Privilege meets transparency: can we practice safe tax?

In the most important aspects of our lives--those that affect our physical, emotional, spiritual, and legal well-being--we intuitively understand the need for strict confidentiality. When a patient seeks treatment from her physician, a penitent solicits guidance and forgiveness in the confessional, or a client requests legal advice from his attorney, the assurance that their communications are confidential enables them to obtain the meaningful help they seek.

There is, of course, a societal cost that must be paid for confidentiality. By shrouding these communications with secrecy, the law denies government agencies and private parties access to that information, even if it is relevant to an issue they may legitimately be pursuing. In such situations, however, society has made the value judgment that the benefits derived from those privileges outweigh the costs of denying others access to the information. The bedrock principle of confidentiality has served us enormously well over the years, despite its cost.

To quote Bob Dylan, the times are changing. In white collar investigations, the Department of Justice routinely insists that corporations and their executives waive claims of privileges as a condition to obtaining the purported benefits of "cooperation" and "acceptance of responsibility" for their actions. In the Valerie Plame-CIA leak investigation, news reporters fend off grand jury subpoenas for disclosure of their confidential sources and notes. Even in the usually lower profile world of civil litigation, claims of privilege often fair only slightly better.

That privilege has fallen out of favor in recent years may largely be a function of the exponentially increasing quantity and probative value of electronic communications. Powerfully revealing communications of the type that never before existed now remain accessible, despite usage of the delete key. The human propensity to express galactically stupid thoughts in writing, the technology to retrieve them, and the breathtakingly reckless (if not criminal) acts of corporate wrongdoing have combined to induce adversaries to seek production of enormous quantities of information in the hope that something may exist to prove their worst allegations.

The courts are now often inclined to accommodate these discovery efforts. For many judges, a claim of privilege poses an interesting intellectual proposition, but also one that should, at least in a close case, yield to the perceived greater good of access to information. With privilege under attack, two essential questions arise for corporate tax practitioners:

* Are there any meritorious claims of confidentiality available to a corporation (and its outside advisers), and

* If so, can the corporation continue to maintain them in the face of the ever increasing demands by government and shareholders for disclosure of potential tax liabilities?

In short, can claims of privilege endure in an increasingly transparent world?

Tax Advice Privileges

A. The Attorney-Client Privilege 

The attorney-client privilege protects communications between the client and the lawyer made for the purpose of enabling the lawyer to provide legal advice or other legal services to the client, as long as both of them intend for the communications to remain confidential and the purpose of the communication is not to further a crime or a fraud. United States v. BDO Sideman, LLP, 2005-1 USTC [paragraph] 50,264 (N.D. Ill. 2005); United States v. Evans, 113 F.3d 1457, 1461 (7th Cir. 1997). The "crime-fraud" exception to the privilege applies even if the lawyer is entirely unaware that the client's purpose in having seemingly innocuous legal work performed is to further a fraud scheme.

1. The Kovel Doctrine Expands the Privilege. If the taxpayer and her lawyer spoke different languages, they would surely require the assistance of a translator to make possible their communications and the lawyer's rendering of legal advice. Because the presence of the translator would be indispensable to the rendering of legal advice, the translator would be viewed as the client's or lawyer's agent to enable the giving of advice, and the translator's involvement would not destroy the claim of privilege.

In United States v. Kovel, 296 F.2d 918 (2d Cir. 1961), a law firm that employed an accountant on its own staff represented a taxpayer who was the target of a grand jury investigation focusing on whether he had committed various income tax offenses. To assist the firm in advising the taxpayer, the taxpayer communicated information to the in house accountant who, in turn, helped explain the client's business and tax reporting to a lawyer in the firm.

The government subpoenaed the law firm's files on the ground that the communications involving the accountant were not subject to the attorney-client privilege. The law firm responded that the use of the accountant was indistinguishable from the use of a foreign language interpreter because the tax and accounting concepts that the accountant communicated to the lawyer were every bit as "foreign" to the lawyer as a language that he did not speak.

The Second Circuit adopted the law firm's foreign language translator analogy and concluded that because the law firm's use of an accountant to assist it in understanding the content of the client's business and financial affairs fostered attorney-client communications and the giving of legal advice, the accountant's communications with both the lawyer and the taxpayer were privileged.

