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Tax Preparer-Client Privilege?

Anybody who has seen an episode of Perry Mason or L.A. Law is familiar with the concept of the attorney-client privilege. In short, it means that your attorney can't rat you out for something that you might have told him or her in confidence. It's a very important concept, which originated in common law.

Many taxpayers believe that the same privilege applies to the accountant-client or tax preparer-client relationship. Unfortunately, nothing could be further from the truth. Why the confusion?

Privilege for federal tax practitioners
In 1998, Congress passed Code Section 7525. This section of the code deals with limited (very limited) privilege relating to providing "tax advice" to a client. For whatever reason, many taxpayers have viewed this limited privilege as akin to the attorney-client privilege noted above, but it's just not true. Sadly, even some tax pros don't quite understand the protection afforded the client under Code Section 7525, and are giving clients a very false sense of security.

Basically, Code Section 7525 allows for a confidentiality privilege in the following situations:

  • Tax advice between a taxpayer and any federally authorized tax practitioner, such as a certified public accountant (CFA), enrolled agent (EA), or attorney
  • Only in non-criminal matters
  • Only in matters regarding the Internal Revenue Service (state, local, and other non-federal tax issues don't apply)
  • Only in tax advice provided after July 22, 1998

The definition of "tax advice" is loosely constructed. Generally, it applies to an accountant's tax memos, opinion, and other documents pertaining to a client's actual or potential tax liability. It does not apply to the information used in preparing the actual tax return, among many other things.

Non-privileged matters
You might think that the privilege protection above is very limited, and you'd be right. Here are some of the issues for which accountant-client privilege does not apply:

  • Work product not involving "tax advice," such as workpapers used to prepare the tax return
  • Matters relating to state, local, or other jurisdictions outside of the IRS
  • Criminal tax matters (where you likely need the attorney-client privilege the most)
  • Non-criminal tax proceedings in which the United States is not a party
  • State court proceedings involving private litigants
  • Any written communications in connection with the promotion of a corporation in a tax shelter

There are even more technical issues that also aren't considered privileged. So what protection does the accountant-client privilege actually provide? About as much as a tent in a tornado!

Waiving the privilege
If you think that trying to understand what is included in "privilege" is difficult, then don't even try to understand the rules regarding waiving that privilege. Essentially, the normal attorney-client privilege is waived if some or all of the information subject to that privilege is made public or is otherwise shared with no expectation of confidentiality. That's a difficult concept to wrap your brain around in the course of understanding the typical attorney-client privilege. It becomes even hazier when attempting to apply it to the accountant-client privilege. Because the law is so broad, and because there have been very few court decisions on the scope of the accountant-client privilege, it's impossible to know what might inadvertently waive that privilege.

Many brilliant legal and tax minds are still unsure of what might trigger an unintentional waiver of the accountant-client privilege. The Congressional Conference report on this legislation provides that the tax practitioner privilege may be waived in the same manner and to the same extent as the attorney-client privilege. This presents a real problem.

Courts often rule that voluntary disclosure of a privileged communication destroys the applicability of the privilege to all communications concerning the same subject matter. Taking this course of action, the IRS could reasonably be expected to argue that the disclosure of non-privileged communication (i.e., that which is outside the scope of the accountant-client privilege) would also constitute a waiver as to all of the tax advice that the client received. Likewise, the IRS could maintain that disclosures under other laws (such as the Securities and Exchange Commission's rules and regulations or various state laws or regulations) would also constitute a waiver as to all of the tax advice. In short, it's a real mess.

Recent court ruling
In a chilling decision handed down recently, a district court concluded that the confidentiality privilege did not apply to prevent H&R Block (NYSE: HRB  ) from handing over client information to the IRS.

In Sorenson V. H&R Block Inc., Mr. Sorenson used H&R Block to prepare his tax return, which contained a number of questionable deductions. When the IRS audited Mr. Sorenson, the H&R Block agent provided the IRS with internal documents between Block and Sorenson, which waived any privilege that Mr. Sorenson might have had. Mr. Sorenson sued H&R Block for a breach of duty of confidentiality.

Mr. Sorenson won the battle but lost the war. The court held that while H&R Block breached its contractual duty to Mr. Sorenson, the court ordered damages in the amount of only $630 -- the amount of his tax preparation fees paid to H&R Block from 1993-1995. The court concluded that there were no extraordinary circumstances sufficient to justify expanding the damage award.

But even more important was what the court had to say on the issue of privilege. According to the court, taxpayers dealing with accountants on tax matters lack a legitimate expectation or privacy. The court said that the trend is moving in the direction of narrowing the scope of privileges. The court also noted that recognizing a new confidentiality obligation or privilege for "tax preparers" not covered by a traditional attorney-client privilege was a step that should not be undertaken without some greater demonstration that the benefits from the new privilege outweigh the cost to society. Ouch.

When in doubt, see an attorney
In my opinion, you should consider your tax preparer-client privilege virtually non-existent. Sure, it's written into the tax code, but because of the broad language and the view of the courts in recent decisions, any accountant-client privilege is not much more than a cloth veil when compared to the curtain of the attorney-client privilege.

Does that mean that you'll have to hire a tax attorney to prepare your return, instead of your local EA or CPA? Not in the least. The courts have ruled that the standard attorney-client privilege doesn't apply to information given to an attorney for the preparation of a tax return, since preparation of tax returns is primarily an accounting service. Likewise, if the IRS wants to see your records in conjunction with an audit, a CPA or EA can certainly be your best friend.

But if you find yourself in a bind, and you think that you might have to go toe-to-toe with our good friends at the IRS in the form of a legal proceeding, or if you have reason to believe that criminal actions might be brought against you by any taxing authority, you should strongly consider the services of a qualified attorney before you begin to explain the entire situation to your tax preparer.

Roy Lewis lives in a trailer down by the river and is a motivational speaker when not dealing with tax issues, and he understands that The Motley Fool is all about investors writing for investors. You can take a look at the stocks he owns as long as you promise not to ask him which stock to buy. He'll be glad to help you compute your gain or loss when you finally sell a stock, though.

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