Attorney-Client, Work-Product, and Fifth Amendment Privileges in Tax Practice and Litigation
By: STEVEN Z. KAPLAN
March 2001
The Seventh Circuit's provocative (and, in many respects, dubious) decision in U.S. v. Frederick, 220 F.3d 496 (7th Cir. 1999), cert. denied, 120 S.Ct. 1157 (2000) profoundly upsets long-held conceptions concerning what communications are privileged in the rendering of tax advice. This decision should cause practitioners to reconsider how they communicate with non-lawyers, and what they say and commit to writing, lest they prejudice the taxpayer or become witnesses against the taxpayer in subsequent civil or criminal tax proceedings.
Frederick opens the door for the IRS and the Justice Department to invade the work product and mental impressions of the taxpayer's advisors and also effectively constricts the privilege that Congress granted to accountants under the 1998 Tax Reform and Restructuring Act when they render tax advice. The degree to which Frederick requires a fresh understanding of the law of privilege becomes particularly clear when we consider the law of privilege after the Second Circuit's decision in Kovel.
I. Kovel Calms The Waters For Decades
If the taxpayer and her lawyer spoke different languages, they would surely require the presence of a third-party translator to make possible their communications and the lawyer's rendering of legal advice. Because the presence of the translator would be indispensable to the rendering of legal advice, the translator would be viewed as the lawyer's agent to enable the giving of that advice.
In U.S. v. Kovel, 296 F.2d 918 (2d. Cir. 1961), a law firm that employed an accountant on its own staff represented a taxpayer who was the target of a grand jury investigation focusing on whether he had committed various income tax offenses. To assist the firm in advising the taxpayer with regard to this investigation, the taxpayer communicated information to the inhouse accountant who, in turn, helped explain the client's business and tax reporting to a lawyer in the firm. The government then subpoenaed the law firm's files on the ground that the communications involving the accountant were not subject to the attorney-client privilege. The law firm responded that the use of the accountant was indistinguishable from the use of a foreign language interpreter because the tax and accounting concepts that the accountant communicated to the lawyer were every bit as "foreign" to the lawyer.
The Second Circuit adopted the law firm's foreign language translator analogy and concluded that because the law firm's use of an accountant to assist it in understanding the content of the client's business and financial affairs fostered the attorney-client communications and the giving of legal advice, the accountant's communications with both the lawyer and the taxpayer were privileged.
Crucial to Kovel's holding that communications with the accountant were privileged was the Court of Appeals' determination that the presence of that third party was essential to effective communication between the lawyer and the client. On the other hand, Kovel recognizes that if a lawyer and/or the taxpayer retain an accountant simply because the client needs accounting services and not to enable the lawyer to communicate intelligently with the taxpayer, neither the accounting work nor any communications between the accountant and the lawyer or between the accountant and the taxpayer would be subject to the attorney-client privilege (though Kovel is silent as to the possible applicability of the work-product privilege in that case).
Kovel acknowledges the inherent difficulty in distinguishing between situations in which the lawyer needs the accountant to assist the lawyer in rendering legal advice to the taxpayer and other cases in which the lawyer or the client simply want to retain the accountant to perform accounting services. The Court of Appeals concluded, however, that no matter how elusive this distinction may be in a given case, drawing it is unavoidably necessary in a system in which there is an attorney-client privilege, but no accountant-client privilege.
The distinction that Kovel drew between communications that merely inform the lawyer and those that enable the lawyer to communicate with the client was presented in the Second Circuit's decision in U.S. v. Ackert, 169 F.3d 136 (2d Cir. 1999). There, the Court of Appeals concluded that a tax lawyer's discussions with an investment banker, though essential to the lawyer's understanding of the proposed transaction and his giving of legal advice to the client, was not subject to the attorney-client privilege because the conversations between lawyer and investment banker did not directly enable the lawyer and the client to communicate with each other effectively. (Ackert, like Kovel, is an attorney-client and not a work-product privilege ruling.)
II. Adlman Expands The Potential Availability Of The Work-Product Privilege.
In U.S. v. Adlman, 134 F.3d 1994 (2d Cir. 1998), a corporation contemplating a reorganization retained an accounting firm to study the possible tax consequences of the proposed transaction that might result in a claim for refund of more than $200 million of tax. In support of its analysis, the accounting firm provided the corporation with a 58-page memorandum discussing every conceivable tax law consequence of the proposed reorganization. After the corporation had filed its claim for refund, the IRS sought production of the memorandum because neither the president of the corporation nor the accountant were practicing lawyers and the communication could not have been protected by the attorney-client privilege.
