A Brief Exploration of Privilege Nuances in the Tax Context
Attorney-client privilege and relevant analogs exist to protect the confidentiality of client communications and to ensure that clients feel free to have frank and honest conversations when seeking advice. However, in the tax context, privilege protections are nuanced and often require an in-depth analysis. This article discusses applicable privileges in the tax context, as well as two key exceptions: waiver and the crime-fraud exception. It also examines three recent cases that highlight the practical implications of these exceptions.
Overview of Applicable Privileges in the Tax Context
The attorney-client privilege protects communications between the client and lawyer that are made in confidence and for the purpose of obtaining legal advice. This privilege extends to information given for the purpose of obtaining legal representation. Attorneys may not disclose communications and information protected by the attorney-client privilege, and clients cannot be compelled to disclose protected communications. The purpose of the attorney-client privilege is to promote unrestrained communication and contact between the lawyer and client in matters in which the attorney’s professional judgment is sought. A key exception to the attorney-client privilege in the tax context is the crime-fraud exception, which excludes communications made (1) if the client was in the process of committing or planning a fraud or crime and (2) in furtherance of the fraud or crime.
The Internal Revenue Code also creates a tax practitioner privilege on the theory that it will encourage clients to provide tax practitioners with complete information so that tax practitioners may better assist their clients in obeying the law. Specifically, under Section 7525 of the code, communications between “federally authorized tax practitioners” and their clients regarding federal tax advice are protected to the same extent as attorney-client communications. “Federally authorized tax practitioners” include CPAs, enrolled agents and actuaries. They also generally include in-house tax department employees who may represent their employers before the IRS. There are certain exceptions to the tax practitioner privilege. The crime-fraud exception, which is analogous to the exception applicable in the context of the attorney-client privilege, also applies in the context of the tax practitioner privilege. Likewise, communications regarding tax shelters are excluded from the scope of the tax practitioner privilege.
Finally, the work-product doctrine is designed to protect communications from discovery when those communications were made in anticipation of litigation. Its scope reaches documents and tangible things prepared in anticipation of litigation. The work-product doctrine is broader than attorney-client privilege. It covers materials prepared by anyone at the direction of the attorney where future litigation was a distinct possibility. However, a party seeking discovery of otherwise protected information can overcome the work-product doctrine by showing substantial need and that there is no other means to access the information without undue hardship.
While a lawyer can invoke the attorney-client privilege to protect communications with her client, it is the client who technically “owns” the privilege. Thus, the client can waive privilege by sharing otherwise privileged information with individuals other than her attorney, or sharing privileged information with an attorney for a non-legal purpose. The communication’s purpose determines whether the communication is privileged. For example, business, tax preparation and accounting advice is not protected, even if provided by a licensed attorney.
Nonlegal Advice Is Not Privileged
Companies and individuals must be cognizant of providing otherwise privileged information to attorneys when there is a nonlegal purpose for doing so. A recent case from the U.S. District Court for the Northern District of California, United States v. Sanmina Corp. & Subsidiaries,1 demonstrates that waiver of the attorney-client privilege and work-product protection may result if otherwise privileged information is provided to lawyers for a nonlegal purpose.2
In Sanmina, the court held that a corporation waived the attorney-client privilege and work-product protection when it provided privileged information to a law firm for the nonlegal purpose of preparing a valuation report that would be provided to the Internal Revenue Service to establish the validity of a deduction the company took.3 In the report, the law firm relied upon two memoranda prepared by Sanmina’s in-house counsel to reach its conclusion.4 When faced with an IRS summons, the corporation refused to produce the two documents referenced in the valuation report on the basis of the attorney-client privilege.5
The court determined that the taxpayer had waived any attorney-client privilege when it disclosed the documents to the law firm for the business purpose of drafting the valuation report.6 The court further held that providing the law firm’s valuation report to the IRS would have waived any applicable privilege as to the material used to reach the valuation.7 Sanmina filed an interlocutory appeal of this decision, which is currently pending before the U.S. Court of Appeals for the Ninth Circuit.8
Preserving Privilege While Working with Accountants
Risk of waiver can present a problem for companies and individuals seeking legal advice regarding complex tax issues. Attorneys often need the advice of a third party — like an accountant — to fully understand material tax issues that their clients face. While the tax practitioner privilege applies in a civil setting, it is not available during a criminal investigation or prosecution. Therefore, disclosing privileged information to accountants during a criminal investigation runs the risk of waiver. Yet communications between a taxpayer’s lawyer and accountant may remain privileged if the accountant was hired under a so-called Kovel9 arrangement.
