In a number of situations, a CPA handling a tax matter should immediately stop work and bring in tax litigation counsel. These “timeout” situations typically occur when the CPA is concerned that the matter will “go criminal,” the matter requires knowledge of the rules of civil discovery and evidence that apply to possible court proceedings, or the matter requires knowledge of nontax administrative law. The presence of these factors, as well as a few other factors, makes it unduly risky for a tax accountant to proceed without the participation of well-qualified tax litigation counsel. This article sets out a “timeout” list to assist in identifying these situations.
Timeout situation No. 1: Any time a client has failed to file tax returns or a FinCEN Form 114, Report of Foreign Bank and Financial Accounts (FBAR) (filed electronically), has willfully made false statements on a filed document, or has evaded tax, a tax accountant should call “timeout.” Willfully failing to file, making a false statement, and evading tax are criminal offenses, and no privilege protects an accountant’s conversations with a client in a criminal matter. CPAs need to end these conversations immediately so that no potentially incriminating testimony not protected by the attorney-client privilege is created.
A limited statutory privilege, under Sec. 7525, protects tax advice communications between a tax practitioner and a client. That privilege, known as the federally authorized tax practitioner or Sec. 7525 privilege, applies only in noncriminal tax matters before the IRS and in federal court. Notably, this privilege does not apply in state court. It also does not apply to any nontax proceeding, or to participation in a tax shelter as defined in Sec. 6662(d)(2)(C)(ii). Moreover, the privilege is recognized only if a privilege would obtain if an attorney were standing in the shoes of the CPA (or other “federally authorized tax practitioner”) making or receiving the communication.
Accordingly, CPAs should be careful not to communicate with a tax client in a matter that has the potential to “go criminal” or that might qualify as a tax shelter. Instead, tax litigation counsel should be brought in, so that conversations with the client are protected by the attorney-client privilege, which applies to some matters that are not protected by Sec. 7525.
Timeout situation No. 2: This situation is related to the first: A tax accountant should never respond to an IRS investigation on behalf of a client who is worried about criminal prosecution. The response may be incriminating, and that is bad enough. But it gets worse: A response can trigger an effort by the U.S. Department of Justice (DOJ) or the IRS to show that the response was a “subject matter waiver” of Fifth Amendment rights under the “sword and shield” doctrine. Under this doctrine, a litigant cannot claim a privilege for information he or she is using as part of a legal defense. The subject matter waiver is worrisome because determining what is within, and what is outside, the subject matter of the waiver is often uncertain and debatable. Moreover, interacting with a criminal investigator creates a risk that the interaction will subsequently be portrayed as part of a cover-up. It is commonplace that prosecutors prefer to prosecute cover-ups because cover-ups (or conspiracies) are often easier to prove than the underlying crime.
In this regard, a tax accountant should never engage with IRS special agents, because they are criminal investigators. A special agent’s involvement in the investigation signifies that the IRS is concerned that criminal activity may have taken place. A special agent is far different from a revenue agent, who is an IRS examiner, and from a revenue officer, who is an IRS debt collector. If a tax accountant gets even a whiff of a special agent’s involvement, the accountant should (1) have no further conversations with the client; and (2) call a tax lawyer with criminal tax experience. The same advice goes for involvement by an agent from a state revenue agency that is tasked with criminal enforcement.
Timeout situation No. 3: A tax accountant should never discuss a situation in which a corporate officer or employee has willfully not paid over employment taxes withheld from corporate employees and has participated in the diversion of this “trust fund” money. Usually, the diversion takes place with the thought that the money will soon be repaid, after the corporation’s finances improve. But an intent to later pay the money over to the IRS does not negate a willful and punishable diversion.
The IRS is vigorously pursuing criminal prosecution of these cases—even when the sums involved are relatively modest. In recent years, a trust fund penalty case in which the taxpayers diverted only about $160,000 was prosecuted criminally (see Department of Justice, Tax Division, Press Release 14-530 (May 19, 2014)). Larger amounts are even more likely to be addressed with a criminal indictment. CPAs should not speak with corporate officers or employees who have culpable involvement with a diversion of trust fund monies. The Sec. 7525 privilege does not protect those communications.