Crucial to Kovel's holding was the court's determination that the presence of the third party was essential to effective communication between the lawyer and the client. On the other hand, Kovel recognizes that if a lawyer or the client retains an accountant because the client needs accounting or tax return preparation services, neither the accounting work nor any communications between the accountant and the lawyer or between the accountant and the taxpayer are subject to the attorney client privilege.

The court in Kovel acknowledged the inherent difficulty in distinguishing between situations in which the lawyer needs the accountant to assist the lawyer in rendering legal advice to the taxpayer and other cases in which the lawyer or the client simply want to retain the accountant to perform accounting services unrelated to the rendering of legal advice. The court concluded, however, that no matter how elusive this distinction may be in a given case, drawing it is necessary in a system in which there is an attorney-client privilege, but no accountant-client privilege.

The distinction that Kovel drew between communications that merely inform the lawyer and those that enable the lawyer to communicate with the client was presented in the Second Circuit's decision in United States v. Ackert, 169 F.3d 136 (2d Cir. 1999). There, a tax lawyer's discussions with an investment banker, though essential to the lawyer's understanding of the proposed transaction and his giving of legal advice to the client, were not protected by the attorney-client privilege because the conversations between lawyer and investment banker did not directly enable the lawyer and the client to communicate with each other.

2. In-House Tax Department Advice. Suppose a corporation employs lawyers in its tax department to work with its other tax professionals in performing the company's tax compliance and reporting functions. If the tax lawyers give tax advice to the company to enable the company to comply with the tax law, is that advice subject to claims of attorney-client privilege? Under the existing case law, the presumption is that the advice is not privileged because it is considered "business advice" or "accountant's work" and not legal advice. United States v. Chevron Corp., 1996-1 USTC [paragraph] 50,201 (N.D. Cal. 1996); United States v. KPMG, LLP, 237 F. Supp.2d 35 (D. D.C. 2002).

The courts presume that in-house tax lawyers who are not working in the office of the general counsel and who do not therefore provide a broad range of legal advice to the company are likely providing only non-legal business advice. That presumption applies unless the corporations can establish that the advice given by the in-house tax department lawyer is the equivalent of what the company would have obtained had the same lawyer been serving in its general counsel's office or as a member of the company's outside law firm. The opposite presumption applies if the advice is given by an outside law firm or the company's general counsel's office.

3. Tax Return Preparation Advice. What if the advice, even if obtained from outside counsel, relates directly to the preparation and filing of the company's return? The case law holds that advice from a lawyer for the purpose of tax return preparation is not "legal advice" because such could have been provided by an accountant and does not require the work of a lawyer. Accordingly, if the advice relates to the preparation of a tax return, the communication is not privileged. United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999); United States v. Randall, 1999-1 USTC [paragraph] 50,596 (D. Mass. 1999); United States v. KPMG, LLP, 237 F. Supp.2d 35 (D.D.C. 2002).

There is much to criticize in that conclusion, particularly as reached and expressed in Frederick, the case that other courts cite for the proposition that the tax return preparation function does not involve the rendering of "legal advice." For those who practice tax law in a sophisticated, high-stakes corporate setting, the preparation of a tax return is hardly the equivalent of the rote transposition of numbers from a workpaper onto a tax return. On the contrary, tax return preparation considerations require a deep understanding of the tax law, an understanding of how that law may permit or require the company to characterize a particular transaction, how the IRS may respond to that characterization, and how a court might rule in the event of a dispute.

This reporting and compliance function requires not only a technical knowledge of the law, but also an understanding of the range of potential factors that may affect the ultimate characterization and treatment of a disputed issue. In reality and substance, it is no different, say, from a company's seeking legal advice regarding its disclosure obligations under the securities laws or any other reporting function. Unless and until a litigant can fully explain to a court what knowledge and judgments are involved in tax compliance work, however, the judicial conception of that function is unlikely to change.

Left unaddressed in the existing case law, moreover, is the exact scope and meaning of "tax return preparation" work. First, it is unclear whether that concept applies to tax law analyses rendered before the preparation of the return. For example, suppose that the company obtains an opinion from an outside tax lawyer analyzing the possible reporting positions for a particular transaction. Counsel recommends that the company reject various possible characterizations of the transaction and adopt the characterization that he concludes is the most appropriate. The company then reports the transactions as counsel has advised.