A Kovel arrangement allows the attorney-client privilege and work-product doctrine to extend to communications with a third-party expert — like an accountant — so long as that expert was hired “for the purpose of obtaining [confidential] legal advice from a lawyer.”10 A Kovel arrangement is created when a client’s lawyer hires an expert — e.g. an accountant — to assist the lawyer with understanding the relevant issues in order to provide legal advice. Properly executed, the Kovel arrangement imports attorney-client privilege to the accountant’s work and communications.
The Common Interest Doctrine Protects Against Third-Party Waiver
In connection with a complex financial transaction, taxpayers may decide to share otherwise privileged communications and materials with third parties — e.g. parties also having financial interests in the transaction — and their attorneys. Generally, disclosing a communication to a third party waives the attorney-client and tax practitioner privileges.11 However, a taxpayer’s disclosure of privileged information to a third party may be protected under the common interest doctrine. The common interest doctrine permits parties to share information without waiving privilege so long as a “common legal interest” exists between the parties, the information is exchanged solely for obtaining and providing legal advice, and the communications are intended to be kept confidential.12
No ongoing litigation is necessary for the common interest privilege to apply; instead, communications made during an “ongoing common enterprise and intended to further the enterprise are protected.”13 Courts have held that documenting the existence of the common legal interest and the agreement to maintain shared communications’ confidentiality in a common interest agreement is relevant to the analysis of the common interest privilege’s applicability.14
Schaeffler v. United States15 demonstrates how courts analyze the common interest privilege and the importance of a common interest agreement in the tax context. Schaeffler involved the restructuring of the Schaeffler Group — a German company having 80 percent of its stock owned by a U.S. resident — and the refinancing of debt owned by a consortium of banks in the wake of the 2008 financial crisis.16
The Schaeffler Group hired legal counsel and an accounting firm to advise on assessing and minimizing the tax consequences of the restructuring and refinancing, knowing that the transactions would likely face IRS scrutiny.17 In the course of the refinancing and analysis of its tax consequences, the Schaeffler Group shared materials that included privileged tax advice with the consortium pursuant to a common interest agreement.18 The IRS later subpoenaed the documents containing the legal tax advice. The Schaeffler Group moved to quash the subpoena and withheld the documents on the basis of the common interest privilege and the attorney work-product doctrine.19
The magistrate judge held that the Schaeffler Group had waived the attorney-client and tax practitioner privileges upon disclosure of the documents to the consortium.20 On appeal, the U.S. Court of Appeals for the Second Circuit reversed, holding that (1) the common interest doctrine protected the exchange of privileged information21 and (2) the work-product doctrine also applied to materials prepared during the course of the transaction because the documents were prepared in anticipation of an IRS audit.22
In holding that the Schaeffler Group and the consortium had a common legal interest, the Second Circuit explained that the parties “had a strong common interest in the outcome of [the] legal encounter [with the IRS]” surrounding the tax treatment of the refinancing and restructuring.23 The court noted that “[a] financial interest of a party, no matter how large, does not preclude a court from finding that a common legal interest also exists and is shared with another party where the legal aspects materially affect the financial interest.”24 The finding of a common legal interest between the parties in Schaeffler was supported by the nature of the parties’ communications, which were “made in the course of an ongoing common enterprise” and were “of a sufficient legal character to prevent a waiver[.]”25 The court noted that the common interest agreement documented the parties’ “common legal strateg[ies]” and “the[ir] mutual obligations.”26
In holding that the work-product doctrine applied to the documents the IRS sought, the court explained that the tax advice at issue “was necessarily geared to an anticipated audit and subsequent litigation.”27 The court noted that the tax advice was more detailed than advice that would be given during the preparation of a “routine tax return”28 and “candidly discusse[d] the attorney’s litigation strategies [and] appraisal of the likelihood of success.”29
Another exception to the attorney-client and tax practitioner privileges is the crime-fraud exception. The crime-fraud exception removes communications from the scope of both privileges where the taxpayer attempts to obtain advice to further the commission of a crime or fraud. Similarly, a Kovel arrangement will not protect communications — or documents — about future criminal acts.
