Frederick complicates tax practitioner privilege.

Sec. 7525 extends, with some significant exceptions, the common-law protections of confidentiality that apply to communications between a taxpayer and an attorney to communications between a taxpayer and any Federally authorized tax practitioner (FATP). Sec. 7525 does not modify the attorney-client privilege but, in effect, extends it to Federal tax advice given by authorized tax practitioners, if such communications would benefit from the attorney-client privilege when the advice is given by an attorney.

Sec. 7525's application is not as broad as the attorney-client privilege and is available only in noncriminal proceedings before the IRS or in noncriminal proceedings in Federal courts in which the Service is a party. This means, for example, that the Sec. 7525 privilege is not available to a taxpayer to contest disclosure of information sought in investigations by other Federal agencies (such as the Securities and Exchange Commission) or by state taxing authorities. Also, the Sec. 7525 privilege does not apply to written communications between an FATP and a corporation in connection with the promotion of a corporation's direct or indirect participation in any tax shelter.

Essentially, the same elements necessary to establish and maintain the attorney-client privilege must exist for the Sec. 7525 privilege to apply. Therefore, cases interpreting the application of the attorney-client privilege are central in determining the probable application of the Sec. 7525 privilege. One such case is Frederick, 7th Cir. 1999, the first appellate court opinion to discuss the Sec. 7525 privilege. In Frederick, the Seventh Circuit affirmed a district court's holding that neither the attorney-client privilege nor the work-product doctrine protected certain documents a lawyer-accountant created while preparing his client's tax returns.

Frederick

The taxpayers hired Frederick, an attorney and accountant, to provide legal representation and prepare their tax returns. During an investigation into the taxpayers' Federal income tax liabilities, the IRS issued a summons to Frederick for the production of certain documents and records. Frederick provided many of the records summoned; however, he refused to turn over all the summoned documents, asserting that some of the materials were protected by the attorney-client privilege or the work-product doctrine. The government subsequently instituted a summons enforcement action against Frederick in Federal district court, which ultimately decided that most of the summoned documents were not protected by either the attorney-client privilege or the work-product doctrine, and ordered him to produce the requested documents.

Frederick appealed the district court's order to the Seventh Circuit. The court began its analysis of whether the requested documents were protected under the privilege by stating the general rule that information a person furnishes to a return preparer for the purpose of preparing a tax return is not privileged. When a taxpayer transmits information to a return preparer for purposes of preparing the return, there is no reasonable expectation of confidentiality; the information will be disclosed to a third party, the Service. Thus, no privilege will attach to the communication. The Seventh Circuit, however, rejected the government's argument that none of the documents was protected, because they necessarily were provided to Frederick in his "tax preparation function" (rather than his "legal representation function"). The court also rejected the government's contention that communications with an attorney in numerical form can never be privileged.

The court also considered whether a so-called "dual-purpose" document (i.e., a document prepared for use in preparing a tax return and for use in litigation) can be protected from compelled disclosure. The court held that dual-purpose documents cannot be privileged (because of their relationship to the tax return).What constitutes a dual-purpose document was not addressed in detail by the court.

Finally, the court considered whether documents prepared in connection with a tax audit are privileged. It viewed the audit as "both a stage in the determination of tax liability, often leading to the submission of revised tax returns, and a possible antechamber to litigation." The court concluded, in effect, that tax-audit assistance was in the nature of accounting work and, therefore, not protected by the attorney-client privilege. The court reached this conclusion by observing that most audits are handled by taxpayers themselves or by accountants.

The original opinion in Frederick was troublesome to many tax practitioners, because it implied that the attorney-client privilege could not protect communications exchanged in the context of a taxpayer's audit. In an unusual move, the Seventh Circuit amended its opinion in an attempt to clarify some of the troublesome language contained in the original opinion regarding tax audits. Addressing the applicability of the attorney-client privilege in a tax audit; the court's amended opinion stated that, when a revenue agent is merely verifying the accuracy of a return, the audit representation is "accountant's work" (whether done by an accountant or by a lawyer) and is not privileged. The court then stated that, if the taxpayer's lawyer assists in the audit to deal with issues of statutory interpretation or case law raised by a revenue agent, the lawyer is doing "lawyer's work" and the attorney-client privilege may attach.

The implication of the Seventh Circuit's amended opinion is that substantiation or computational work performed by an attorney during an IRS examination will not be protected by the attorney-client privilege, but that the privilege may operate to protect legal analysis performed by an attorney during a Service examination. The Sec. 7525 privilege should likewise be expected to protect similar tax advice involving analysis of the law, as opposed to substantiation of numbers on a return, rendered by FATPs in connection with an IRS audit.

Although the Frederick opinion is binding only in the Seventh Circuit, it can be anticipated that the Service will use it as precedent, regardless of the taxpayer's location. Accordingly, practitioners should attempt to avoid creating dual-purpose documents that could be said to have been prepared for return preparation as well as for tax audit assistance purposes, litigation or other tax advice purposes.

FROM WILLIAM W. CIESAR, CPA, J.D., LL.M. CHICAGO, IL; JOHN KEENAN, J.D., WASHINGTON, DC, AND THOMAS M. CRYAN, CPA, J.D., WASHINGTON, DC