8.          Priveledge

Of course, the sharing of advice and opinions among advisors and preparers raises the issue of privilege.  The hazards of waiving the attorney-client privilege and its statutory accountant-client counterpart (Code Section 7525) can be difficult to navigate when only two parties (the taxpayer and his or her advisor) are involved.  What if there are three or more parties working on the transaction?  What happens to these privileges when a tax return preparer relies on the advice of another preparer or a non-preparer?

Under federal law, privileges are very narrowly construed and strictly applied.  The attorney-client privilege protects communications made in confidence between a taxpayer and his or her professional legal advisor to obtain or render legal advice, unless the taxpayer waives the privilege. ⁴⁴  Code Section 7525 treats certain communications between a taxpayer seeking tax advice and his or her accountant as if they were communications between the taxpayer and an attorney.  Thus, if a taxpayer hires either an attorney or an accountant to provide tax advice with respect to the treatment of an item or a transaction, their communications may be privileged.  In addition, an attorney may retain an accountant to assist in rendering his or her tax advice, such as when an attorney hires an accountant to “translate” the complexities of a client’s financial affairs. ⁴⁵

These rules do not give blanket protection to communications among a taxpayer and his or her attorneys and accountants, especially in combination.  There are two principles that severely limit the privileges. 

First, the privilege only applies with respect to legal advice.  The IRS often argues that much of the work done to prepare tax returns does not involve legal advice.  Many courts have concluded that the preparation of tax returns is outside the scope of the attorney-client privilege, ⁴⁶ although some courts appear to be willing to examine individual cases. ⁴⁷  In any case, do not assume that any work that an attorney performs will automatically be viewed as rendering legal advice.  The accountant-client privilege under Code Section 7525 is technically subject to the same limitations, since that privilege is explicitly co-extensive with the attorney-client privilege.  These limitations are much more burdensome on accountants, however, because a much smaller percentage of their work (as opposed to attorneys’ work) constitutes legal advice; the IRS can be expected to argue (and many courts will agree) that virtually everything an accountant produces relates to non-legal advice, such as the preparation of tax returns, and is thus discoverable.

Second, only communications which are and can reasonably be expected to remain confidential can be privileged.  Obviously, communications of information that will appear on a tax return are not confidential.  But the need for confidentiality is much broader.  As noted above, an attorney hired by a taxpayer to render legal advice can engage the services of an accountant to assist in determining the proper tax treatment.  In such a case, the accountant is considered the agent of the attorney, hired by him to assist in his understanding of the legal issues, and thus there is no waiver of confidentiality.  However, if the client, rather than the attorney, employs the accountant, and if the accountant assists the attorney in the latter’s advice (e.g., by explaining to the attorney the reasoning behind an earlier determination), their communications may not be considered privileged.  Here, the accountant is not the attorney’s agent, but a third party, with whom communications are not privileged.

A taxpayer who seeks to rely on the advice of counsel as a defense may waive the attorney-client privilege with respect to that advice.  For example, when taxpayers responded to government interrogatories concerning an accuracy-related penalty claimed they had reasonable cause based on advice of counsel, that response was deemed a permanent waiver of the attorney-client privilege with respect to the transactions at issue, because it would have been unfair for the taxpayers to raise the defense without allowing the government access to the communications upon which the defense was based. ⁴⁸  This type of implied waiver is particularly dangerous in the context of Section 6694, because not only the taxpayers, but also their preparers, may resort to a reasonable cause defense.  A taxpayer who allows privileged communications from one preparer to be shared with another, knowing that the latter might use such communications in a reasonable cause defense, may be deemed to have waived any confidentiality with respect to those communications, even if they are never actually used in that way. 

For these reasons, attorneys and accountants should anticipate that communications associated with advice a taxpayer or preparer relies upon in reporting a position on a tax return will not be privileged and may be subject to discovery by the IRS.  A taxpayer who keeps this possibility in mind can more precisely direct his advisors in the giving of advice.  For example, a taxpayer might hire an attorney to undertake a detailed analysis of a particular transaction, but request that the attorney draft a much briefer and less detailed statement for the taxpayer’s accountant to use in return preparation.  The accountant should be able to rely upon the less detailed statement, and it along with the rest of the accountant’s files will be discoverable; the more detailed analysis, however, will remain privileged in the hands of the attorney.

9.         Practitioner Skill

Do different preparers face different standards in the application of Section 6694?  Specifically, are more sophisticated or specialized preparers held to a higher standard?

