IRS Increases The Need for Attorney-Client Privilege on Tax Issues
It may come as an unpleasant surprise to some readers to discover the Internal Revenue Service (“IRS”) has been using tax audits as cover for criminal investigations, which can directly relate to the tax issues or to some other federal matter. In addition, sometimes the tax audit (civil investigation) is cover to collect evidence on another party. These dual or multi-purpose investigations are known as “parallel investigations.” (Internal Revenue Manual [“IRM”] 5.1.5 et seq and 9.5.1 et seq.) In the August 2015 edition of The Tax Advisor, Justin Andrezzi, Randall Andrezzi and Arlean Hibschweiler wrote a comprehensive article called “When Civil isn’t Civil” on the topic.
In a parallel investigation the IRS may be gathering evidence for a criminal investigation at the same time they are conducting a civil tax audit. This would not be particularly noteworthy except for the fact that the IRS is conducting the criminal investigation without disclosure to the taxpayer or his/her representative. Within IRM 184.108.40.206, the IRS specifically instructs its agents to provide an ambiguous answer if asked about whether there is a criminal investigation underway in parallel with the civil tax audit. They are therefore using the civil investigation (tax audit process) as cover for a criminal investigation and intentionally hiding it. This invites the potential that the taxpayer could unwittingly make incriminating statements or provide incriminating evidence in support of an unanticipated and/or unrelated criminal indictment. Similarly, a response to an Information Document Request (“IDR”) or Examiner’s question received under the pretext of a civil, tax audit may not be considered full and complete when reviewed from the perspective of a criminal investigation and thus, could be misconstrued as “evasive” possibly resulting in the taxpayer being charged with obstruction of justice. Such tactics by the IRS will leave many accountants and advisors in a difficult position with their clients.
The challenge accounting professionals will face is how best to proceed when their client is being audited by the IRS. The proverbial “tea and crumpets” approach, i.e., warm, friendly compliance with every request of the investigator, during a civil audit can unwittingly open up a client to self-incriminating disclosures as usable evidence for the criminal investigation. On the other hand, “playing the cards close to your chest” could result in a client being charged with obstruction of justice.
The existence and more frequent use of parallel investigations requires careful consideration and handling, not just upon receiving notification of and/or during the tax audit, but perhaps more importantly, during the planning and implementation phases of significant tax matters. At a minimum, at the very start of any inquiry or tax audit ask the following questions:
- Ask for the audit work plan. This has always been a good practice. If the Agent does not have a work plan, you need to make them form one.
- Next, let the Agent know that you are aware of the existence of parallel investigations and therefore must ask the following question: “Are you conducting this audit in conjunction with a criminal investigation or working in parallel with any other federal agency at the same time or in connection with this audit?”
If the answer is an unwavering “No”, then the audit can proceed as it normally would in a civil audit because any damaging information would generally be excluded from a criminal case, even if the Agent had answered this direct question untruthfully when saying “No”. Any information provided in those circumstances would carry with it the protections afforded to taxpayers under Internal Revenue Code (“IRC”) § 7525 (“Tax practitioner-client privilege” as it applies to communications between a taxpayer and a federally- authorized tax practitioner, if those communications involve the provision of tax advice). Additionally, if the IRS agent was being untruthful, the client could likely rely on the “Exclusionary Rule (a legal principle under constitutional law which holds that evidence collected or analyzed in violation of the defendant’s constitutional rights is sometimes inadmissible for a criminal prosecution in a court of law).
However, if the Agent follows the IRM, the Agent will not provide a definitive answer. The Agent will probably respond with something like “I can’t disclose that” or some other ambiguous reply as they are not obliged to tell you if there is a criminal investigation running parallel to the tax audit, and as previously mentioned, they are instructed to be evasive or obtuse. If this happens, you and your client have been “put on notice” (albeit informally) to proceed with caution. The taxpayer and representative must now be very careful in how they respond to IDRs and examination questions.
More to the point, if an attorney has not previously been involved in the representation of the client, it would be prudent to bring in a lawyer to handle the continuing dialogue with the Agent. Under circumstances involving criminal investigations, an accountant and his/her client cannot rely upon IRC § 7525 since it only applies to tax advice in noncriminal matters before the IRS and noncriminal tax proceedings in federal court. Similarly, state statutes cannot serve to protect communications between accountants and clients because such privilege isn’t recognized under federal common law (see Couch v. United States, 409 U.S. 322 (1973)). The strongest protection that can be achieved in such situations is that afforded by Attorney-Client Privilege.