Is the lawyer's analysis privileged because it is "legal advice" or is it not privileged because it is "tax return preparation" advice? If the courts treat the analysis as falling within the "tax return preparation" rubric, the communication of that advice would not be privileged. The question would then arise whether any tax law advice would ever be privileged, given that all such advice is arguably tax return preparation-related to some degree. In light of the existing case law, a corporation seeking to maximize claims of attorney-client privilege, should, when seeking advice from its outside tax counsel or accountants, pose its request in terms that are not directly tied to the preparation of its return.

4. The Doctrine of Waiver. Because the need for confidentiality is the basis for the privilege, the presence of a third-party who is not a lawyer or a client during those communications may, as a threshold matter, negate the existence of the privilege. Similarly, the lawyer's or client's subsequent disclosure of a privileged communication to a third party can destroy the privilege not only with regard to the party to whom it is disclosed, but with regard to all other parties who may later demand production of it in another proceeding.

If, for example, the client or the lawyer knowingly discloses the legal advice to the SEC, that disclosure will likely constitute a waiver of the privilege when another party demands production of it. United States v. Massachusetts Institute of Technology, 129 F.3d 681 (D. Mass. 1997). (Only in the Eighth Circuit is a disclosure of privileged information to a government agency not a general waiver of the privilege with regard to non-governmental parties seeking what the company has disclosed to that agency. Diversified Industries v. Meredith, 572 F.2d 596, 611 (8th Cir. 1978).)

If the company has intentionally waived the privilege by producing confidential information to a third person, the further question arises regarding the scope of that waiver. Does the waiver apply only to the document or item of information disclosed or to the entire subject matter of the disclosure? A company may well decide that it can part with a particular memorandum discussing a specific tax issue, but its disclosure of that memorandum may result in it waiving all claims of privilege with regard to all communications concerning that issue. This question of a limited waiver versus a complete subject matter waiver turns on a facts-and-circumstances analysis and merits careful consideration before the company decides to turn over privileged information of any kind to anyone.

Where the communication of privileged information is unintentional, however, as may occur when a law firm produces tens of thousands of pages of its clients' documents to the government and inadvertently discloses some letter or memorandum that it did not intend to produce, the privilege may not be lost. In the case of inadvertent disclosures, most courts will apply a facts-and-circumstances test. If the court finds that the disclosure was inadvertent and that the company and its lawyers were diligent in attempting to prevent disclosure of privileged material even though the material was disclosed to an adverse party, the court is likely to treat the disclosure as inadvertent and preclude the adverse party or others from using it.

B. The Courts Eviscerate the Section 7525 Tax Advice Privilege

Section 7525 of the Internal Revenue Code created, as of July 22, 1998, an apparent privilege for tax advice rendered by a non-lawyer tax professional to a client. The purpose of section 7525 was to protect tax advice from disclosure to the government whether it was rendered to a taxpayer by a lawyer or an accountant.

The scope of that statutory privilege was, however, effectively limited by the Seventh Circuit's decision in Frederick. There, an individual retained a lawyer to advise him in connection with a government investigation regarding the taxpayer's previously-filed tax returns. Because the lawyer was also an accountant, the taxpayer further retained him to prepare a tax return that was about to become due. The lawyer and the taxpayer communicated with each other not only regarding the facts underlying the past tax years for which the client was being investigated, but also about financial information necessary to prepare the soon-to-be-filed return. The lawyer's notes and files contained statements and communications that blended discussions of both the tax investigation and tax return preparation work, possibly because the problems created by the past year returns were likely repeated or carried forward to current and future year returns.

The government sought production of the lawyer's notes and files on the theory that (1) his work in preparing the return was not privileged because it was non-lawyer "accounting work" and not "legal advice," and (2) the lawyer's performing non-privileged accounting work destroyed any claim of privilege relating to documents and communications that referred to both the criminal investigation and the tax return preparation.

The Seventh Circuit agreed with the government, holding that (1) the preparation of a tax return is traditional "accounting work" and not the providing of legal advice; (2) communications between a lawyer and a taxpayer relating to the preparation of an as-yet unfiled tax return are not privileged because the lawyer is then functioning as an accountant and not as a lawyer (on the ground that tax return preparation is not "lawyer's work"); (3) communications between the lawyer and the client that touched on matters relating to both the tax return preparation and the ongoing investigation had a "dual purpose," only one of which was privileged; and (4) the non-privileged purpose of the communication contaminated the otherwise privileged nature of the same communication.