Courts vary in their application of the crime-fraud exception. However, generally the party opposing the assertion of privilege must demonstrate that there is a reasonable basis to suspect (1) that the lawyer or client was committing or intending to commit a crime or fraud and (2) that the attorney advice/work product was used in furtherance of the alleged crime or fraud.30
A November 2018 decision highlights how the crime-fraud exception works in practice. In United States v. Issa,31 the Southern District of New York held that a Kovel arrangement did not extend to three documents as a result of the crime-fraud exception.32 The court found that the documents were prepared and submitted to the defendant’s Kovel accountant for the purpose of allowing the accountant to prepare a false and fraudulent amended tax return for corporations controlled by the defendant.33 Accordingly, the IRS was allowed to use the documents in its criminal case against the taxpayer.34
United States v. Adams: An Analysis of Waiver and the Crime-Fraud Exception in the Context of a Kovel Arrangement
Privileges are fragile. Still, courts recognize the policy reasons behind their existence and endeavor to protect the right to have candid communications with counsel and other advisers. An October 2018 decision, United States v. Adams,35 demonstrates how one court approached the privilege analysis in the context of a Kovel arrangement where the government sought communications and documents reflecting legal advice and analysis created after the controversy at issue had begun.
In Adams, the defendant faced multiple counts of embezzlement, fraud and tax evasion.36 In response, Adams, under advice of counsel and with the aid of a Kovel accountant, filed amended tax returns.37 Prior to filing the amended returns, the government had sought a range of communications among Adams, his attorneys and his accountants, but Adams asserted that they were privileged and refused to provide them to the government.38 The government argued that the filing of the amended returns waived any applicable privileges or protections of documents containing information used in preparing the amended returns.39 Further, the government argued that the crime-fraud exception to attorney-client privilege would apply, permitting discovery of the communications.40 In its decision, the court rejected both privilege challenges.
In analyzing the waiver argument, the court reviewed the information on the amended returns and held that the attorney-client privilege and work-product doctrine still protected the information, advice and data that was “unpublished” on the returns, but utilized in their preparation.41 Because the information in the documents that the government sought was not revealed on the amended tax returns, the privilege was not waived.42
The court also held that the government had failed to meet the threshold to invoke the crime-fraud exception.43 Specifically, after an in camera review of the documents at issue, the court held that the government did not establish that the advice that Adams sought from his lawyer or Kovel accountants was itself obtained in furtherance of a crime or fraud.44
When considering privilege in the tax context, it is important to keep in mind the following suggestions:
- Waiver rules are complicated. When in doubt, clients should not share confidential or privileged information without first obtaining legal advice regarding the implications of doing so.
- Consider privilege and work-product issues early in transactional and litigation contexts. Establishing — and following — proper confidentiality protocols can avoid potential waiver and future litigation expenses.
- While communications between a client and his accountant are privileged in the civil setting, they are not in a criminal setting.
- Kovel arrangements between attorneys and accountants should be properly documented and all formalities in implementing them must be respected.
- If third parties share a common legal interest and anticipate sharing otherwise privileged materials, the common legal interest and the obligation to keep any shared information confidential should be documented in a common interest agreement. The shared interest must be legal in nature, and not purely commercial.
- When disclosing privileged documents pursuant to a common interest agreement, disclose only the privileged documents that are directly related to the shared legal interest, and only with counsel’s approval.
1 United States v. Sanmina Corp. & Subsidiaries , 2015 US Dist LEXIS 66123, 115 A.F.T.R.2d (RIA) 1882 (ND Cal May 20, 2015, No. 5:15-cv-00092-PSG), 2018 WL 4827346, at *1 (N.D. Cal. Oct. 4, 2018), appeal docketed, No. 18-17036 (9th Cir. October 19, 2018).