According to existing regulations, all preparers are held to the same standard in the determination of the likelihood of success of a position taken on a tax return, because the regulations define an objective measurement.  However, if there is an understatement of tax and the preparer argues that there was reasonable cause and that he acted in good faith, one of the factors that the IRS must consider is whether “the preparer’s normal office practice, when considered together with other facts and circumstances such as the knowledge of the preparer, indicates that the error in question would rarely occur.” ⁴⁹  Here, the reference to the “knowledge of the preparer” appears to place a higher burden on the more sophisticated preparer.  However, to the extent that the standards of practice are defined by reference to the more sophisticated preparers, less sophisticated preparers are subject to greater risk, and might be expected to institute more meticulous office practices (such as checklists and review procedures) to compensate for his or her lesser knowledge in guarding against errors.

On the other hand, while all preparers appear to be held to the same objective standard in their determination of the strength of a position, there is some latitude in the existing regulations to account for the sophistication of particular preparers.  In preparing tax returns, for example, preparers may generally rely upon the information given to them by taxpayers without making independent verification.  However, a preparer “may not ignore the implications of information furnished to the preparer or actually known by the preparer.” ⁵⁰  This mandate leaves room for the argument that a more knowledgeable preparer may face a higher burden than someone less familiar with tax law, to whom “the implications” of certain information may not be apparent.
In sum, all preparers must adhere to an objective standard in determining the reasonableness of a position, standards may demand more care and effort from a less sophisticated preparer.  Such preparers might also be expected to put into place more detailed office practices to minimize errors.  A more sophisticated preparer, though, might be assumed to have a greater awareness of the implications of the information provided to him or her by a taxpayer, giving him or her a greater responsibility to follow up on those implications.

10.       Penalty Payments

As noted above, the penalties have been increased to the greater of $1,000 or 50 percent of the income derived by the preparer with respect to the return or claim, and $5,000 or 50 percent of the income derived with respect to the return or claim, in the case of willful or reckless conduct. ⁵¹  Because the trigger for the penalty is the preparation of “any return or claim for refund” with an understatement of liability, not the treatment of any particular item or position, it appears that any preparer can only be penalized once with respect to a particular return, but that the amount of the penalty will be based on all the income derived with respect to that return.  In other words, if a preparer provides advice on five different issues, affecting five separate items on one return, and there is a violation under Section 6694 with respect to two of those items, the preparer will only be subject to one penalty, but that penalty will be the greater of $1,000 or 50 percent of the income derived from the preparer’s work on all five issues.

The language of the statute provides for a reduction in the amount of the latter penalty for any amounts charged under the former, so that the maximum penalty under Section 6694 would be the greater of $5,000 or 50 percent of the income derived. ⁵²  There are no similar abatements stated with respect to multiple returns or to multiple preparers who worked on one return.  Therefore, it appears that, as was clearly intended under the old law, a preparer who takes the same erroneous position on several different returns will be required to pay full penalties with respect to each return.  Also, where two different preparers give advice on the same erroneous position in a single return, each could be penalized in an amount equal to 50 percent of its respective income derived.  Note that if Circular 230 applies to the advice given by a preparer, and if that advice does not meet Circular 230 standards, such preparer may be subject to an additional penalty of 100 percent of the income derived. ⁵³

Because penalties may be based on “the income derived . . . with respect to the return,” preparers should exercise care in defining such income.  Preparers who perform multiple tasks for a taxpayer, only one of which is the preparation of a tax return, should separately itemize the amount billed for return preparation, to forestall IRS claims that the penalty should be based on a larger amount.

As noted above, penalties levied under Section 6694 would not be deductible as business expenses under Code Section 162(a).  Section 162(f) explicitly denies deductibility for “any fine or similar penalty paid to a government for violation of any law,” and Treasury regulations make it clear that this includes any civil penalty imposed under chapter 68 of the Code (which includes Section 6694). ⁵⁴

What Does This Means for Taxpayers and Preparers?

The combination of being subject to stricter standards than taxpayers and the current absence of official guidance seems to put preparers into an uncomfortable position, having to urge their clients to secure opinions as to the tax treatment of transactions and report positions that the clients themselves have no obligation to report.  However, the situation need not be seen or presented as a conflict of interests.  Rather, preparers should take the opportunity to point out to their clients that their recommendations for obtaining opinions and disclosing positions are consistent with the ethical obligations and best practices of both the preparer and the taxpayer.  The establishment of such practices across the board for tax preparers appears to be one of the long-term goals of Treasury and the IRS, and professionals who put such practices into place now will best serve their clients and themselves.

