state tax actions, the tax practitioner and her client may find that what is privileged at the federal level is not privileged at the state level.

With the IRS and state revenue departments frequently sharing information, this federal limitation on the privilege may also tend to make it somewhat illusory in practice. Also, administrative proceedings before federal agencies other than the IRS, such as the Securities and Exchange Commission, are not within the scope of the privilege.

Finally, the tax practitioner privilege under the code does not apply to any written communication in connection with the promotion of the direct or indirect participation of a corporation in a tax shelter. What constitutes a corporate tax shelter is not subject to precise definition, and the tax practitioner and the IRS may have different views on this issue.

If the tax advice is determined to involve a corporate tax shelter, it can trigger tax shelter promoter listing and disclosure requirements on the part of the tax practitioner that ultimately come into conflict with the assertion of the privilege. The IRS has been very aggressive recently in asserting these listing and disclosure requirements through administrative summonses, and has, by and large, been successful in having the courts favor the listing and disclosure requirements imposed under the code over privilege arguments.

The attorney/client privilege

The tax practitioner privilege by statute is also limited to the scope of the attorney/client privilege. The attorney/client privilege, while recognized by the code, is a judicially developed doctrine that can trace its origins to English common law. The attorney/client privilege also includes a number of requirements and exceptions.

First, the client must have sought legal advice. The term “legal advice” has been interpreted to mean both advice on litigation matters and advice on the legal consequences of proposed transactions. Business advice does not rise to legal advice unless it includes an analysis of the legal impact of a business decision. Some courts appear to be suggesting that legal advice can only be rendered by a lawyer.

By implication, since tax advice can be rendered by both lawyers and non-lawyers, tax advice does not rise the level of legal advice. Since the tax practitioner privilege is limited to tax advice, such an interpretation would destroy the tax practitioner privilege.

Second, the attorney/client privilege requires that the communication with respect to legal advice must be made in confidence by the client with the expectation that the communication will be kept confidential. As the attorney/client privilege has developed, communications with respect to the preparation of tax returns have not been protected by the attorney/client privilege, since the client would have no expectation of privilege with respect to a tax return that is required to be disclosed to the government.

This has been applied to communications that actually appear in the return as well as communications related to the preparation of the tax return. Courts have sometimes used language that would tend to indicate that tax advice rendered while the tax return is being prepared or before it is completed would tend to relate to the preparation of the return.

There is often no clear time limit as to how far you might go back before the submission of the tax return. There is also no clear limit on who can be involved in work related to the preparation of the return. This limit is not necessarily limited to the person designated as the tax return preparer.

Such interpretations tend to bring into question the extent to which either the attorney/client privilege or the tax practitioner privilege can be related to tax advice outside of a litigation context.

Finally, the attorney/client privilege must not have been waived by the client. The waiver could come about either through an express waiver or a de facto waiver, e.g. through communication to a third party. Courts have sometimes said that the submission of the tax return to the government constitutes a waiver of the attorney/client privilege with respect to work in connection with preparation of the return.

The Sarbanes-Oxley Act

The Sarbanes-Oxley Act of 2002, enacted as a result of a series of corporate governance and auditing scandals, addresses problems with the corporate governance of public companies and the independence of their outside auditors. It is already having a significant impact on how public companies view their tax and audit work.

Although there is no clear requirement that audit work and tax return preparation work be separated, many public companies are becoming very careful to avoid even any potential appearance of a conflict of interest. Tax compliance work is, therefore, increasingly being handled by tax practitioners who are not affiliated with the individuals doing the audit work for the company.

As public companies become more conservative in their segregation of audit and tax work and the type of tax work, they may set the standard for privately held companies, as well. If many companies are separating their tax return preparation work from other tax work, courts may tend to view companies that have failed to maintain the same degree of separation as having lost the tax practitioner privilege in one of the ways discussed above.

Tax shelter litigation

In our Aug. 4, 2003, column, we discussed the growing body of tax shelter cases arising out of the IRS’s efforts to enforce administrative summonses with respect to the tax shelter promoter listing and disclosure requirements. That column focused on the issue of whether the tax practitioner is promoting tax shelters or rendering tax advice. Those cases have also involved assertions of privilege, either by the tax practitioner on behalf of the client or, in some cases, by the clients themselves through actions to intervene in the litigation to prevent disclosure of their identities.

Thus far, it appears that the courts, while recognizing the existence of an identity privilege, have tended to favor the statutory requirement of disclosure over assertions of privilege. Even taxpayers that have an opinion stating that a particular transaction is not a tax shelter have had trouble preserving the privilege.

Preserving the tax practitioner privilege

As soon as the tax practitioner privilege was enacted into law in 1998, many commentators were warning that the privilege might prove to be illusory in practice. Many sophisticated tax clients today say that they do not assume that any privilege exists in connection with seeking tax opinions. Tax practitioners would probably be well advised not to rely on the existence of a tax practitioner privilege in their dealings with their clients.

Still, in the face of this general skepticism, certain steps can be taken to increase the likelihood of a privilege assertion surviving challenge. It will be easier to assert the privilege if the tax advice came from someone not associated with the preparation of the tax return. It will be easier to assert the privilege if the proposed transaction with respect to which the tax advice is being requested was not a transaction proposed by the person from whom the tax advice is being sought.

The proposed transaction should also be one that has not been identified by the IRS as a tax shelter. It can also help to have the tax practitioner involved as an agent of the client’s attorney, so that the practitioner’s tax advice and written communications can be asserted not only under the tax practitioner privilege but under the attorney/client privilege, as well.

George G. Jones, J.D., LL.M., is the managing editor of Federal and State Tax, and Mark A. Luscombe, J.D., LL.M., CPA, is the principal analyst of Federal and State Tax, at CCH Inc., in Riverwoods, Ill.

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