Tax privilege, a mixed blessing

CPA Journal, The, Oct 1998 by Woehlke, James A, Pascarella, Stephen E II

Undoubtedly, 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)1.