The court reasoned that the section 7525 privilege could apply only in those cases in which the advice, if given by a lawyer, would be protected by the attorney-client privilege. Because it concluded that a lawyer does not render "legal advice" when the work involves the preparation of a tax return, the Seventh Circuit held that tax preparation advice is not protected when an accountant provides it. Concluding that the purpose of the statutory provision was to put lawyers and accountants on the same footing in rendering tax advice and services and that a lawyer's assistance in preparing a tax return was not legal advice, the court held that the privilege could not apply when an accountant provide the same type of tax advice.

In a gratuitous and potentially more harmful observation, Frederick characterized "accountant's work" as including the representation of a taxpayer during an IRS appeals process. Accordingly, the government may someday consider going after lawyer and tax accountant communications with their clients relating to protests and appeals office representation. As it did in respect of tax return preparation advice, Frederick demonstrates a profound misconception regarding the legal advice component of agency-level tax disputes. Nonetheless, the decision remains a cornerstone of current case law addressing privilege claims in these areas.

Frederick involved communications relating to the preparation and filing of the taxpayer's original return. What if, however, the issue is not the preparation of the original return, but instead the decision whether to prepare and file an amended return? Assume that a corporation that is concerned about the accuracy of its original returns retains a lawyer to advise it whether to amend that return or, instead, to hunker down and hope that the IRS remains blissfully ignorant of the under-reporting. Unlike the filing of an original return, there is no statutory obligation to amend a previously filed return. The decision to file an amended return in such circumstances is uniquely a judgmental one that a lawyer should make only after taking account of all relevant information, including what an amended return might reveal and how much trouble its filing might create for the client.

Does Frederick enable the government to summons or subpoena the accountant who prepared an actual or proposed amended return that a lawyer had engaged the accountant to prepare to enable the lawyer to advise the taxpayer whether to file an amended return or do nothing? Does it matter whether the amended return is actually filed or whether the lawyer decides not to file it? Frederick raises but does not answer these questions.

Frederick's contention that a "dual purpose" communication is completely unprivileged may not apply if the taxpayer can show that the communication is severable, in whole or in part, between its privileged and non-privileged subject matters. The full range of problems with and issues raised by Frederick aside, other courts have embraced it. United States v. KPMG, LLP, 316 F. Supp.2d 30, 34 (D.C.D.C. 2004). Moreover, the section 7525 privilege, by its express terms, does not create a work-product privilege for the accountant or apply to any proceeding involving a marketed tax shelter or a criminal investigation or prosecution. John Doe v. Wachovia Corporation, 268 F. Supp.2d 627,636-37(W. D.N.C. 2003). As currently interpreted, section 7525 offers little comfort to taxpayers.

C. The Work-Product Privilege

The work-product privilege creates a zone of confidentiality in which parties and their lawyers can communicate regarding anticipated litigation and prepare for litigation and trial without concern that the adverse party can gain access to their analyses and strategies. Hickman v. Taylor, 329 U.S. 495 (1947).

The work-product privilege protects two different types of information in differing ways. With regard to so-called factual work product (e.g., a lawyer's notes of what a witness told her during an interview), the law affords the lawyer and the client a qualified privilege to protect that information, and imposes upon a party seeking to obtain it the burden of showing some compelling need for the information. Thus, if one party has notes of an interview of a witness who is now deceased, the other party may be able to obtain access to them because it does not have the opportunity to interview or examine that person.

In contrast to such factual work product, opinion work product is the type that reflects a lawyer's opinions, conclusions, mental impressions, or trial strategies. As to opinion work-product, the law accords a near absolute privilege. United States v. Adlman, 134 F.3d 1194, 1203 (2d Cir. 1998). Indeed, it is difficult to conjure a case in which an adverse party could gain access to the thought processes of the other side's litigation counsel.

In tax practice, the most troublesome work-product issue is determining when material is prepared "in anticipation of litigation." Suppose, for example, that in connection with a corporation's consideration of a proposed business transaction, it studies the potential tax treatment of the deal before it decides whether to enter into it. In that case, its pre-closing consideration of the tax law may assess not only the possible tax treatment of the transaction, but also the chances that the IRS may later attack the desired tax treatment. Can the work-product privilege apply even at that early stage?

