The Internal Revenue Service Restructuring and Reform Act of 1998 added Internal Revenue Code § 7525, "Confidentiality Privileges Relating to Taxpayer Communications." This provision is intended to extend a confidentiality privilege to certain communications between taxpayers and non-attorney tax practitioners. However, a variety of key limitations significantly limit the scope of this new privilege, and the Internal Revenue Service has already indicated that the new provision has only limited effect on examinations. Tax engagements and related communications, particularly those involving non-attorney tax practitioners, need to be carefully considered in light of these new and still developing rules.
Section 7525 and the Committee Reports
Code § 7525 provides as follows:
(a) UNIFORM APPLICATION TO TAXPAYER COMMUNICATIONS WITH FEDERALLY AUTHORIZED PRACTITIONERS.--
(1) GENERAL RULE. -- With respect to tax advice, the same common law protections of confidentiality which apply to a communication between a taxpayer and an attorney shall also apply to a communication between a taxpayer and any federally authorized tax practitioner to the extent the communication would be considered a privileged communication if it were between a taxpayer and an attorney.
(2) LIMITATIONS. -- Paragraph (1) may only be asserted in--
(A) any noncriminal tax matter before the Internal Revenue Service, and
(B) any noncriminal tax proceeding in Federal court brought by or against the United States.
"Tax advice" is defined as advice given by a tax practitioner with respect to a matter which is within the scope of the individuals authority to practice before the IRS. Further, the privilege does not apply to communications relating to tax shelters (as defined by Code § 6662). Section 7525 is effective with respect to communications made on or after July 22, 1998.
Congress intended for this new privilege to extend a significant, although limited, privilege to tax practitioners. The Senate Committee Report explained the reason for this new provision:
The Committee believes that a right to privileged communications between a taxpayer and his or her advisor should b available in noncriminal proceedings before the IRS and in noncriminal proceedings in Federal courts with respect to such matters where the IRS is a party, so long as the advisor is authorized to practice before the IRS. A right to privilege in such situations should not depend upon whether the advisor is also licensed to practice law.
Based on the statutory language and Congress expressed intent, most tax practitioners expected this new provision to have a significant impact on dealings with the IRS. However, the IRSs current position and common law regarding the attorney-client privilege indicate that many materials relating to tax engagements may still be discoverable by the IRS.
Internal Revenue Service Position
The IRS addresses new § 7525 on its Internet home page (http://www.irs.ustreas.gov/prod/tax_regs/rra-3411.html). After generally outlining the scope of the new provision, the IRS states that "there is unlikely to be any immediate impact because the new statutory privilege may be asserted only as to communications made after the date of enactment" and that "it is unlikely to affect examinations of tax periods prior to 1998." Of course, this ignores potentially privileged communications made currently with respect to prior periods and related IRS activities.
With respect to the substance of § 7525, the IRS acknowledges that there are "significant interpretive issues." The IRS also states that the new privilege is "clearly a different privilege [than attorney-client], created solely by statute, and defined as much by the statutory language as by reference to the common law attorney-client privilege." The IRS acknowledges that there will be questions of statutory interpretation regarding definitions of the terms, such as "tax advice" and "communication," and other questions regarding circumstances in which taxpayers may waive, or lose the ability to assert, the privilege. These questions are to be referred to IRS counsel when they arise.
Probably the most telling statements on the IRS home page fall under the heading "Necessary Actions" and the subheading "Things We Can Do," where the following statement appears:
"The statute grants a new privilege which does not arise automatically but must be asserted by the taxpayer. Employees may still seek the same information in the same manner as before the statute. The only difference is that taxpayers may now assert, in noncriminal proceedings, a confidentiality privilege for communications made after the date of enactment to federally authorized tax practitioners concerning tax advice sought or received." (emphasis added).
Thus, the IRS will be operating as usual, and the privilege will only apply if raised by a taxpayer or representative. Any attorney involved in a tax engagement will certainly have to consider this privilege in addition to issues relating to the traditional attorney-client privilege.
Privilege Limitations
The IRS properly notes that significant interpretive issues remain under new § 7525. By its terms, the new provision does not apply to criminal actions, which is a significant difference from the attorney-client privilege. Similarly, § 7525 does not apply to actions involving any opposing party other than the IRS, so it does not apply to other administative agencies or parties.
It is also important to remember that § 7525 is based on the common law attorney-client privilege. Therefore, the new tax practitioner privilege should be subject to waiver and may be limited to situations where it is raised by the taxpayer, as noted by the IRS. In addition, situations where the attorney-client privilege does not apply probably also limit the scope of § 7525. An important example in this context is the exchange of information in connection with tax return preparation, which may not be covered by the attorney-client privilege. Much of the work and related communications between tax practitioners and taxpayers may similarly fall outside the scope of the attorney-client privilege and may not be considered "tax advice" for purposes of § 7525. This will create complicated privilege situations for multi-disciplinary firms that provide accounting, consulting and tax advice services to a given taxpayer.
Practical Considerations
The enactment of § 7525 and the expected difficulty in interpreting its application in different circumstances should serve as a reminder to carefully consider privilege issues in all engagements. This will now be particularly true for tax engagements, where failure to properly handle communications could limit the application of § 7525 and the traditional attorney-client privilege. There are some basic considerations that may help protect communications.
Client and Tax Practitioner Education. Clients seldom fully understand privilege issues beyond a general idea that their discussions with attorneys may be confidential. Most clients need assistance in avoiding waiver of the attorney-client privilege and will need to be educated on the limitations of § 7525, if they are even aware of the new provision. Similarly, accountants and other tax practitioners do not tend to be familiar with privilege issues and may need assistance in interpreting § 7525 as it relates to the traditional common law attorney-client privilege. All tax practitioners and clients should be reminded that disclosure of information or communications to the IRS or third parties may result in waiver of the privilege.
Engagement Letters. Engagement letters should be standard practice for tax matters. Tax practitioners, including attorneys, will want to clarify in writing that the nature of their engagement relates to tax advice, so that the related communications arguably qualify for § 7525 or common law attorney-client privilege. This may require multiple engagements (and related letters) for practitioners and firms that provide a variety of services for a particular taxpayer, especially if some of the services do not involve privileged communications. In these circumstances, communications should not include mixed subjects where only certain portions may be privileged.
Marking/Labeling Communications. It is good practice to label all confidential tax advice communications. Labels such as "Privileged and Confidential Tax Practitioner-Client Communication" may help establish the privilege and will certainly be a good reminder to clients and practitioners that the information should not be provided to the IRS or disclosed to third parties. Confidentiality language is also important with respect to facsimile and electronic mail communications.
Attorneys Directly Engaging Accountants. There are situations where § 7525 simply is not adequate. By its terms, the new provision does not apply to criminal IRS proceedings. There also may be a variety of situations where disclosure of information to accountants or other tax professionals is needed, but disclosure to these non-attorneys would result in waiver of attorney-client privilege with respect to the information. In these circumstances, attorneys should consider engaging the non-attorney tax practitioner directly so that their communications and work product are at least arguably privileged. See United States v. Kovel, 296 F.2d 918 (2d Cir. 1961) (communications with accountant may be privileged where accountant engaged by attorney).
These are just a few practical issues to considr in future and ongoing tax engagements. The technical application of the attorney-client privilege and the new tax practitioner privilege in § 7525 will require careful analysis in each particular situation.