2 Sanmina, 2018 WL 4827346, at *1.
6 Id. at *2-3.
7 Id. at *3-4.
8 United States v. Sanmina Corp., No. 18-17036 (9th Cir. October 19, 2018).
9 In United States v. Kovel , an accountant employed by the law firm representing the target of an investigation was subpoenaed to appear before the grand jury investigating the target. 296 F.2d 918, 919 (2d Cir. 1961). When the accountant refused to answer questions, he was held in contempt and sentenced to a year in prison. Id. at 919–20. On appeal, the U.S. Court of Appeals for the Second Circuit reversed the conviction, holding that attorney-client communications did not lose their privileged nature by virtue of having been shared with the accountant. Id. at 921–22. Rather, the court analogized the accountant’s role to that of an interpreter facilitating communications between an attorney and a non-English speaking client and found the accountant “necessary, or at least highly useful, for the effective consultation between the client and the lawyer which the privilege is designed to permit.” Id. at 921.
10 Id. at 922.
11 See Schaeffler v. United States , 806 F.3d 34, 40 (2d Cir. 2015) (“A party that shares otherwise privileged communications with an outsider is deemed to waive the privilege by disabling itself from claiming that the communications were intended to be confidential.”); see also United States v. Rockwell International , 897 F.2d 1255, 1265 (3d Cir. 1990) (“The attorney-client privilege does not apply to communications that are intended to be disclosed to third parties or that in fact are so disclosed.”).
12 See Schaeffler, 806 F.3d at 40 (citing United States v. Schwimmer , 892 F.2d 237, 243 (2d Cir. 1989)); Katz v. AT&T Corp. , 191 F.R.D. 433, 436 (E.D. Pa. 2000) (“The common interest doctrine is an exception to the general rule that the attorney-client privilege is waived upon disclosure of privileged information with a third party.”).
13 See Schaeffler, 806 F.3d at 40 (citing Schwimmer, 892 F.2d at 243).
14 Id. at 38 n.2.
15 Schaeffler v. United States, 806 F.3d 34 (2d Cir. 2015).
16 Id. at 37.
18 Id. at 37.
19 Id. at 37-38.
20 Id. at 38-39.
21 Id. at 40-41.
22 Id. at 45.
23 Id. at 41.
24 Id. at 42.
25 Id. (citing Schwimmer, 892 F.2d at 243).
26 Id. at 41.
27 Id. at 44.
29 Id. at 45 (citing United States v. Adlman , 134 F.3d 1194, 1200 (2d Cir.1998)) (citations omitted).
30 See e.g., Triple Five of Minnesota v. Simon , 213 F.R.D. 324, 327 (D. Minn. 2002), aff'd, No. Civ. 99-1894 (PAM)(JGL), 2002 WL 1303025 (D. Minn. June 6, 2002) (citing In re Grand Jury Investigation , 842 F.2d 1223, 1226 (11th Cir. 1987)) (“First, there must be a prima facie showing that the client was engaged in criminal or fraudulent conduct when he sought the advice of counsel, that he was planning such conduct when he sought the advice of counsel, or that he committed a crime or fraud subsequent to receiving the benefit of counsel's advice. Second, there must be a showing that the attorney's assistance was obtained in furtherance of the criminal or fraudulent activity or was closely related to it.”)
31 United States v Issa , 2018 US Dist LEXIS 6041 (SDNY Jan. 8, 2018, No. 17-cr-00074 (CM)), 2018 WL 6518856, at *1 (S.D.N.Y. Nov. 28, 2018).
35 United States v Adams , 2018 US Dist LEXIS 184490 [D Minn Oct. 27, 2018, No. 0:17-cr-00064-DWF-KMM], 2018 WL 5311410, at *1 (D. Minn. Oct. 27, 2018), aff'd, 2018 WL 6446387 (D. Minn. Dec. 10, 2018). The magistrate judge in Adams also considered whether certain other documents unrelated to the Kovel arrangement were privileged.
36 Adams, 2018 WL 5311410 at *1.
37 Id. at *1-2.
38 Id. at *2.
40 Id. at *3-4.
41 Id. at *2.
43 Id. at *4-5.
44 Id. at *5. The opinion did not discuss the first factor — whether Adams was engaged in criminal or fraudulent conduct at the time he sought advice of counsel — in its analysis of the application of the crime-fraud exception.