In Adlman, a corporation contemplating a reorganization retained an accounting firm to study the possible tax consequences of the proposed transaction that might result in a claim for refund of more than $200 million of tax. In support of its analysis, the accounting firm provided the corporation with a lengthy memorandum discussing a host of possible tax law consequences of the proposed reorganization. After the corporation executed the transaction and filed its claim for refund, the IRS sought production of the memorandum because neither the president of the corporation nor the accountant were practicing lawyers and the communication could not have been protected by the attorney-client privilege.

The Second Circuit held that, although there was no available attorney-client privilege, the memorandum might be privileged as work-product if it had been prepared "in anticipation of litigation," a phrase meaning that litigation is not merely possible or foreseeable, but most likely certain. The appeals court recognized that the preparation of the memorandum could have been "in anticipation of litigation," given that the claim for refund amount was so great that the denial of the claim and the need to commence a refund suit were essentially moral certainties. The Second Circuit concluded that the accountant's memorandum might have been prepared "in anticipation of litigation," even though, at the time that it had been prepared, the reorganization had not yet been consummated, no claim for refund had yet been filed, and any litigation would not commence until years later. (Had the taxpayer retained a lawyer to advise it on the possible tax consequences of the proposed reorganization and had that lawyer, in turn, retained the accounting firm to provide the memorandum to him, the attorney-client privilege might have protected the memorandum; the failure to do so reduced the taxpayer to a work-product claim that the district court later rejected after the Second Circuit remanded the case to it for findings on whether that privilege did apply.)

D. The Common Interest Privilege

A privilege that taxpayers ignore all too often is the common interest (or "joint defense") privilege that permits persons with the same or highly similar interests to establish confidentiality for their communications with each other. Under the common interest doctrine, two or more taxpayers having the same or similar unagreed tax issue can join together to share information, legal research, settlement or trial strategies, and expert witness opinions with one another in confidence, even if they are at differing stages of the dispute and are in different industries. United States v. United Technologies Corp., 979 F. Supp. 108,110 (D. Conn. 1997).

Under a common interest arrangement, the privilege applies not only to a taxpayer's communications with its own lawyer, but also to the taxpayer's and its counsel's communications with the other taxpayer and its counsel. For taxpayers who are used to the divide-and-conquer approach that the IRS sometimes practices, combining resources and thinking with other similarly situated taxpayers can be a powerful balancing tool.

E. The Settlement Offer "Privilege"

Rule 408 of the Federal Rules of Evidence makes inadmissible at trial any offers to settle the dispute. As interpreted, it also excludes from evidence communications that are related to the making of a settlement offer. While the Rule does not speak in terms of a "privilege" that precludes settlement materials from being discovered, addressing the issue only in terms of what is inadmissible in evidence at trial, courts have nonetheless recognized the need for confidentiality in the formulation and consideration of settlement offers. Accordingly, courts have been extremely protective of settlement-related communications because they realize the inherent unfairness of allowing a party access to its adversary's risk analysis of the case that underlies most settlement offers.

The Government's "Deliberative Process" Privilege

Either in a Freedom of Information Act request or during discovery in litigation, a taxpayer may request the production of IRS or Treasury Department documents relating either to the facts and theories that the government is asserting in connection with the taxpayer's own case or to the government's general consideration of the particular tax issue in question. In response to that request, the government may assert the deliberative process privilege that qualifiedly protects the opinions, conclusions, recommendations, and mental impressions of government agents from disclosure. Tax Analysts v. Internal Revenue Service, 294 F.3d 71 (D.C. Cir. 2002)

The privilege, however, protects only "pre-decisional" materials of the type that are prepared and communicated from a subordinate to a superior before the IRS asserts its audit position. Once the agency has formulated its opinions and conclusions, any subsequent communications or documents are "post-decisional" and are not subject to production unless they contain material that is subject to some other privilege, for example, the attorney-client or work-product privilege.

Even if the document is "pre-decisional" and subject to the privilege, however, the government is obligated to produce those portions of the documents that do not contain protected opinions, conclusions, recommendations, and mental impressions. Accordingly, it should redact only the privileged material and produce the factual statement content of any document containing privileged information. When the government interprets the scope of the privilege in an over-exuberant manner and declines to produce factual statements contained in government memoranda and reports, the taxpayer should not hesitate to challenge the claim of privilege.

