CPA-Client Privilege Doesn't Extend to Criminal Proceedings
It's Monday morning and your client, who recently retained you for estate tax planning advice, informs you that the IRS is auditing her income tax returns from the past three years. In reviewing her tax returns and financial documents for the audit, you realize that she has underreported $3 million. When you reveal your findings to her, she does not sound surprised. She asks for advice on how to proceed with the IRS audit.
Knowing that this civil audit could turn into a criminal action, what should you do to ensure the maximum protection of your client's confidences under applicable privilege laws? The first step is to advise the client not to discuss this matter with you, as these communications may not be privileged.
Many taxpayers wrongly believe there is an "accountant-client privilege" in California that cloaks their communications and the tax return information itself. Although California recognizes an attorney-client privilege, it does not recognize a similar accountant-client privilege.
Federal and State Tax Practitioner Privilege
California and federal law do have a narrow statutory privilege that allows taxpayers to discuss tax advice with qualified tax advisers in noncriminal tax matters in the same manner they may consult with tax attorneys. Both statutes give tax-advice communications the same privilege protections that apply to a communication between a taxpayer and an attorney, as long as the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
A privileged attorney-client communication is one made in confidence (and not shared with third parties) for the purpose of obtaining legal advice from a lawyer (Evid. Code. Secs. 952, 954).
So far, so good: The tax practitioner privilege would seem to apply to your communications with your client about her current estate tax planning matters. It also would apply if the IRS audit of your client remained civil-meaning the IRS could not force you to divulge oral tax advice given to the taxpayer. But that is where the scope of the protection ends. In practice, the tax practitioner privilege is narrow-whittled down by major exceptions that don't apply to attorney-client privilege.
For example, as noted, the privilege does not apply in criminal matters. If your client's income tax practices become the subject of a criminal investigation, the IRS is likely to argue that the information you obtained in regard to the estate tax planning matters fall within the ambit of the criminal investigation, and it will be difficult to draw a line for purposes of the privilege.
Indeed, even absent a criminal investigation, you could still be forced to divulge your client's communications with you (in a divorce proceeding, for example) because in California, the privilege may only be asserted in noncriminal cases before the State Board of Equalization or the FTB [see Revenue and Taxation Code secs. 700.1(a), 21028(a)].
Similarly, the federal tax practitioner privilege only applies in civil tax proceedings before the IRS and in federal court brought by or against the United States (see 26 U.S.C. Sec. 7525).
In addition, the privilege does not extend to communications about tax return preparation [see United States v. APMG LLP, 237 F. Supp. 2d 35, 39 (D.D.C. 2002); United States v. Gurtner, 474 F.2d 297, 299 (9th Cir. 1973)]. Nor does it apply to communications regarding tax shelters (which the statute defines broadly) or made in furtherance of a crime or fraud [see 26 U.S.C. § 7525(b); United States v. BDO Seidman, LLP, 492 F.3d 806, 819 (7th Cir. 2007) (describing crime-fraud exception)].
And, the statutory privilege does not protect the accountant's work product from disclosure (see APMG, 237 F. Supp. 2d at 39).
In light of these exceptions, any communications with your client about tax return preparation and her potentially fraudulent underreporting of income will not be protected by the tax practitioner privilege. And, if the case turns criminal, any privilege protections that may have applied to your estate tax advice are also likely to disappear.
Tax Return Privilege
Furthermore, although some taxpayers may believe that California's so-called "tax return privilege" protects their communications with their accountant, this does not apply in the criminal context. California courts recognize a privilege for tax returns, both individual and corporate, in civil discovery proceedings. Tax returns, as well as the information they contain, are therefore protected from public scrutiny, subject to certain exceptions [see Sav-On Drugs" In6. v. Superior Court, 15 Cal. 3d 1 (1975); RTC Sec. 7056; Fortunato v. Superior Court, 114 Cal. App. 4th 475, 481 (2003)]. However, this privilege is not available when a taxpayer is facing a government enforcement action.
If you find yourself in a situation where you suspect your client of criminal activity, your next assumption should be that your communications with that client will not be protected, and any work papers or communications with your client may have to be disclosed to the IRS under its subpoena power.
In our hypothetical scenario, it will be critical for your client to refrain from discussing the underreported income with you and to instead speak to an attorney as soon as possible to protect her interests in the face of a potential criminal action.
Advise the Client to Hire a Lawyer and Get a Kovel Letter
Although there is no direct privilege that will attach to your communications with your client, there is a derivative privilege known as a Kovel arrangement that offers a way to protect confidential accountant-client communications in criminal cases.
