United States: Curing Non-Compliance: Practical Factors to Consider in the United States - Part 2

Last Updated: November 13 2008
Article by Michael G. Pfeifer
This article is part of a series: Click Curing Non-Compliance: Practical Factors to Consider in the United States - Part 1 for the previous article.

B. Limitation on Tax-Related Communications

Although tax engagements and tax-related communications between attorneys and clients are generally protected by the same set of privileges as communications between attorneys and clients generally, no privilege extends to protect communications related to the preparation of a client's tax return by an attorney. The general rule is that where a client transmits information so that it might be used to prepare his tax return, such transmission generally defeats any expectation of confidentiality. That is, the attorney-client privilege and work product privilege protect only those communications that are legal in nature, such as those made to enable the preparation of a brief or opinion letter, and generally do not extend to protect communications related to the preparation of a client's tax returns.52 Thus, for example, while advice relating to the tax consequences of a proposed transaction, when rendered by an attorney, is generally considered legal advice protected by the privileges, such information generally will not be protected from disclosure if it is ultimately used to prepare the client's tax return.53

In addition, there is no Common Law accountant's or tax preparer's confidentiality privilege similar to the attorney-client privilege or work product privilege.54 Indeed, the rationale for not extending these privileges to tax preparation work appears to be that, since there is no Common Law tax preparer's privilege, a taxpayer must not be permitted to hire an attorney to do the work that an accountant or the taxpayer himself normally would do, in order to obtain greater protection than a taxpayer who did not use an attorney as his tax preparer would be entitled to.55

This limitation on the application of the confidentiality privileges can pose a significant problem for clients with potential criminal tax exposure, since such clients often need both legal and accounting expertise to manage their risk. For example, in order to make a "voluntary disclosure," a client must properly report his or her liability on an amended or delinquent return, which would generally require a tax preparer's general and accounting expertise. One method of resolving this problem is by using a "Kovel agreement" to engage an independent accountant to perform the necessary tax preparation work.

C. Kovel Agreements

The Kovel agreement derives its name from the Second Circuit case of United States v. Kovel,56 the leading case that originally recognized the attorney-client privilege when an accountant is engaged to assist in providing legal services to a client. The basic premise of the Kovel arrangement is that the accountant so engaged is acting as an "agent" of the attorney for the purpose of assisting with the provision of legal advice and, therefore, information transmitted to the accountant must fall under the protection of the attorney-client privilege.57

Although oral agreement may be permitted by law, as a practical matter, practitioners should document a Kovel arrangement in writing, specifically defining the scope of the accounting services to be provided and responsibilities to be managed by the accountant or accounting firm in the engagement. An accountant or accounting firm engaged under the Kovel agreement is generally considered to work directly for the attorney as an independent contractor and is considered to work only indirectly for the client as part of the legal team rendering legal services to the attorney's client, even if the accountant's fees are paid directly by the client.

D. New Standards of Conduct for Tax Return Preparers

Effective generally for tax returns prepared after May 25, 2007, the Small Business and Work Opportunity Tax Act of 2007 (the "2007 Act"),58 amended several provisions of the Code to (i) extend the application of the income tax return preparer penalties to all tax return preparers, (ii) alter the standards of conduct which must be met by tax preparers to avoid imposition of penalties, and (iii) increase the applicable penalties. The Treasury Department and IRS intend to issue regulations to implement the changes under the 2007 Act and, on December 31, 2007, released Notice 2008-1359 to be used as interim guidance by tax return preparers.

Although the 2007 Act extends the return preparer penalties to preparers of all tax returns and not just to preparers of income tax returns, Notice 2008-13 clarifies that preparers of many information returns will not be subject to the new penalty provision unless they willfully understate tax or act in reckless or intentional disregard of the law. The Notice further explains the application of the new rules to specific returns—e.g., the preparer of a Form 1065 may be deemed to be the preparer of any of the partners' individual income tax returns (i.e., Form 1040), if the items on the partnership return constitute a substantial portion of each partner's income tax return.

Regarding the standard of a tax return preparer's conduct with respect to undisclosed positions on a tax return, the 2007 Act replaces the former "realistic possibility standard"60 with a requirement that the preparer have a reasonable belief that the tax treatment of the position would "more likely than not" be sustained on the merits.61 Where the taxpayer discloses the position on the tax return, the 2007 Act requires only a "reasonable basis"62 for the tax treatment of the position taken on the return63 Notice 2008-13 explains that preparers can generally rely on taxpayer representations in preparing returns and can also generally rely on representations of third parties, unless the preparer has reason to know they are incorrect.