Maintaining Privilege for "Uncertain Tax Positions"

Suppose a corporation that is locked in a significant tax dispute with the IRS or the Department of Justice has unassailable claims of privilege for its legal analyses regarding the merits of its case. Are there any considerations that can nonetheless jeopardize or effectively negate its ability to maintain to those claims? The answer, particularly in light of the Financial Accounting Standards Board's recent revision to the reporting of "uncertain tax positions," is in the affirmative. Under Financial Accounting Standard No. 109, effective as of 2007, a public company will be required to create a tax liability reserve on its financial statements, unless it concludes that it is "more likely than not" to prevail.

Under existing accounting standards, the question of whether a company has to reserve for disputed tax issues is governed by the "loss contingency" principles of Financial Accounting Standard No. 5 that requires a company to establish a reserve on its financial statements only if it is "probable"--to an 80-90 percent degree of likelihood--that it will lose the issue. Under FAS 109's "more likely than not" standard, however, the company must now reserve for an uncertain tax position, unless it concludes that it is at least 51 percent likely that it will win. To reach that conclusion, the company and its auditors will now have to predict not only the likely outcome of ongoing or future IRS examination proceedings, but also that of any unagreed disputes that may be litigated.

A. The Corporation's Dilemma

A company's financial statements are, of course, its own. In the first instance, it must make the determination regarding the need to establish a reserve on its financial statements for a disputed tax position. The issue then arises regarding the basis on which the company can make its judgment. It will, of course, naturally turn to its outside tax dispute counsel or in-house general counsel's office to solicit an opinion regarding the likely hazards, risks, and possible outcomes. The question then becomes whether those lawyers can reach a reasoned judgment about the likely outcome of a dispute that may not be resolved, by settlement or litigation, for several years. Can counsel reasonably and fairly handicap the odds of a given dispute and, if requested, will they agree to offer any such opinion?

The problem is, of course, that predicting the outcome of a dispute with the government or the judgment that a court or jury may reach may be inherently impossible. If lawyers could predict the outcome of disputes that were not either clear winners or clear losers, few of them would waste their time practicing law. They would, instead, become trial consultants or gamblers. Lawyers do, indeed, routinely weigh the relative merits of the claims and defenses relevant to a dispute, but that is a far cry from attempting to predict the outcome to a degree of certainty necessary to satisfy a "more likely than not" standard. Lawyers will typically refrain from such prognosticating because they cannot know what facts the court or jury will accept as proven, what witnesses will be found credible, what legal doctrines will be applied, and how the law will be applied to facts in dispute. For such reasons, few lawyers will hazard a guess as to the likely outcome, least of all when the issue is whether a public company should create a reserve on its financial statements for investor and SEC consumption.

Nonetheless, the company has to make a decision based upon its own assessments and whatever it can wring out of its counsel regarding the merits of the case. What happens next if it decides that it need not create a reserve because it remains convinced that its "more likely than not" position is correct?

B. The Auditor's Dilemma

The auditors, of course, cannot simply accept the company's decision on the reserve issue, and must exercise their own judgment and due diligence regarding the likely outcome. The auditors may lack in-depth knowledge of the dispute and be unaware of the factors upon which the company and its counsel have been focusing. Nonetheless, they are now charged with forming an opinion regarding the likely outcome of the dispute.

In an effort to become educated, the auditors will undoubtedly want access to the company's litigation analyses, including those of its outside trial counsel. (Indeed, an extant AICPA auditing standard--AU Section 9326 (April 2003)--essentially requires those opinions.) Those analyses, after all, will contain the most detailed and candid discussions of the case and the likely pros and cons of the company's position. If the auditors seek access to that type of analysis, however, the company faces the question whether to waive the privilege by giving the information to the auditors. Both the Department of Justice and the IRS have already made clear their intentions to go after these analyses if the company produces them to the auditors. In public comments, a Tax Division representative has stated that "[i]f management is relying on an opinion for some part of its analysis for the reserve, that becomes part of what the auditors will insist on seeing ... They should not expect confidentiality for opinions that become part of the tax reserve file." See BNA Daily Tax Report, May 9, 2006, at G-7.