Non-signing preparers have more flexibility than signing preparers, since (at least under existing regulations) non-signing preparers can meet their disclosure requirements by including, with their advice to the taxpayer or to another preparer, a statement that the position at issue needs to be disclosed.  Signing preparers currently have no such option.  It is possible that Treasury will recognize the awkward position in which signing preparers could find themselves if they have a duty to disclose but the taxpayer does not.  Treasury may, therefore, offer regulatory relief to signing preparers.

In practice, there may only be a limited number of situations in which preparers are required to disclose but the taxpayer is not.  In order to avoid disclosure, a taxpayer must be able to demonstrate the objective existence of specific authority (statutes, rulings, regulations, cases, and the like) that indicate at least a 40 percent chance of success.  A preparer must demonstrate a subjective reasonable belief that the position is more likely than not to be upheld, and there is no limit to the authority upon which this belief can be based.  Therefore, it may often be possible that while a taxpayer could not marshal “authority” strong enough to show more than a 40 percent chance of success, a preparer could nevertheless have a reasonable belief that the position is more likely than not to succeed.  If this belief is based at least in part on advice received from another preparer or advisor, then the preparer could also benefit from the reasonable cause and good faith exception.

If it does come to the point where the taxpayer feels he has substantial authority but the preparer has no reasonable belief in more likely than not status, the preparer should explain to the taxpayer that disclosure is necessary not merely to protect the preparer from penalty but to conform with the new standards of practice that Section 6694 put into place.  Treasury and the IRS have long sought to shift some of the burdens of oversight to tax preparers, in pursuit of their ultimate goal of increasing the reliability of our self-reporting tax system, and the modification of Section 6694 represents a major leap forward towards this goal.  Preparers are now expected take responsibility for the positions on which they rely in return preparation, to institute internal policies and procedures to minimize errors, and to seek outside advice when necessary.  Preparers should institute these best practices and apply them consistently.  While on a case-by-case basis, such practices might lead to apparent conflicts of interest with the taxpayer, in the long run they demonstrate a reliability and integrity that can only enhance the preparer’s representation of the taxpayer. 

The apparent conflict of interests may serve to protect the taxpayer: if a preparer cannot subjectively take the position that the whole universe of authority does not justify a reasonable belief in a 51 percent likelihood of success, that may indicate that the IRS will have an easier time showing that authority gleaned from a more limited subset of that universe does not reach the 40 percent threshold.  Also, while disclosure is traditionally associated with an increased audit risk, it is likely that under new Section 6694, disclosures will increase dramatically, given the stricter standards, higher penalties, and the broader definition of “preparers.”  In the face of such an avalanche of paper, the IRS may not have the resources it needs, and may need to alter the way it addresses disclosures ⁵⁵.  In practical terms, this may mean that disclosure will carry less risk for the taxpayer than in the past.

In the long term, it may be that the changes in Section 6694 are a harbinger of future movement in the law towards the synchronization of taxpayer and preparer penalties.  Another sign of such movement was the creation (in the same statute that altered Section 6694) of Code Section 6676.  This new Section provides a penalty for taxpayers who make an excessive claim for refund or credit without a reasonable basis.  Before the creation of Section 6676, a taxpayer could be penalized for underpayments of tax, but not (except with respect to listed or reportable transactions) for erroneous claims for refund.  Under old Section 6694, however, preparers could be penalized for unreasonable claims for refund.  Thus, the introduction of Section 6676 was another step in the synchronization of taxpayer and preparer penalties.  The disparity introduced by Section 6694 may only be temporary, and it may well be resolved not by another change to 6694, but by a change in 6662 increasing the taxpayer’s threshold for disclosure.
Such synchronization can already be seen between Section 6662 and Circular 230.  Section 6662 already provide a more-likely-than-not standard for taxpayers with respect to tax shelters, which are defined as partnerships or other entities, plans, or arrangements with a significant purpose of avoiding federal income tax. ⁵⁶  The more-likely-than-not standard and significant purpose of avoiding federal income tax also defines what constitutes a reliance opinion under Circular 230. ⁵⁷  In the face of such a trend, it is best practices for both taxpayers and preparers to harmonize their disclosure efforts.