The Second Circuit in Adlman held that while there was no available attorney-client privilege, the memorandum might still be privileged as "work-product" if it had been prepared "in anticipation of litigation," a phrase meaning that litigation is not merely possible or foreseeable, but most likely certain. The Court of Appeals recognized that the preparation of the memorandum could conceivably have been "in anticipation of litigation," given that the claim for refund was so staggeringly high that the denial of the claim and the need to commence a refund suit were moral certainties. The Second Circuit concluded that the accountant's memorandum might have been prepared "in anticipation of litigation," even though, at the time that the memorandum had been prepared, the reorganization had not yet been consummated, no claim for refund had yet been filed, and any litigation would not commence until years later.
(Of course, had the taxpayer retained a lawyer to advise it regarding the possible tax consequences of the proposed reorganization and had that lawyer, in turn, retained the accounting firm to provide the memorandum to him, the attorney-client and work-product privileges might have protected the memorandum. The failure to do so relegated the taxpayer to the relatively weak claim of "work product," which was ultimately rejected after the Court of Appeals remanded the case to the district court for findings as to whether that privilege could apply.)
III. Frederick Upsets Accepted Notions of Privilege And The Accountant's Statutory Tax Advice Privilege.
In U.S. v. Frederick, 182 F.3d 496 (7th Cir. 1999), the taxpayer retained a lawyer to advise him in connection with a government investigation regarding the taxpayer's previously-filed tax returns. Because the lawyer was also an accountant, the taxpayer retained him to prepare a tax return that was about to become due. The lawyer and the taxpayer then communicated not only regarding the facts underlying the past tax years for which the client was being investigated, but also about financial information necessary to prepare the soon-to-be-filed return. The lawyer's notes and files contained statements and communications that blended together discussions of both the tax investigation and tax return preparation work. (As one might imagine, the problems created by the past year returns may well have carried forward in their effect or been the same as those that would be presented on any current or future year return. Accordingly, significant care was likely required in the preparation of any new return.)
The government then sought production of the lawyer's notes and files on the theory that (1) his work in preparing the return was not privileged because it was "accounting" work and not the giving of "legal advice" and (2) the lawyer's performing unprotected accounting work "tainted" any claim of privilege relating to documents and communications that referred to both the investigation and the tax return preparation. The Seventh Circuit agreed with the government, holding that (1) the preparation of a tax return is traditional accounting work and not the providing of legal advice; (2) communications between a lawyer and a taxpayer relating to the preparation of an as-yet unfiled tax return are not privileged because the lawyer is then functioning as an accountant and not as a lawyer; (3) communications between the lawyer and the client that touched on matters that related to both the tax return preparation and the ongoing investigation had a "dual purpose," only one of which was privileged; and (4) the non-privileged purpose of the communication taints the otherwise privileged nature of that communication.
Frederick apparently presumes that tax return preparation involves little more than the rote entering of numbers upon a form and it ignores the legal analysis that the process of return preparation often requires. The decision fails, moreover, to comprehend that sophisticated tax return preparation often requires an analysis of audit and litigation risks of the very type that Adlman realized might trigger application of the taxpayer's work-product privilege. Why the preparation of a tax return is inherently unprotected, while the legal advice that a client might receive, say, from a securities lawyer before making some disclosure to the SEC is protected, is entirely unclear. Why should we necessarily regard a tax return that is being prepared by a lawyer who is also taking account of the return's possible impact on a pending criminal or civil tax investigation of the taxpayer to be accounting work and not the giving of legal advice?
Equally important is Frederick's treatment of the 1998 Tax Reform and Restructuring Act's accountant-taxpayer privilege. Section 7525(a) of the Code. The Court of Appeals (in patent dicta) reasoned that the accountant's statutory privilege under the 1998 Act applies only in those cases in which a lawyer would have an attorney-client privilege. Because it concluded that the lawyer did not have a privilege when performing tax return preparation work or any other work that had a "dual purpose," it held that the accountant would likewise have no privilege because the purpose of the statutory provision is to put lawyers and accountants on the same footing in the rendering of tax advice and services. By negating any attorney-client privilege for tax return preparation work, the Seventh Circuit also negated the statutory accountant's tax advice privilege for the same work.