Given the government's stated intention to go after these legal analyses, the question arises whether cautious litigation counsel will ever want to render any kind of candid opinion, knowing that the government might eventually gain access to it and use the lawyer's own analysis against the company. If the government insists upon treating these materials as producible (assuming the auditors have gained access to them), the purposes for which such analyses are written will be undermined. Moreover, knowing that the government will go after these analyses, no lawyer will likely advise the company to produce it to the auditors, particularly if the dispute is at a sensitive point, such as in litigation.

On the other hand, the company's refusal to provide the analysis may induce the auditors to insist upon the establishment of the reserve. If they do so, however, they face potential liability to the company's current shareholders because the reserve may well impair their investment. First, if the auditors believe a reserve is then needed, the question may arise why they did not reach that conclusion before some class of shareholders purchased their shares. Moreover, if the dispute is later resolved in the company's favor, that outcome may pose liability for the auditors on the ground that they erroneously insisted upon the establishment of the reserve. In short, the decision to require or not require a reserve poses potential liability for any auditor who, in hindsight, guesses incorrectly regarding the likely outcome of the dispute.

C. The Lawyer's Dilemma

Suppose that the company decides that it wants to provide the auditors with the benefit of its counsel's analysis, and it directs its lawyers to provide their written evaluations of the dispute to the auditors and also to meet with them to discuss the case. Can counsel honor that direction without reservations or concerns?

The current ABA/AICPA "treaty" on lawyer's responses to auditor's requests for dispute-related information precludes the lawyer from rendering an opinion to an auditor regarding the likely outcome of a dispute unless the lawyer concludes that the outcome of the dispute is either a "probable" winner or loser, with "probable" meaning an 80-90 percent likelihood. In short, lawyers are directed not to quantify the chances of winning or losing the vast majority of tax controversies that fall within the range most problematic in applying FAS 109's "more likely than not" standard. Litigation counsel is directed not to opine on precisely the issue that FAS 109 seemingly assumes counsel can and will opine.

Counsel's decision to communicate with the auditors regarding the merits of the dispute may also expose the lawyer to potential shareholder or SEC liability if the auditors rely, as they would, upon that analysis in resolving the reserve issue. The lawyer may sincerely believe in the company's case and provide the auditors with a convincing argument upon which they rely in deciding that a reserve for the potential liability is not merited. If the case is later tried and lost or if it is later settled unfavorably, action against the company, its auditors, and its counsel by disgruntled shareholders or an unhappy SEC is not hard to envision. Knowingly stepping into waters that are so shark-infested may also compromise the lawyer's errors and omissions coverage, particularly if it is a breach of professional responsibility to attempt any predicting of the outcome of the case for an auditor.

Aside from convincing the FASB that FAS 109 is unworkable, there is no universal solution to this tax liability reserve dilemma for a company and its advisers. As a threshold matter, the company and its advisers will need, in each instance in which the desire for privilege conflicts with the demands for disclosure, to weigh how insistent the auditors are for the information, whether there are ways of satisfying the auditors' needs with information that is not privileged, how material the tax issue is to the company's financial condition, how the company weighs the risks of having the government gain access to the information if it is given to the auditors, and how the company's tax professionals and management can responsibly assist the auditors. In the process, privileges may go out the window, and the corporation and its outside professionals may be sued for what they decided to do or decided not to do, all in the name of greater transparency.

The policy reasons driving the need for privilege are no less real in a post-Enron world than they were when the legal system embraced them. Nonetheless, the current insistence of Congress, the SEC, and the FASB for greater degrees of disclosure are not only altering the adversarial relationship between the company and the government during a tax dispute, but also fundamentally changing the company's relationships with its own auditors and lawyers. Unlike any time in the past, accountants and lawyers now find themselves advising their corporate clients not only with a view toward the client's potential liabilities and best interests, but also with a view toward their own. This conflict-laden environment may preclude the ability of all concerned to act in the sole best interests of company, preserve the client's privileges, and sleep soundly at night. While maintaining confidentiality and privilege have their costs, the impulse toward ever greater degrees of transparency may prove even more costly in the long run.

STEVEN Z. KAPLAN is a shareholder in the firm of Fredrikson & Byron, P.A. in Minneapolis, where he practices in the areas of tax litigation, business litigation, and regulatory agency defense. He is a graduate of Bowdoin College and the University of Chicago Law School and a former trial attorney with the Department of Justice Tax Division.