Managing Potential Tax Exposure

A. Voluntary Disclosure

Clients with potential criminal tax exposure might be able to avoid criminal liability by making a so-called "voluntary disclosure." Criminal tax exposure arises when a taxpayer either has filed a fraudulent return (false as to the amount of tax reported or false as to some material item required to be disclosed on the return) or has failed to file a return timely. However, this is particularly problematic for a taxpayer who has knowingly (or, perhaps, even unknowingly) committed tax fraud in the past and now wants to become U.S. tax compliant. For such taxpayer, filing a timely current return alone, in order to come back into the "system," might raise questions regarding a prior failure to file. Further, filing an accurate current return might tend to identify omitted income or incorrect fact statements on prior returns.

The traditional method of commencing a voluntary disclosure, in order to avoid potential criminal liability, is to file an amended return or delinquent return (as appropriate) before the IRS or another Government agency has opened an inquiry regarding a taxpayer's prior returns (or lack thereof). Filing an amended or delinquent return does not undo the crime, and making a voluntary disclosure does not guarantee immunity from criminal prosecution. However, as a matter of internal practice, the IRS generally will give consideration to a taxpayer's voluntary disclosure, along with all other relevant factors, in determining whether criminal prosecution will be recommended for the taxpayer.64 In addition, given that the IRS has limited investigative resources, it obviously is in the Government's self-interest to encourage taxpayers who owe additional tax to file amended or delinquent returns. Accordingly, voluntary disclosure might be a viable option, with significantly less exposure for criminal liability, for taxpayers seeking to correct past mistakes.

All components of a voluntary disclosure must be truthful. A voluntary disclosure occurs when the communication is truthful, timely and complete, and when, in addition: (i) the taxpayer shows a willingness to cooperate (and does, in fact, cooperate) with the IRS in determining his correct tax liability, and (ii) the taxpayer makes good faith arrangements with the IRS to pay, in full, the tax, interest, and any penalties determined by the IRS to be applicable.65 Generally, in practice, no favorable consideration will be given to a partial voluntary disclosure that is followed by a claim of the Fifth Amendment, a refusal to cooperate in an audit, or a refusal to give financial information relevant to a claim of inability to pay.

A voluntary disclosure is considered timely when it is received by the IRS before the IRS has initiated or notified the taxpayer of a civil examination or criminal investigation and before the IRS has acquired information, either directly or from a third party, regarding the taxpayer's noncompliance.66 A noncompliant taxpayer should not overlook the possibility of making a voluntary disclosure merely because he no longer has the records from which to calculate his tax liability. What is required is a taxpayer's best estimates based on all available information, not precision. However, a taxpayer whose return contains "best estimates" rather than precise information should indicate on the face of the amended or delinquent return that the figures are the taxpayer's estimates and also include the methods used to calculate the estimates.

B. New Informer Rules

Although some individuals may consider it "offensive," the other side of the coin relative to voluntary disclosure is the IRS informer program. A taxpayer who knows or suspects that another taxpayer is not complying with the tax laws can report such activity to the IRS on Form 3949-A. Alternatively, a taxpayer can also send a letter to the IRS, providing identifying information regarding the taxpayer suspected of noncompliance (name, address and taxpayer identification number, if known), the years that might be involved and estimated dollar amounts of the any unreported income. The informer-taxpayer is not required to disclose his identity, which can, with the assistance of the IRS, generally be kept confidential.

Informer cases typically take several years to develop. While many, if not most, never lead to any action taken by the Government, due to, e.g., lack of any real basis for the claims or an inability to obtain necessary evidence (or even jurisdiction of the taxpayer), others may go to a grand jury and result in prosecution. The IRS may provide a reward for the information, ranging from 1% to 15% of the amount recovered by the IRS (but not more than $10 million).67 To make a claim for a reward, an informant must file Form 211, which asks the informant to provide an estimate of the potential tax liability, the pertinent facts in the case, and an explanation of how the informant obtained the information.68

In addition, in December 2006, the IRS created the "Whistleblower Office" to receive and process information that helps uncover tax cheating by employers and company officials and to provide appropriate rewards to "whistleblowers." The Whistleblower Office processes tips received from individuals who spot tax problems or suspicious activity in their workplace. To make a claim for a reward, a "whistleblower" must also file Form 211.69