The attorney-client privilege prevents disclosure of confidential communications made for the purposes of facilitating rendition of professional legal services (see Proposed Federal Rule of Evidence 503). The client holds the privilege, and in the case of IRS audits, the privilege would extend to the following communications: 1) between the client or client’s representative and his attorney or the attorney’s representative; 2)between the client’s attorney and that attorney’s representatives;3)from the client or his/her lawyer to a lawyer representing another person in a matter of common interest; 4) between representatives of the client; and 5) between lawyers representing the client (see Proposed Rule 503 of the Federal Rules of Evidence). For example, communications between the client’s attorney and the CPA for purposes of litigation support would be considered confidential under the attorney-client privilege. Such a relationship between an attorney and a CPA involving a common client in an IRS investigation or in conjunction with a significant tax project can be, and are typically, established under the Kovel Rule.
In the landmark case of United States v. Kovel, 296 F2d 918 (2d Cir. 1961), Kovel, an accountant and a former IRS agent, had been hired by a law firm to help advise about a tax fraud matter involving one of their clients. During his employment Kovel interviewed and exchanged communications with the client. Later, Kovel was subpoenaed by a grand jury to testify as to those communications. When Kovel refused he was sentenced to a year in prison for contempt of court. The Second Circuit Court of Appeals reversed the contempt citation and ruled there was no reason in the case to exclude accountants from the list of those who assist lawyers in providing legal services.
Often, CPAs and accountants represent their clients in tax audits. In order for a CPA or accountant to achieve a “Kovel” attorney-client privilege for communications with their clients, an attorney must be involved from the inception of the audit or tax matter, if not sooner. Even if an attorney becomes involved, a specific set of conditions must be met or else a loss of the privilege can occur resulting in the failure of the legal protection strategy. Provided specific conditions are met, the attorney-client privilege will act as umbrella protection with regards to communications and work product that is developed to assist the client with the audit or tax matter. By working under the Kovel Rule, an attorney and CPA can better control how, what and when information is made available to the IRS under investigation circumstances.
In order to establish Kovel Rule protections, the CPA and attorney should work together in the following manner:
- Employ the CPA through an engagement agreement or a “Kovel Letter”, a letter from the attorney to the CPA stating the attorney is hiring the CPA to assist with litigation support work for the client. This will formalize the relationship and provide written proof as evidence. The agreement should specifically state that all communications between the attorney, client and accountant are to remain confidential and that all the accountant’s work product is the attorney’s property.
- The CPA should document work product specifically related to the client’s matter as “Confidential”. This should be done at the top of all documents which contain genuinely confidential information, and such documents should be segregated from other non-confidential documents relating to the same client.
- If the CPA firm provides the client both litigation support service and other non-litigation related accounting and tax services, the litigation support services should be handled by a separate member of the firm from the other non-litigation matters. This will keep the matter “segregated” within the CPA firm for purposes of maintaining the privilege.
- Use secure means of communications. Wireless phones, cell phones and emails have been attacked in court as being “unsecure” and thus lacking a reasonable expectation of privacy. Arguments could successfully be made to the contrary as this is an evolving area of law, however, in order to avoid brining these legal arguments into the client’s case, communications should be over well recognized, secure mediums: land lines (telephone), encrypted emails or emails through a secure portal, and faxes should include a cover sheet with a disclaimer that the fax is being made as part of a privileged and confidential communication.
- Conduct meetings with only essential personnel involved in the client’s matter and document the meeting by taking minutes with notations as to the subject and legal reason for the meeting.
- Keep a call log with the client and attorney, or the attorney’s representative, indicating the date, time, subject and legal reason for the call.
- Invoice the law firm for the CPA work done in connection with the client’s matter. The law firm, not the client, should pay the CPA’s invoice to ensure that the CPA’s work was billed as litigation support services separately from other accounting and tax services.
You cannot predict whether you are part of a parallel investigation. The IRS or other federal agency might be looking for evidence related to another party, not the taxpayer, or they could be looking for evidence of some non-tax related violation. It therefore becomes more important to consider ways to protect confidential data by using attorney-client privilege from the beginning of any tax planning or transfer pricing matter to be able to manage data and control the IRS’s reach. By working through a law firm you can manage the IRS’s access to work product and other sensitive material, if any. At BILTgroup, we have extensive experience in assisting accountants and their clients with IRS investigations, both civil and criminal, as well as, assisting clients by establishing Kovel arrangements and agreements with accountants and other specialists in order to extend attorney-client and work product doctrine legal privileges to all aspects (e.g., planning, implementation and defense) of significant tax matters. BILTgroup employs a secure portal for email communications and document sharing between accountants and clients in order to maximize confidentiality and the legal protections afforded by the attorney-client privilege. Before your client undertakes significant tax planning and/or an IRS audit gets started, contact our firm to arrange a consult with you and your client. It will protect against inadvertent disclosures, maximize your client’s legal protections and prevent malpractice issues from arising within your practice and client relationships.