In an even more gratuitous and potentially harmful observation, the Seventh Circuit in Frederick also noted that the definition of what is accountant's work would likely also include the representation of a taxpayer at appeals. Accordingly, the government may someday consider going after lawyer communications and work-product relating to protests and appeals office representation on the theory that the lawyer is really acting as an accountant. (If so, however, how can a lawyer not licensed as an accountant be functioning as one?).
Frederick, it should be noted, dealt with communications that related to the preparation and filing of the taxpayer's original return. What if the issue is not the preparation of the original return, but, instead, the decision to prepare and file an amended return? Suppose that a lawyer is retained by a taxpayer who has a concern about the accuracy of his original returns. Unlike the filing of an original return, there is no statutory obligation to file an amended return. The decision whether or not to file an amended return in the circumstances just described, potentially criminal as they are, is uniquely a judgmental one that a lawyer would make only after taking account of all relevant information, including what an amended return would show. Assume that the lawyer hires an accountant to assist him in preparing a possible amended return for that purpose. Does Frederick enable the government to summons or subpoena the accountant who prepared an actual or proposed amended return? Does it matter whether the amended return is actually filed or whether the lawyer decides not to file it? Frederick raises, but does not answer, these questions.
Lastly, Frederick is questionable even under its own analysis because it fails to consider the practicality and necessity of redacting the privileged from the non-privileged content of any "dual purpose" communications. The problems with Frederick aside, it continues to be the law in the Seventh Circuit and may support the contention that any communication relating to the preparation of a tax return under any circumstance is the giving of accounting and not legal advice. In re Grand Jury Proceedings, 220 F.3d 568 (7th Cir. 2000); see also U.S. v. Randall, 99-1 USTC par. 50,596 (D. Mass. 1999).
IV. A Few Observations Regarding the Fifth Amendment
A natural person, of course, has a Fifth Amendment privilege not to incriminate himself or herself. (While a non-natural person, such as a corporation, has no Fifth Amendment privilege, the individuals within the corporation or other entity, do have their own Fifth Amendment privileges.) What should tax lawyers and accountants do if they find themselves in situations in which they become concerned that a return that is the subject of an ongoing examination was knowingly false in some material way?
Certain things are clear in this circumstance. First, the taxpayer should not provide statements or information that would incriminate him, as to do so is, of course, self-defeating. Moreover, the taxpayer cannot tell a knowing falsehood to an IRS or Department of Revenue agent in an interview or in the giving of any other information, as to do so is itself a crime. Accordingly, placing a taxpayer who has potential criminal exposure in the position of communicating directly with a tax examiner puts the taxpayer in the position of either telling the truth and incriminating himself or telling a lie which will only escalate the taxpayer's problems geometrically.
The problem of potential criminal tax consequences for the taxpayer is particularly acute for an accountant who has no privilege with the taxpayer for any incriminating statements that the taxpayer may make to the accountant. (Even on its face, the statutory accountant's privilege does not apply in criminal proceedings.) If the taxpayer begins to discuss or confess to a tax crime or if the accountant sees other evidence of fraud, the accountant should immediately avoid further discussion with the taxpayer and should advise the taxpayer to retain a qualified lawyer immediately. The accountant's failure to do so may result in him or her becoming a witness against the taxpayer.
Many tax lawyers and accountants fear that the claiming of the Fifth Amendment or the taxpayer's refusal to cooperate fully with the IRS should be avoided because it may only make the taxpayer look bad or it may tip off the tax examiner. In such cases, however, leaving the IRS or Department of Revenue to suspect that the taxpayer is a possible tax cheat is far superior to having them discover from the taxpayer's own words that he is a cheat or, worse yet, that the taxpayer has attempted to conceal a tax crime by telling a lie that compounds the proof against him with regard to the original tax crime and that itself constitutes the independent crime of making a false statement or obstructing justice.
Lastly, the decision to invoke the taxpayer's Fifth Amendment privilege at the examination stage does not mean that the taxpayer cannot later decide to communicate with the government. In civil litigation, there is a negative inference that the court or jury can draw from the invocation of the Fifth Amendment, but such cannot be drawn in a criminal case, consistent with the Fifth Amendment right itself. By deferring any statements to the IRS or the Department of Revenue during the examination stage, the taxpayer may be able to limit his criminal exposure and defer the need to consider testifying (truthfully, of course) until a later time when all of the risks and rewards of his testifying can be weighed more intelligently.