Based on a Second Circuit decision, United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), a Kovel arrangement describes a process whereby an attorney engages an accountant to aid the attorney in the provision of legal services. Although the disclosure of attorney-client communications to third parties generally waives the attorney-client privilege,
Kovel arrangements provide an exception to this rule. In essence, the accountant acts as a subcontractor to the attorney in the attorney's representation of the taxpayer-client.
In the Kovel case, a law firm specializing in tax law employed an experienced accountant on its own staff. In the course of representing a client that was the target of a grand jury investigation for various income-tax offenses, the taxpayer communicated information to the accountant and the accountant prepared work for the client at the direction of the attorneys.
When the accountant appeared before the grand jury and refused to answer questions, the judge held him in criminal contempt and sentenced him to a year in prison. The accountant challenged that decision to the Second Circuit. The Second Circuit held that the attorney-client privilege extends to communications made by a client to an accountant in the attorney's employ incident to the client's obtaining legal advice from the attorney.
The court analogized the accountant's role to that of a translator helping the attorney who is "ignorant of the [client's] foreign language" to give more effective legal advice (Kovel, 296 F.2d at 921-22).
Since Kovel, courts have recognized both a privilege protection that attaches to communications between the accountant and taxpayer client, as well as a work product protection that attaches to the accountant's work papers and file.
Although California state courts have not yet addressed Kovel, under California Evidence Code sec. 954, accountants may be included in the attorney-client privilege if their presence furthers the interest of the client and is reasonably necessary to assist the lawyer in giving the client legal advice. The key is that the accountant's job is to assist the attorney, not the taxpayer, in navigating the accounting complexities that are incident to defending the criminal tax lawsuit.
Importantly, although clients may prefer it for efficiency and cost reasons, you should not agree to a Kovel arrangement if you have already been acting as the taxpayer client's CPA. If you are the taxpayer client's longtime accountant, the line between your work as an accountant and your work as the attorney's consultant may be blurred.
What you knew and when you knew it vis-a-vis the Kovel arrangement will become critical, and possibly difficult to establish. Although your instinct may be to continue helping your longtime client, you may actually do her a disservice by taking on the Kovel engagement. Instead, recommend another qualified accountant to serve as the Kovel accountant and with whom you can work to provide information regarding your pre-Kovel work.
If you are the new Kovel accountant, you should advise your client to stop communicating with the longtime CPA directly. Instead, information gathering from the prior CPA should be done by the legal team, including the Kovel accountant. Also, be aware that the party asserting the attorney-client privilege has the burden of establishing the privileged nature of the communications. You and the Kovel attorney should follow these best practices to ensure that the taxpayer client can meet that burden:
Memorialize the Kovel relationship in writing (with a Kovel letter) before any services are performed. The engagement letter should be on the law firm's letterhead and addressed directly to the Kovel accountant.
The letter should state clearly that the law firm is engaging the accountant directly and that the accountant is rendering services to aid the attorney in the provision of legal services (rather than the accountant providing the taxpayer client with tax-related services). Examples of services that typically fall within a Kovel engagement are reviewing tax returns and determining errors; reviewing financial records for unreported income or inappropriate write-offs; advising the attorney on technical tax issues; and computing taxes to assist in criminal sentencing issues.
Whereas many standard law firm engagement letters state that any work product generated is the property of the "client," the language should state that the work product generated by the accountant is the property of the law firm. In essence, the law firm becomes your client.
Although the attorney is not required to be involved in every communication between you and the client, the attorney should oversee all those communications, and work you perform under the Kovel arrangement must be done at the direction of the attorney.
Make sure you address any letters or memos you prepare to the law firm, not to the taxpayer client or "the file."
While it is acceptable for the taxpayer ultimately to pay your bills as the Kovel accountant, it's a good idea to have the billing run through the attorney first. Or, the attorney may take a bigger retainer at the outset from the taxpayer client and pay you with those funds.
You should prominently label all correspondence "attorney-client privileged" and all work papers "attorney work product."
In the rare case where you, as the existing CPA, are engaged as the Kovel accountant, you should implement an ethical wall in your accounting firm so that professionals who were involved in preparing prior returns will not have access to Kovel privileged communications.
Given the complexity of these privileges and their application, if you believe a case could turn criminal, have your client seek the advice of an attorney. In the criminal context, an accountant's communications with the taxpayer only become privileged when the accountant enters into a Kovel arrangement to assist the attorney in providing legal services to the client. Establishing a Kovel relationship early and taking steps to protect your client's privileged communications can make a big difference in a later criminal action.
Jessica K. Nall is a partner and Janice W. Reicher and Chandra S. Russell are associates at Farella Braun + Martel LLP. They can be reached at [email protected], [email protected] and, [email protected]. Meg E. Manchester, an associate in Farella Braun + Martel's tax group, contributed to this article.