A "whistleblower" may be eligible for a monetary award if the total amount in dispute (the tax, plus penalties, interest, additions to tax, and additional amounts) exceeds $2 million for any taxable year, if the taxpayer is a company; if the taxpayer is an individual, the individual's gross income must exceed $200,000 for any taxable year in question. Awards are generally paid in proportion to the value of information furnished. However, as a general matter, the amount of award will be at least 15%, but no more than 30%, of the collected proceeds in cases in which the IRS determines that the information submitted by the informant substantially contributed to the collection of tax. The award percentage may be reduced in some circumstances.70

Conclusion

There are numerous complex U.S. tax provisions potentially relevant to cross-border fact patterns that can give rise to "unforeseen circumstances" and challenging tax issues for unsuspecting (and occasionally not so unsuspecting) persons who are or may become U.S. taxpayers.  The possibilities for such problems are virtually limitless. Certainly, in trying to understand and resolve such issues, it is important that U.S. tax practitioners understand the nuances of the substantive tax provisions that apply.  At the same time, it is also important for them to recognize that taking remedial actions to try to bring a taxpayer back into compliance with U.S. tax rules inevitably involves more than just the substantive tax rules.  Close attention must also be paid to the equally numerous and complex procedural rules contained in the Code as well as to certain fundamental rules and principles of legal and professional practice.

Footnotes

52. See United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999); In re Grand Jury Subpoena Duces Tecum, 731 F.2d 1032, 1037 (2d Cir. 1984) (advice rendered by an attorney concerning the tax consequences of alternative employee compensation plans is considered legal advice); Matter of Federated Dep't Stores, Inc., 170 B.R. 331, 354 (S.D. Ohio 1994) (tax planning advice rendered by an attorney is legal advice); see also In the Matter of Grand Jury Proceedings, 220 F.3d 568, 571 (7th Cir. 2000).

53. See Frederick, 182 F.3d at 500.

54. However, note that section 7525, as enacted by the Restructuring and Reform Act of 1998 (Pub. L. No. 205-206), provides a limited confidentiality privilege to federally authorized tax practitioners (e.g., certified public accountants) with respect to tax advice in noncriminal tax matters ("section 7525 privilege"). The section 7525 privilege has significant limitations, including the limitation that it applies only to noncriminal tax matters before the IRS and the federal courts. In addition, the section 7525 privilege does not extend to written communications in connection with the promotion of the direct or indirect participation of all tax shelters, whether entered into by corporations, partnerships, individuals, tax- exempt entities and any other entities. § 7525(b).

55. See United States v. Arthur Young & Co., 465 U.S. 805, 817-19, 79 L. Ed. 2d 826, 104 S. Ct. 1495 (1984); Couch v. United States, 409 U.S. 322, 335, 34 L. Ed. 2d 548, 93 S. Ct. 611 (1973); United States v. Frederick, 182 F.3d 496, 500 (7th Cir. 1999), cert. denied, 145 L. Ed. 2d 1070, 120 S. Ct. 1157 (2000).

56. 296 F.2d 918, 922 (2d Cir. 1961).

57. ."What is vital to the privilege is that the communication be made in confidence for the purpose of obtaining legal advice from the lawyer." Kovel, 296 F.2d at 922; see also United States v. Brown, 478 F.2d 1038, 1040 (7th Cir. 1973).

58. Pub. L. No. 110-28.

59. 2008-3 I.R.B. 282 (Jan. 22, 2008).

60. In practice, the "realistic possibility" standard generally means that the tax position has at least a one-in-three chance of success if challenged by the IRS.

61. The "more likely than not" standard generally means that the return preparer believes, in good faith, that there is a greater than 50% likelihood that the tax treatment of an item will be upheld if challenged by the IRS. See Notice 2008-13.

62. The "reasonable basis" standard generally means that the tax position has at least a 25% chance of success if challenged by the IRS.

63. This is the same standard to which a taxpayer preparing his own return is held. Holding the taxpayer and return preparer to differing standards is problematic, and the Treasury Department is apparently investigating ways to eliminate the difference. It may well be that this can only be accomplished by further legislation.

64. IRM 9.5.11.9.

65. Id.

66. IRM 9.5.11.9.

67. § 7623(a) authorizes the IRS to pay such sums as are necessary to detect tax underpayments and bring persons guilty of violating the tax laws to trial. See IRS Publication 733, Rewards for Information Provided by Individuals to the Internal Revenue Service (Rev. Oct. 2004).

68. Form 211, Application for Reward for Original Information.

69. See id.

70. See generally § 7623(b).

This article is designed to give general information on the developments covered, not to serve as legal advice related to specific situations or as a legal opinion. Counsel should be consulted for legal advice.

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This article is part of a series: Click Curing Non-Compliance: Practical Factors to Consider in the United States - Part 1 for the previous article.
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