It is a serious mistake to allow an IRS revenue officer to interview the client. The setting is routine enough. A revenue officer shows up at the business’s premises, often unannounced, and says that he or she wants to discuss past-due employment taxes. The officer runs through a series of questions set out on a Form 4180, Report of Interview With Individual Relative to Trust Fund Recovery Penalty or Personal Liability for Excise Taxes, fills out the form, and then asks the person to sign. The questions on Form 4180 are designed to establish “willfulness,” which is necessary to impose a Sec. 6672 civil penalty, but facts that are sufficient to support imposing a civil penalty can also suffice to support a criminal charge. A taxpayer should not be permitted to participate in an interview unless it is clear that the taxpayer was not involved or lacked power or authority to divert the trust fund taxes. A criminal charge is a life-changing event.
Timeout situation No. 4: Tax litigation counsel usually should be brought in as soon as a summons is issued to a taxpayer. First, the similarities of a summons to civil discovery are obvious (although the IRS’s summons power reaches even more broadly). Second, if there are criminal overtones to the summons, very complicated issues involving the Fifth Amendment and a subject matter waiver may arise. Extreme care should be taken not to say, or fail to say, something that can later be portrayed as part of a cover-up. Even if there is no suggestion of criminal concerns, a summons typically signifies that the taxpayer’s response to an IRS information document request (IDR) was viewed as inadequate, implying a possible future interaction with the DOJ and the courts. Drafting responses to summonses, particularly when the matter has criminal overtones, is tricky business best left to tax litigation lawyers.
Timeout situation No. 5: Tax litigation counsel should be brought in early if a matter is being positioned for a civil refund suit, especially if large dollar amounts are involved. The most favorable venue for such a suit is usually federal district court, and the least favorable is usually Tax Court, with the Court of Federal Claims falling somewhere in the middle. It is up to legal counsel, not a CPA, to judge which is the most appropriate forum, each of which has its pros and cons. Moreover, strategy informs the choice of forum, and choice of strategy is also a decision for tax litigation counsel.
To go to the two more generally favorable forums, federal district court and Claims court, a timely and sufficient claim for refund is a prerequisite, along with full payment of the tax. A claim for refund, unless it is a “protective” claim, is required to set out facts and grounds “in detail.” But a claim should not be overly precise, as that runs the risk of precluding factual and legal arguments that were not anticipated. Nor should a nonprotective, regular claim be too vague, as that can run afoul of the “in detail” requirement of Regs. Sec. 301.6402-2(b). This is a tricky balancing act. Unless there is no time left in the statute-of-limitation period to file a claim, a tax litigator should be brought in to draft (regular) claims because they are likely to be under the microscope in court, where the IRS scrutinizes the refund claims in an attempt to find a “variance” that precludes a taxpayer from making a particular argument or from obtaining part of the amounts sought to be recovered.
When litigation is anticipated, legal duties exist that require preserving documents that may be relevant to the anticipated litigation, including electronic files and emails. Businesses are well-advised to circulate and observe a request to maintain documents in anticipation of litigation, commonly known as a “litigation hold.” Tax accountants may not be in the best position to make decisions about which documents should be preserved and how. Early involvement by tax litigation counsel is advisable when litigation is anticipated, as the downside of a document “spoliation” claim raised in court can be significant.
Relatedly, a prelitigation strategy sometimes includes filing a Freedom of Information Act (FOIA) request, which resembles a discovery demand. The sufficiency of a FOIA request frequently ends up being litigated in court. Tax litigation counsel should be involved in the decision whether to file a FOIA request and in drafting any FOIA request that is filed.
Timeout situation No. 6: If an expert witness who participated at the administrative level is to be relied upon again in court, the process of preparing the expert report is fraught with risk, and tax litigation counsel should participate, at least if enough tax dollars are at stake. The law governing the drafting of expert-witness reports has evolved. Currently, if the report was ghostwritten, a participating tax professional may be subject to sanctions, not to mention that the expert’s credibility is impaired. A tax professional working with the expert needs to take into account the discovery rules and the rules of evidence bearing upon the discovery of sensitive information exchanged between the client and the expert, and between the tax professional and the expert. Tax litigation counsel has a key role to play in handling experts expected to be used in litigation.
Timeout situation No. 7: If a taxpayer will be going to court to challenge the application of a regulation, tax litigation counsel should be brought in early. Over the last 18 months, Supreme Court jurisprudence addressing the validity of regulations has taken some positive turns for taxpayers. This helpful case law has arisen entirely in cases dealing with nontax administrative law (see, e.g., Environmental Protection Agency v. EME Homer City Generation, L.P., 134 S. Ct. 1584 (2014) (requiring an agency to reasonably explain a reversal of a regulatory position); City of Arlington v. Federal Communications Comm., 133 S. Ct. 1863 (2013) (instructing “rigor” and “seriousness” in determining whether a regulation is within the statutory authorization)). Most cases concerning the validity of, and weight to be given to, regulations and other agency guidance are not tax cases.
In early 2011, the Mayo Foundation case (562 U.S. 44 (2011)) made clear that the two-step Chevron test (Chevron U.S.A. Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984)) for determining whether a regulation is valid applies to almost all federal agencies, including the IRS and the Treasury Department. Probably, few tax accountants (and few tax lawyers as well) attempt to keep up with developments in nontax administrative law on the validity of regulations and other regulatory guidance. Tax accountants may not have the time to interpret and apply nontax administrative law. Accordingly, when a challenge to the application of regulatory guidance is anticipated, participation by tax litigation counsel familiar with current developments in administrative law is advisable.
Timeout situation No. 8: Tax litigation counsel should be brought in when a large-dollar matter is before IRS Appeals for possible settlement. Legal counsel’s presence makes the point to Appeals that the taxpayer would like to settle but is not reluctant to litigate. Bringing a tax litigator to the table demonstrates that the taxpayer is ready, willing, and able to litigate. Tax litigation counsel also provides a counterweight to the IRS’s tax litigators, who in recent years have been given a larger role during administrative proceedings. Indeed, the IRS attorney who litigates the case for the IRS in Tax Court will often have previously had a role at the administrative level.
Timeout situation No. 9: This situation seems obvious and should go without saying. Tax litigation counsel should be brought in when the validity of a transaction is under the IRS microscope, and the taxpayer relied on the accountant’s or attorney’s advice in structuring the transaction. A CPA or attorney should never put himself or herself in the position of defending a transaction when one defense to the penalty imposed for the transaction is the taxpayer’s reliance on that CPA’s or attorney’s professional advice.
Timeout situation No. 10: Tax litigation counsel should be brought in to advise on tax planning issues where the transaction under consideration is “close to the edge” or aggressive. Attorney-client privilege issues are tricky, and Sec. 7525 privilege issues are even trickier, especially with its broad carve-out for tax shelter advice. Tax litigators develop a sense for not only whether a structure works in technical tax terms but also for how the structure will play in front of a generalist judge or a jury. The ultimate test for whether a structure works is often in the eyes of the beholder. In the U.S. justice system, a jury often has the ultimate say—which should make planners who go too close to the edge with an aggressive structure think twice. An assessment of how a judge or jury might react to an aggressive structure is best left in the hands of an experienced tax litigator.
Role of the CPA and choosing counsel
Of course, that a “timeout” should be called does not imply that the accountant should have no role going forward. It simply means that the reins need to be turned over to someone with tax litigation experience. Often, a tax accountant is “deputized” under a so-called Kovel arrangement, which allows the preservation of the attorney-client privilege (under Kovel, 296 F.2d 918 (2d Cir. 1961)). In a Kovel arrangement, an accountant hired by a lawyer may be extended the attorney-client privilege where the accountant assists the attorney.
Obviously, many of the “timeout” situations are driven by concerns about the prospect of a criminal investigation or charge, by a need to understand the rules of civil discovery and evidence, or by a need to understand nontax administrative law. Accordingly, tax litigation counsel selected for these situations should preferably have (1) a substantial background in litigating and trying cases, preferably including criminal law experience; (2) a deep substantive background in tax law; and (3) a solid nontax administrative-law background. It is much less efficient, and probably more expensive, to have these functions performed by hiring a nontax litigator to assist a substantive tax lawyer who is not a litigator. Ideally, the desired attributes should be located in one well-qualified person.
Conclusion
There are times when it is perilous for a tax accountant to continue handling a tax matter. Some tax representation activities should be handled by well-qualified tax litigation counsel. It is extremely important for a tax accountant to spot the biggest perils quickly, so that regrettable, and sometimes irreversible, actions are not taken. The tips in this article can help practitioners detect these situations early.
Thomas D. Sykes (tsykes@gouldratner.com) is a partner at Gould & Ratner LLC in Chicago.
To comment on this article or to suggest an idea for another article, contact Sally P. Schreiber, senior editor, at sschreiber@aicpa.org or 919-402-4828.
AICPA RESOURCES
JofA articles
- “Tax Matters: Work Product Protection and Attorney-Client Privilege in an IRS Audit,” Feb. 2014, page 58
- “Are Courts Ready to Protect More Accountant-Client Communications?” Jan. 2014, page 36
- “Client Tax Fraud and the CPA,” Aug. 2011, page 24
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